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Index Investing Makes Markets and Economies More Efficient (2016)
- fallingfrog 9y agoThis guy is making all kinds of assumptions to get his results that can't possibly be true. On a first read it looks like he's assuming: Stocks in the passive investment category stay that way forever- they are never sold at any price. Money never enters or leaves the stock market Companies never issue or buy back stock. I mean with bat crazy assumptions like these, you can come up with any conclusions you want!
- fallingfrog 9y agoFor one thing: as soon as the price of an asset drops far enough in the active market, all those people in the passive market holding the stock are going transition from "passive" to "active" in a hurry. So that breaks the assumption set right there: passive stocks are never truly passive.
- kgwgk 9y agoWhat do you mean? An ETF tracking the S&P 500, for example, is not going to sell a stock no matter how much does it drop (until it gets excluded from the index, of course).
- fallingfrog 9y agoPeople can sell their shares of the ETF, and as you say, stocks can get excluded from an index.
- OscarCunningham 9y agoThat's just not true. If I see that one of my stocks has just dropped by a huge amount that doesn't mean that it's going to carry on dropping. There's no "momentum" (at least on a short timescale).
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- sova 9y agoSuch a blanket statement. I could be selling people's thumbs and toes out of my basement as part of an index fund. Not that I know anything about what it requires to become an indexed fund, but I am fairly certain there is no ethical or moral obligation to benefit the world or humanity.
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- olau 9y agoHow far did you read? The author is starting from a basic state and working up from that with simple examples. Approximately halfway down the article starts considering "The Impact of Net Fund Flows".
- cs702 9y agofallingfrog: I'm downvoting you because you clearly read only the very beginning of the OP, which goes on to address all these points head-on later on in the text. Please refrain from criticizing OP's without fully reading them!
- hellsten 9y agoFor those interested in indexation, FRMO's Murray Stahl has published some thought-provoking articles about indexation here: http://www.frmocorp.com/indexation.html http://www.frmocorp.com/indexation.html In principle, the theory behind indexation is very much like the theory of perfect competition. In perfect competition, the idea is that no participant is sufficiently powerful or sufficiently large to influence the price of the product. The product is assumed to be homogeneous, and shares are designed to be homogeneous. In the theory of market efficiency, no one has an information advantage over anyone else, and there is always enough liquidity. It seems reasonable to make those assumptions. Yet, it is worth making some observations about them.
- deleted 9y ago[deleted]
- cft 9y agoI always thought that the role of the stock market is the collective intelligence of a large pool of investors, that allocates resources to the most effective or highest performing businesses. Index investing is a blunt instrument that does not allow investors to resource-allocate on the fine-grained individual business level. In the best case, it's more like the Soviet central planning, where a handful of people selecting which stocks comprise an index do most of the financial planning. In the worst case, it causes bubbles- the only decision power there is buy/sell , the detailed microeconomic information about individual businesses is almost irrelevant to the investors.
- golemotron 9y agoThe bubble reference is particularly apt. It's a bunch of people saying "I'll do what they are doing."
- rhombocombus 9y agoWhile this is true, there is a lot of value in individual investors investing in index funds, and their performance has borne that out. I don't think that individual investment is going anywhere any time soon. For an investment product that is stable and has more distributed risk, however, index investment can't really be beaten, or rather it hasn't been beaten yet.
- kolbe 9y agoFree riders. And there's good reason to believe that the future of investment will not have a group of corporate governors to free ride off of going forward.
- sethev 9y agoOwnership seems to get mixed up with efficient capital allocation in a lot of discussions about this (referring to likely comments, not the article). For index investing to work you only need a market that's "efficient enough in aggregate". What you're actually purchasing is ownership of future economic growth.
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- kolbe 9y agoEconomists are always right within their own narrowly-defined models! Yes, if you pre-define a set of securities that you will forever be limited to exclusively trading, and divide two groups into passive (never makes another trade again) and active (makes trades), the two groups will perform equally (excluding fees). Now, in the real world, there are several significant reasons why that model model offers nothing but a fun little thought experiment.
- mannykannot 9y agoThis does look too contrived to be meaningful, but the author claims that it is an example of a general rule identified by Fama and Sharpe: "The aggregate performance of the active segment of a market will always equal the aggregate performance of the passive segment." (before frictions like trading costs and taxes are taken out.) I hope those economists have a more sound basis for this claim than the author gives here - assuming, of course, that the author of this article is not misrepresenting or misinterpreting them. To take an extreme case, if all the passive investment is in a single asset, I don't see how this could be, and an issue with passive index investing is that it is in a limited set of assets.
