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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

#161

Post by jonknee »

dcolkitt wrote: post #92
mrep wrote: post #11

Earlier quoted context omitted.

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on al…

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…

Yes, if indexes sell off any many times their average daily volume that means components will as well. That's fine. If something happens where people are selling the S&P 500 down 20% in a single trading session (the full day circuit breaker limit) there should be chaos amongst the components because shit has hit the fan. Savvy players will scoop up deals, most people will do nothing and life will move on.

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

#162

Post by kolbe »

FabHK wrote: post #65
Aunche wrote: post #42

Earlier quoted context omitted.

I don't think so. Otherwise Uber and Snap would both be in the S&P 500.

There are certain criteria, see [1] or [2] for a summary. They need to be publicly traded for sufficient time, have sufficient free float, be profitable, etc. See [3] for example on why Tesla isn't. [1] https://us.spindices.com/documents/methodologies/methodology... [2] https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_cr... [3] https://seekingalpha.com/article/4088016-will-tesla-join-s-a...

Yep. So, you don't just own the top 500 stocks by market cap. You own a set of stocks that resemble that idea, but are in fact still choices made by S&P. Also notice that stocks don't immediately get dropped when they fall below that criteria; there's a buffer for how bad they have to get to be dropped. Additionally, the rules governing these choices are free to change at any time. For example, whether stocks with split voting shares should qualify is still a discussion.

Let's also not forget Hacker News's favorite law: Goodhart's Law. The S&P has performed wonderfully well when it was observed as an index. But now that it's a target, the world will change around it.

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

#163

Post by jonknee »

rocqua wrote: post #140
vkou wrote: post #135

Earlier quoted context omitted.

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.

If I sell my ETF, the AP buys it from me, and gets to redeem it for a basket of shares of fixed proportion. Suppose stock X gets 1% in that basket. The issue is if stock X happens to be very illiquid, the APs selling stock X could drive down the price. In a non ETF, managers could decide to relatively slow down the sale of X, to prevent crashing the price. However, in an index fund the mechanism dictates all stocks a…

Authorized participants arbitrage all day, if they see dislocation they can certainly hold on to certain names.

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

#164

Post by laminarflow »

AlanYx wrote: post #129
hogFeast wrote: post #99

Earlier quoted context omitted.

If you think it is "smart-ass", you don't understand what I am saying (or, more probably, what Burry is saying). There are no "camps" here. The OP is trying to create a tribe (passive investors are cultish, so this is a very odd comment...I will assume an honest mistake) but that makes no sense on this topic (unless you are selling something, which he is). The meta of my point is: people try this discussion over and…

Thanks for this -- your comment above about "transforming something illiquid to something liquid" and dcolkitt's post above explaining the possible consequences when indexed ETFs are substantially more liquid than many of the underlying securities really helped me understand the crux of Burry's argument. Are you aware of any academics that are studying this issue or modeling the risks?

See 'Horizon Kinetics' for a library of statistically-rigorous work on this.

https://horizonkinetics.com/commentary-type/under-the-hood-i...

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

#165

Post by rocqua »

jonknee wrote: post #163
rocqua wrote: post #140

Earlier quoted context omitted.

If I sell my ETF, the AP buys it from me, and gets to redeem it for a basket of shares of fixed proportion. Suppose stock X gets 1% in that basket. The issue is if stock X happens to be very illiquid, the APs selling stock X could drive down the price. In a non ETF, managers could decide to relatively slow down the sale of X, to prevent crashing the price. However, in an index fund the mechanism dictates all stocks a…

Authorized participants arbitrage all day, if they see dislocation they can certainly hold on to certain names.

Arbitrage (as done by APs) is mostly about gathering an instantaneous spread. Much like market makers, that strategy is not about holding a position.

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

#166

Post by laminarflow »

mrfredward wrote: post #32
awillen wrote: post #7

As I read it, the word bubble in the Burry interview was really just used for clickbait purposes - 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.

