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Warren Buffett says it's OK, and has an excellent explanation for this. If I recall correctly: imagine you take all the investors in the US economy and put them

Warren Buffett says it's OK, and has an excellent explanation for this. If I recall correctly: imagine you take all the investors in the US economy and put them in a room. Divide the room in halves. One side contains all the active investors, the other side contains all the passive investors. If each side owns roughly half of the economy, their returns will be equal. In that case, it's better to sit on the side with the lower fees... so one should naturally sit on the passive side. Setting Warren Buffett aside, what you neglect to mention is that the stock market is both a primary and secondary capital market. We can speculate about how to speculate... whether to be passive or active... but this concerns only the functionality of the secondary market. There's still primary market functionality: companies issue stock to raise capital, buyback stock, and issue dividends. Thus, even if all the investors are passive, there's still always one active agent in the game: the company itself. And a capitalization-weighted index is ideally suited for this activity: it automatically shifts capital away from companies buying back stock (essentially, companies returning money to investors) to those issuing new stock (essentially, companies seeking to raise capital).

joezydeco 10y ago
Buffett is close to winning a $1 million, 10-year bet he made with the head of the hedge fund Protege Partners. The bet was simple. Buffett would invest in a Vanguard S&P 500 index fund, and the hedge fund could do anything they wanted. http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/ http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/ http://www.npr.org/2016/03/10/469897691/armed-with-an-index-fund-warren-buffett-is-on-track-to-win-hedge-fund-bet http://www.npr.org/2016/03/10/469897691/armed-with-an-index-...
- nostromo 10y ago
  The irony of course is that Buffett became one of the world's richest people by being an active investor.
  - jacques_chester 10y ago
    True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error. When full ownership is taken (his preferred option), the original management is almost always left in place. No rules or guidance are given. The subsidiaries work however they worked before acquisition. That said, after reading through his 50 Berkshire Hathaway letters, the main lesson I drew was: own insurance companies which underwrite for profit under all economic conditions.
    - pooper 10y ago
      > True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error. The Bank of America deal shows how good a deal you can get when you can put $5B where your mouth is > In exchange, Berkshire Hathaway received $5 billion worth of preferred stock yielding 6% a year plus warrants to purchase 700 million shares of Bank of America common stock at an exercise price of $7.14 per share. apologies in advance for linking to fool.com http://www.fool.com/investing/general/2015/08/19/how-much-is-warren-buffetts-5-billion-investment-i.aspx http://www.fool.com/investing/general/2015/08/19/how-much-is...
      - jacques_chester 10y ago
        Right. In fact the financial crisis was a busy few years for Berkshire-Hathaway. Like everyone else they took a drubbing, but they also unleashed a lot of their unused cash to make deals on generous terms. It helped that they were structurally inclined to build up cash. As Buffet explains, a booming share market is bad for him: everything is too expensive to buy. So cash piles up, waiting for good deals of sufficient magnitude to arise. When a bust arrives, there are bargains everywhere and a lot of money to buy into them.
- acchow 10y ago
  > That’s not merely a high hurdle—the law of averages suggests it’s near to impossible to clear. Ugh. Now we have npr teaches "law of averages" backwards
- harry8 10y ago
  I could win that bet if I were able to buy Goldman Sachs during the GFC at a 20% discount to market like Warren was able to. A good troll would have been to buy Berkshire Hathaway.
matco11 10y ago
Warren Buffett was referring to traditional (long-only) investment funds... He himself was for many years running a hedge fund (and had learned from the pioneers of hedge fund investing.) https://www.bloomberg.com/view/articles/2012-04-24/what-was-the-very-first-hedge-fund-ask-warren-buffett https://www.bloomberg.com/view/articles/2012-04-24/what-was-... http://www.forbes.com/sites/randalllane/2012/03/26/warren-buffetts-50-billion-decision/#5eefecfda57d http://www.forbes.com/sites/randalllane/2012/03/26/warren-bu... https://www.quora.com/What-was-the-fee-structure-of-Warren-Buffetts-first-investment-partnership-started-in-1956 https://www.quora.com/What-was-the-fee-structure-of-Warren-B...
ced 10y ago
imagine you take all the investors in the US economy and put them in a room. Divide the room in halves. One side contains all the active investors, the other side contains all the passive investors. If each side owns roughly half of the economy, their returns will be equal. Won't the "tracking fee" of the index funds keep increasing, as a larger and larger fraction of the market is covered by them? Whenever a stock rises to X$, billions' worth of index funds will rush to buy the stock to rebalance their holdings, but clearly that should further raise the price of the stock (and they'll have to buy it at X+0.10, or X+0.50).
- froogle 10y ago
  Cap-weighted funds (like anything tracking the S&P 500) already hold the stocks in comparison to their market cap. If a stock goes up, they don't need to buy more of it - the value of the shares they hold will increase to exactly the right proportion that they should have. (There do exist other types of funds which try equally weight the stocks they hold, which means the fund has to rebalance when the stocks change price.) Typically, cap-weighted funds only have to rebalance when individual members of the fund buy/sell - and they try to make it so people are buying/selling to those within the fund where possible to avoid having to do even that. The result is a very low churn, which is part of why index funds have lower fees. Usually, the more assets an index fund has under management, the lower an index fund's fees get.
  - ced 10y ago
    That makes sense, thank you. Where does the tracking fee come from then? EDIT: and doesn't my above argument hold at the boundary? When a stock is brought into the S&P, suddenly all of the index funds need to stock up on it, further bolstering its price, no?
    - froogle 10y ago
      Fees come from the transaction costs of having to buy/sell shares (churn is low but non-zero), operate websites, paying salaries, running customer support, doing tax paperwork, etc. Not much magic there. You're correct about what happens at the boundary, yes. There's a well-known arbitrage opportunity for stocks that are known to be about to be brought into the S&P 500 (their prices DO tend to increase, I believe), if you want to research that. Like all publicly known arbitrages, I doubt you can make any money off it personally anymore though. This is part of why the recommendation is not to use an S&P 500 fund, but something more like Vanguard's Total Stock Market fund, which includes medium/small-cap companies. Not that it's a huge deal, though - mutual fund companies are usually pretty clever about spreading large orders out over time.
digi_owl 10y ago
I seem to recall a claim that companies no longer issue stock to raise capital. Instead they issue bonds, much the same way as a government or municipality.
- jganetsk 10y ago
  Every IPO is a company issuing stock to raise capital.
  - digi_owl 10y ago
    My impression is that these days an IPO is for the founder and VCs to cash in and bail the ship.
    - jganetsk 10y ago
      Well, you are right that capital has had net outflow http://www.theatlantic.com/politics/archive/2015/02/kill-stock-buyback-to-save-the-american-economy/385259/ http://www.theatlantic.com/politics/archive/2015/02/kill-sto...
  - hibikir 10y ago
    True, but we are having a lot less IPOs lately: We see companies with valuations well in the billions, venture backed, that aren't IPOing. We are seeing non-public companies writing contracts with dual-trigger RSUs because options have become completely worthless. So while it's still possible to raise capital by printing stock, this is happening less and less lately.
ThrustVectoring 10y ago
"owns roughly half of the economy" is doing a lot of work. It's not necessarily true that the choices that active investors make average out to be roughly equivalent to the choices that passive investors make. Like, the active investors could very well own the better-performing half of the economy, because they put in the work to figure out what portion of the economy is actually worth more than the market thinks it is.