- hackerapperd 9y agoFireWall been breach at Northwest prepared for take off in minus 15 min
- hackerapperd 9y agosend
- paulpauper 9y agoIt’s important to remember, here, that secondary market trading and investing is a zero-sum game for the participants. For a given market participant to outperform, some other market participant has to underperform. Obviously, for a market participant with a given level of skill, the ease at which that participant will outperform will be a function of the quantity of unskilled participants that are there for the skilled participant to exploit. To the extent that the prevalence of indexing preferentially reduces that quantity, it makes outperformance more difficult. That is a myth that refuses to die. Market makers and liquidity providers enter into neutral trades so it doesn't matter which way the market goes..they make money from the spread and churn. Just because you made $40k from being long Google doesn't mean some schmuck lost $40k. Eventually, indexing comes around to disrupt the industry. Of the 500,000 individuals that were previously managing funds, 499,500 go out of business, with their customers choosing the passive option instead. The remaining 500–which are the absolute cream of the crop–continue to compete with each other for profit, setting prices for the overall market. Indexing has been around for a long time now, but active mgmt has had a terrible time and is actually getting worse in recent years, against the author's thesis that passive investing is supposed to create a small pool of 'superstars'.
- dforrestwilson 9y agohttp://www.investopedia.com/terms/o/opportunitycost.asp http://www.investopedia.com/terms/o/opportunitycost.asp Some schmuck sort of did. The market makers and liquidity providers are not the source of the sold stock, simply intermediaries. "is actually getting worse in recent years, against the author's thesis that passive investing is supposed to create a small pool of 'superstars'." This is a huge point of contention. Capital takes a long time to flow out of mutual and hedge funds which have been underperforming. It could be many years yet before any "superstars" emerge.
- paulpauper 9y agoI mean as in a P&L statement. If I sold a bitcoin at $1 in 2010 did I lose $4000? no but I may regret it. If someone short sold it, then it would be a $4000 loss.
- lend000 9y agoThis could not be more wrong and it's discouraging to see it on the front page of HN -- index investing exerts a normalizing pressure on the prices of assets, which is rarely supported by the underlying values of the companies. This is unlikely to be a popular opinion amongst passive investors, but day traders and market makers are responsible for making economies for efficient and providing price discovery (if they make profits) by reducing the spread and reducing volatility. Traders who lose money have the opposite effect -- they make assets more volatile by pushing up tops and pushing down bottoms. Active long term value investors also contribute to positive price discovery and reduce volatility (if they make money) for the same reasons, but on a different time scale.
- bandrami 9y ago> day traders and market makers are responsible for making economies for efficient and providing price discovery Price discovery of a price that's only useful to other baseball card collectors^H^H^H^H^H^H sorry, market traders. I'm not surprised everybody is missing the biggest advantage of index investing: it gets you a diverse collection of income-producing assets.
- lend000 9y ago> I'm not surprised everybody is missing the biggest advantage of index investing This isn't about whether index investing is a good strategy for many people, especially those with low-moderate risk appetites and no time/expertise for active investing or trading. It's about whether or not index investing makes markets and economies more efficient (which the article erroneously claims). I claim they have the opposite effect, but they create value in and of themselves that counteracts that distortion to the benefit of index fund users (and to the benefit of traders who arbitrage the distortion).
- pishpash 9y agoPassive investors were not going to make the market more efficient anyway since they are not informative. They carry only one piece of information which is that they have some money to invest into the economy and would be okay to take some risk, and they express that well enough through a passive financial product reproducing what the financial industry itself calls the "market returns." They of course do care to make some money; nobody is in it to lose money, so how are they making the market less efficient? It's not that different from saving the money in a bank for the bank to allocate. Now, if the passive investment flow comes to dominate volume on any given day, then the "marginal" trade becomes a passive, uninformative one; then we have a problem.
- skdjksjdksjdk 9y agoQuick Question: Why is efficiency a desired outcome in markets? Or is it just a natural outcome of competing players?
- eanzenberg 9y agoFor planning, risk assessment and strategy.
- codeplea 9y agoThat's a good point. I think efficiency is desired because it usually provides fairness. In an inefficient market, trades are at the "wrong" price, and so that seems unfair. When there is a trade-off between inefficiency and fairness, we seem to prefer fairness (e.g. insider trading laws make the market less efficient but more "fair").