The Bloomberg article mixed Bury's words and the author's words quite a bit, and I'm beginning to wonder if the whole reason we're having this discussion is because some important nuance was lost. It's hard to see why Mom and Pop buy and hold index investors should care about the liquidity risk Bury talks about...market cap weighted funds will be fine in the long run because the ratio of each underlying stock to a fu…

I agree with your views, but anecdotally, my worry is about how many of those Mom and Pop investors bought the index funds specifically because the index funds have recently performed well; and of that faction, how much of the capital allocated to index funds was pulled from other sources, causing those sources to fall in value?

The data would also support that on a dollar-weighted basis, most index fund investors are not really buying-and-holding:

"Turnover rates for two of the most popular ETFs are higher than 3500%(!), an average holding period of about a week. That is dozens of times greater than the trading liquidity of even its most liquid constituents"

http://www.grantspub.com/files/presentations/Grant's%20Confe...

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

#167

Post by gzu »

kolbe wrote: post #162
FabHK wrote: post #65

Earlier quoted context omitted.

There are certain criteria, see [1] or [2] for a summary. They need to be publicly traded for sufficient time, have sufficient free float, be profitable, etc. See [3] for example on why Tesla isn't. [1] https://us.spindices.com/documents/methodologies/methodology... [2] https://en.m.wikipedia.org/wiki/S%26P_500_Index#Selection_cr... [3] https://seekingalpha.com/article/4088016-will-tesla-join-s-a...

Yep. So, you don't just own the top 500 stocks by market cap. You own a set of stocks that resemble that idea, but are in fact still choices made by S&P. Also notice that stocks don't immediately get dropped when they fall below that criteria; there's a buffer for how bad they have to get to be dropped. Additionally, the rules governing these choices are free to change at any time. For example, whether stocks with sp…

It’s a huge stretch to say the S&P 500 isn’t the current top 500 stocks by market cap just because they don’t include several recent IPOs and have discretion to exclude stocks based on potential stock manipulation. These are very rare cases that have little affect on the overall index. In time (not instantly) they add large established companies. Proportions are always weighted directly to market cap percentage. They’re not weighing some stocks higher than others like how an active manager would allocate.

Agree “beating the index” is quite a joke since that is the benchmark for fund performance and so much money is passive invested now. Matching the index performance is saying “our fund equities have appreciated on equal basis to how all others have”.

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

#168

Post by jonknee »

rocqua wrote: post #165
jonknee wrote: post #163

Earlier quoted context omitted.

Authorized participants arbitrage all day, if they see dislocation they can certainly hold on to certain names.

Arbitrage (as done by APs) is mostly about gathering an instantaneous spread. Much like market makers, that strategy is not about holding a position.

Yes, but strategies change in a crash. It's possible no one learned from the 2015 flash crash, but I bet a lot of smart funds out there are ready for one. If a dumb AP is going to put out a crazy price someone is going to be there to snap it up.

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

#169

Post by hyperpape »

dcolkitt wrote: post #92
mrep wrote: post #11

Earlier quoted context omitted.

How would they lose liquidity? Authorized participants [0] are always in the market for ETFs. If an ETF share price is crashing out of line with the index it tracks, they will step in and buy shares, swap them with the ETF issuer for the shares of the underlying stock in the index, and sell those shares for an arbitrage profit. Even if one of the underlying stocks becomes illiquid, a big enough price divergence on al…

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?

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

#170

Post by wcoenen »

walshemj wrote: post #158
sambe wrote: post #22

Earlier quoted context omitted.

These sections seem to address the point to me: * "The tail is not wagging the dog" - index funds are a relatively small percentage of total share ownership. * "Benchmark huggers have always been around" - owning ~the index was not started with index funds. * "Active funds literally own the market" - the sum of portfolios of non-index funds ends up having the same profile. * "Price discovery is a cop-out" - relativel…

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?
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