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A critique of the claim that passive investing is a bubble

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Re: A critique of the claim that passive investing is a bubble

#191

Post by dcolkitt »

hyperpape wrote: post #185
dcolkitt wrote: post #180

Earlier quoted context omitted.

No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock. Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to no…

I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active f…

That's an interesting point. While it's definitely true that any major unwind of that size will disrupt the market, there's some reasons to believe an ecosystem dominated by active investors would do better.

First as mentioned before, active investors have discretion. There's strong reason to believe that as the sell-off's happening that they'd move into the most dislocated stocks. That acts as kind of a negative feedback loop. It wouldn't stop a market-wide selloff, but would keep things more balanced between single-name stocks vis-a-vis the rigid rules governing passive index managers.

Second, by definition active funds are more differentiated from one another. Passive indexing produces a mono-culture with analogous ecological risks to what we see in nature. The typical active fund only holds about 50 positions at any given time. So, on the whole while active investors in aggregate hold 0.3% of their portfolios in Chubb, at an individual level most funds hold zero. And some minority may hold 1%, 5%, 10% or more of their assets in Chubb. So if one fund fails, that's less likely to spread contagion to every other fund in the universe.

In that type of unwind scenario, some funds will do pretty decently, and some funds will do horribly. But the point is there will be a dispersion of results. That makes the market as a whole more robust. Panicking investors are more likely to re-allocate their capital from the bad funds to the good funds, rather than pull all their out in a flight to quality.

Re: A critique of the claim that passive investing is a bubble

#192

Post by pas »

vkou wrote: post #135
peteradio wrote: post #44

Earlier quoted context omitted.

Requirement to sell across the board seems to be the unique issue.

They aren't required to sell, unless fund-holders are selling their ETFs. If those fund-holders were owning the stocks directly, instead of ETFs... Those same fund-holders would be... Selling their stocks. Causing the exact same downward price pressures.

But people would see that the best bid is too low, so they would hold that part of their portfolio. (Because there's no point in realizing that huge loss.)

Re: A critique of the claim that passive investing is a bubble

#193

Post by BryanBigs »

hyperpape wrote: post #169
dcolkitt wrote: post #92

Earlier quoted context omitted.

Burry's point wasn't that the ETFs would lose liquidity, but rather than the lightly-traded names in the index would. If the index instruments have a lot more liquidity than the underlying names, then that means they won't be able to gracefully absorb the liquidity shocks from an unwind in the index. Here's some back of the envelope calculations. Between SPY, IVV, and VOO alone, there's $500 billion in S&P 500 index…

This is a great explanation. Can you explain why this isn't a problem for actively managed funds, though? Do they just avoid stocks like CB?

When I actively managed money for mutual funds, we had limits on both total % ownership and how many days of volume we could own. We were small cap growth, so sometimes we could be stopped from owning as much of a company as we wanted because it was too illquid. Passive doesn't care - it buys what it needs to replicate the returns of the underlying. Also, it's well known that if a hedge fund (or mutual fund) is in trouble, they sell more of what they CAN rather than what they want. That's one reason why we always knew who else owned the stocks we did. Index funds have no leeway here. They need to sell - whether there is liquidity available or not. My gut is, there will be much less liquidity available during the next crisis than you'd expect. A lot of "non passive" investment is quant driven, which ends up becoming very homogenous in nature across different firms. Many also have momentum factors in play, where they buy short term positive momentum and sell the reverse. Once again,vthey don't have a lot of leeway for humans to say "this market is different".

Re: A critique of the claim that passive investing is a bubble

#194

Post by gbear605 »

newshorts wrote: post #75

> When an index fund investor sells, they’re technically selling their holdings in direct proportion to their weighting in the index. So there is literally no market impact. Correct me if I’m wrong but isn’t there a well known price premium for stocks included in major index funds? As I understand it, the most popular indexes target a few companies, thus index funds that track them funnel a disproportionate volume of…

A lot of popular indexes are either total market funds or hold a large fraction of the market

Re: A critique of the claim that passive investing is a bubble

#195

Post by jancsika »

dcolkitt wrote: post #191
hyperpape wrote: post #185

Earlier quoted context omitted.

I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active f…

That's an interesting point. While it's definitely true that any major unwind of that size will disrupt the market, there's some reasons to believe an ecosystem dominated by active investors would do better. First as mentioned before, active investors have discretion. There's strong reason to believe that as the sell-off's happening that they'd move into the most dislocated stocks. That acts as kind of a negative fee…

Wouldn't a random selection process for basket assets and/or weights do just as well as active fund management to stave off this systemic risk?

Re: A critique of the claim that passive investing is a bubble

#196

Post by AlanSE »

id wrote: post #186
AlanSE wrote: post #124

Earlier quoted context omitted.