joezydeco 10y ago

Buffett is close to winning a $1 million, 10-year bet he made with the head of the hedge fund Protege Partners. The bet was simple. Buffett would invest in a Vanguard S&P 500 index fund, and the hedge fund could do anything they wanted. http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/ http://fortune.com/2016/05/11/warren-buffett-hedge-fund-bet/ http://www.npr.org/2016/03/10/469897691/armed-with-an-index-fund-warren-buffett-is-on-track-to-win-hedge-fund-bet http://www.npr.org/2016/03/10/469897691/armed-with-an-index-...

nostromo 10y ago
The irony of course is that Buffett became one of the world's richest people by being an active investor.
- jacques_chester 10y ago
  True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error. When full ownership is taken (his preferred option), the original management is almost always left in place. No rules or guidance are given. The subsidiaries work however they worked before acquisition. That said, after reading through his 50 Berkshire Hathaway letters, the main lesson I drew was: own insurance companies which underwrite for profit under all economic conditions.
  - pooper 10y ago
    > True, but he (and Munger) generally invest quite conservatively. He doesn't buy for capital gain, but to hold indefinitely. He buys businesses he understands, with financials he understands, for prices he figures reflect a fair discount on the economic value, plus a generous margin of error. The Bank of America deal shows how good a deal you can get when you can put $5B where your mouth is > In exchange, Berkshire Hathaway received $5 billion worth of preferred stock yielding 6% a year plus warrants to purchase 700 million shares of Bank of America common stock at an exercise price of $7.14 per share. apologies in advance for linking to fool.com http://www.fool.com/investing/general/2015/08/19/how-much-is-warren-buffetts-5-billion-investment-i.aspx http://www.fool.com/investing/general/2015/08/19/how-much-is...
    - jacques_chester 10y ago
      Right. In fact the financial crisis was a busy few years for Berkshire-Hathaway. Like everyone else they took a drubbing, but they also unleashed a lot of their unused cash to make deals on generous terms. It helped that they were structurally inclined to build up cash. As Buffet explains, a booming share market is bad for him: everything is too expensive to buy. So cash piles up, waiting for good deals of sufficient magnitude to arise. When a bust arrives, there are bargains everywhere and a lot of money to buy into them.
acchow 10y ago
> That’s not merely a high hurdle—the law of averages suggests it’s near to impossible to clear. Ugh. Now we have npr teaches "law of averages" backwards
harry8 10y ago
I could win that bet if I were able to buy Goldman Sachs during the GFC at a 20% discount to market like Warren was able to. A good troll would have been to buy Berkshire Hathaway.