I've asked this question before and consistently failed to get a clear answer - why is there any deviation between index fund weighting and market cap? To some extent, I'm sure the definition of a "public" company comes into play. Not all stocks are traded in all exchanges, so you could include stocks only listed on one exchange. Then there's the practice of many index funds picking the top N stocks by market cap. Th…

>The small cap stocks should be limited in weight by... their small market cap. A lot of index funds include small caps nowadays. Not all of them because it's more difficult to track 4000 versus 500 stocks. Also the more popular indexes have usually been around for a long time and have fewer constituents. >it seems that weight does not correspond to capitalization Pretty much all index funds invest in the public floa…

The public float sounds legit. I wouldn't argue with that, in fact, it's probably the technically accurate metric.

Where I was coming from was...

https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average

> The value of the Dow is not a weighted arithmetic mean[5] and does not represent its component companies' market capitalization, but rather the sum of the price of one share of stock for each component company. The sum is corrected by a factor which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.[6]. It is not an accurate representation of the US market or total market.[7][8][9]

It mentions "consistent value", but that's over time. You can be misrepresented in weightings but still consistent over time.

Basing the weightings on the stock price sounds royally stupid... if I'm even reading that correctly. But maybe this insanity is just the DOW?

It's also the first one I grab for, because it's the first one that media reports on.

Re: A critique of the claim that passive investing is a bubble

#197

Post by Expez »

wcoenen wrote: post #170
walshemj wrote: post #158

Earlier quoted context omitted.

Liquidity can be a very serious problem for open ended funds and they have to keep cash on had to meet redemptions unlike closed ended funds like investment trusts.

Why would cash be involved for an ETF redemption? Doesn't the ETF manager just hand over the underlying securities?

No, it's cash in and cash out. That's the entire point of an ETF, that it's very easy to buy and sell yet still tracking something complex.

Imagine if you'd invested in the Russel 3000 index, which aims at tracking the entire US stock market. If the ETF manager transferred the securities as you exited you'd now have to manually sell 3000 securities across many markets. The ETF has tools and processes for this, you don't. You pay them a fee for the convenience of not having to deal with the underlying assets.

Another example would be something like the iShares gold or iShares silver ETF. They hold precious metals in a secure vault on your behalf, for a fee. You probably don't want a delivery from an armored truck every time you exit the ETF! :)

Re: A critique of the claim that passive investing is a bubble

#198

Post by IshKebab »

gnicholas wrote: post #72
IshKebab wrote: post #68

Earlier quoted context omitted.

People more or less do do that. I've often searched for something on Amazon and bought the most popular result.

Sure, but do you buy a bundle of goods this way? That’s the analog of index investing.

Sure, when I buy a crate of wine, or a box of chocolates.

Stretching the analogy somewhat but I think the point still stands that it doesn't require the entire market to actively invest to keep everything priced very close to the same price they would be if index funds didn't exist.

Re: A critique of the claim that passive investing is a bubble

#199

Post by throw0101a »

awillen wrote: post #184
throw0101a wrote: post #183

Earlier quoted context omitted.

> his argument wasn't so much that index funds are overvalued, it was that there's opportunity in small caps because they're underrepresented in index funds, and everyone else is investing in index funds. Which index fund though? If you're talking about VOO, which follows the S&P500, maybe. If you're talking about VTI (CRSP US Total Market Index), probably less so. See also Russell 3000 and Wilshire 5000.

Well inasmuch as he's talking generally about index funds and where money is going, he's going to be talking about the major ones, like those that track the S&P.

Yes, though Vanguard themselves have supposed stopped offering VOO internally as part of their employee 401(k) plans, and changed over to VTI.

* https://www.marketwatch.com/story/vanguard-thinks-its-own-em...

VTI has become the third ETF to pass US$ 100B in assets:

* https://www.cnbc.com/2018/09/11/most-investors-choose-sp-500...

SPY (a competitor to VOO) is the biggest though, and it follows S&P 500.

Re: A critique of the claim that passive investing is a bubble

#200

Post by wcoenen »

Expez wrote: post #197
wcoenen wrote: post #170

Earlier quoted context omitted.

Why would cash be involved for an ETF redemption? Doesn't the ETF manager just hand over the underlying securities?

No, it's cash in and cash out. That's the entire point of an ETF, that it's very easy to buy and sell yet still tracking something complex. Imagine if you'd invested in the Russel 3000 index, which aims at tracking the entire US stock market. If the ETF manager transferred the securities as you exited you'd now have to manually sell 3000 securities across many markets. The ETF has tools and processes for this, you do…

ETFs are trade on exchanges for cash, but the fund manager is not involved in that. You simply sell your ETF shares to another buyer. Redemptions are something different that only "authorized participants" can do, and as far as I know the ETF share is traded (or actually destroyed) for the underlying securities in that case.

https://www.investopedia.com/terms/r/redemption-mechanism.as...

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