matco11 10y ago

Warren Buffett was referring to traditional (long-only) investment funds... He himself was for many years running a hedge fund (and had learned from the pioneers of hedge fund investing.) https://www.bloomberg.com/view/articles/2012-04-24/what-was-the-very-first-hedge-fund-ask-warren-buffett https://www.bloomberg.com/view/articles/2012-04-24/what-was-... http://www.forbes.com/sites/randalllane/2012/03/26/warren-buffetts-50-billion-decision/#5eefecfda57d http://www.forbes.com/sites/randalllane/2012/03/26/warren-bu... https://www.quora.com/What-was-the-fee-structure-of-Warren-Buffetts-first-investment-partnership-started-in-1956 https://www.quora.com/What-was-the-fee-structure-of-Warren-B...

ced 10y ago

imagine you take all the investors in the US economy and put them in a room. Divide the room in halves. One side contains all the active investors, the other side contains all the passive investors. If each side owns roughly half of the economy, their returns will be equal. Won't the "tracking fee" of the index funds keep increasing, as a larger and larger fraction of the market is covered by them? Whenever a stock rises to X$, billions' worth of index funds will rush to buy the stock to rebalance their holdings, but clearly that should further raise the price of the stock (and they'll have to buy it at X+0.10, or X+0.50).

froogle 10y ago
Cap-weighted funds (like anything tracking the S&P 500) already hold the stocks in comparison to their market cap. If a stock goes up, they don't need to buy more of it - the value of the shares they hold will increase to exactly the right proportion that they should have. (There do exist other types of funds which try equally weight the stocks they hold, which means the fund has to rebalance when the stocks change price.) Typically, cap-weighted funds only have to rebalance when individual members of the fund buy/sell - and they try to make it so people are buying/selling to those within the fund where possible to avoid having to do even that. The result is a very low churn, which is part of why index funds have lower fees. Usually, the more assets an index fund has under management, the lower an index fund's fees get.
- ced 10y ago
  That makes sense, thank you. Where does the tracking fee come from then? EDIT: and doesn't my above argument hold at the boundary? When a stock is brought into the S&P, suddenly all of the index funds need to stock up on it, further bolstering its price, no?
  - froogle 10y ago
    Fees come from the transaction costs of having to buy/sell shares (churn is low but non-zero), operate websites, paying salaries, running customer support, doing tax paperwork, etc. Not much magic there. You're correct about what happens at the boundary, yes. There's a well-known arbitrage opportunity for stocks that are known to be about to be brought into the S&P 500 (their prices DO tend to increase, I believe), if you want to research that. Like all publicly known arbitrages, I doubt you can make any money off it personally anymore though. This is part of why the recommendation is not to use an S&P 500 fund, but something more like Vanguard's Total Stock Market fund, which includes medium/small-cap companies. Not that it's a huge deal, though - mutual fund companies are usually pretty clever about spreading large orders out over time.

digi_owl 10y ago

I seem to recall a claim that companies no longer issue stock to raise capital. Instead they issue bonds, much the same way as a government or municipality.

jganetsk 10y ago
Every IPO is a company issuing stock to raise capital.
- digi_owl 10y ago
  My impression is that these days an IPO is for the founder and VCs to cash in and bail the ship.
  - jganetsk 10y ago
    Well, you are right that capital has had net outflow http://www.theatlantic.com/politics/archive/2015/02/kill-stock-buyback-to-save-the-american-economy/385259/ http://www.theatlantic.com/politics/archive/2015/02/kill-sto...
- hibikir 10y ago
  True, but we are having a lot less IPOs lately: We see companies with valuations well in the billions, venture backed, that aren't IPOing. We are seeing non-public companies writing contracts with dual-trigger RSUs because options have become completely worthless. So while it's still possible to raise capital by printing stock, this is happening less and less lately.

ThrustVectoring 10y ago

"owns roughly half of the economy" is doing a lot of work. It's not necessarily true that the choices that active investors make average out to be roughly equivalent to the choices that passive investors make. Like, the active investors could very well own the better-performing half of the economy, because they put in the work to figure out what portion of the economy is actually worth more than the market thinks it is.