- yellowstuff 9y agoMatt Levine of Bloomberg writes a lot about how insider trading laws seem to be about fairness, but are really about theft of information from the rightful owner. It's hard to square a market centered around fairness with the vast informational and technological advantages that professional traders use legally.
- yellowstuff 9y agoThe core social benefit of financial markets is to get capital to where it can be used most productively. This is why Google could get funding in 1998 and why Venezuela can't today.
- bandrami 9y agoWhat did Google's initial funding have to do with the securities market?
- tacostakohashi 9y agoThe angels / VCs that funded it did so with the knowledge that they'd be able to go public later and get their money back out. If there's no market for selling equity in mature companies, there's less incentive for starting or investing in small / growing companies.
- CoreXtreme 9y agoInvesting in index is like subscribing for slavery. It only benefits people with tons of money. Sure, it's less risky. But along with preventing massive downside, it prevents massive upside too. I've just got 1 life, limited time and I want to risk everything for a massive upside, not efficient market.
- euyyn 9y agoI'd think investing all your money in playing the lottery opens up a much bigger upside. Sure, it's more risky, but you've just got 1 life!
- mfoy_ 9y agoWait... are you trying to tell me that scratch tickets aren't essentially the same thing as stock certificates?
- euyyn 9y agoI'm just saying, don't subscribe for slavery!
- CoreXtreme 9y agoI am thinking more along the line of Hedge Funds and angle investing in startups than lottery which is not an investment!
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- cs702 9y agoThe OP defines an "efficient" market as one in which active investors cannot consistently outperform the average by selectively picking individual securities. In this regard, the OP is absolutely right that index investing is making markets "efficient," because active and passive managers, when considered as two distinct aggregate groups, must necessarily earn the same average return before fees, expenses, and frictional costs. HOWEVER, that doesn't necessarily mean the growth of index investing makes markets more accurate at pricing securities. There's NO evidence of that. Maybe the growth of index investing is doing the opposite: making markets LESS ACCURATE at pricing securities. Indeed, by many measures, US stock prices are looking positively FROTHY these days.[1][2][3] [1] https://www.nytimes.com/2017/09/15/business/stock-market-mass-psychology.html https://www.nytimes.com/2017/09/15/business/stock-market-mas... [2] https://www.nytimes.com/2017/06/29/business/stock-market-value-trump.html?mcubz=1 https://www.nytimes.com/2017/06/29/business/stock-market-val... [3] http://time.com/money/4943479/wall-street-prediction-stock-market-downturn/ http://time.com/money/4943479/wall-street-prediction-stock-m...
- bandrami 9y agoWhat is the "accurate" price of a security, particularly if it does not pay a dividend? And what good is achieved by that price being found?
- cs702 9y agoPricing is more accurate when it's closer to the net present value of the profits that could be taken out of the business by a person "who buys it for keeps," to paraphrase J. M. Keynes. The more accurate a market is at pricing securities, the less severe the magnitude of bubbles and subsequent crashes. Bubbles are extreme examples of overoptimistic pricing. To be clear, I do NOT know if index funds are causing pricing to be less, or more, accurate. I don't think anyone else knows either. That said, it seems to me that (1) the ongoing mass-scale removal of intelligence from the investment process is unlikely to make pricing more accurate, and (2) these days, stock prices are looking frothy by many measures (e.g., Shiller CAPE).
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- bandrami 9y agoIs efficiency a desired quality of a market?
- cjlars 9y agoThis assumption that passive investors have no cash inflows / outflows totally breaks his model. As soon as passive investors start buying or selling the index -- a real world necessity -- they are playing a zero sum game against a counterparty. Specifically, active investors could sell overpriced stocks to indexers and buy underpriced stocks from indexers, which in turn drives the price discovery. This churn allows for active investors, as a group, to gain alpha at the expense of indexers. Piggybacking off the article's example: Suppose news breaks that Facebook has made a catastrophic legal error which will result in them losing 50% of their revenue over the next year. This is obvious to the active investors who collectively decide to sell their Facebook shares, resulting in a fall in the total value of the index equal to the drop in value for Facebook. In the time it takes the old pre-news price to drop to the new post-news price, active investors have, on net, sold Facebook and gone to cash and will have shared in a relatively small portion of the crash, and passive investors will have bought Facebook due to churn, or held Facebook as part of the index, resulting in them absorbing a larger portion of the crash than active investors. So how does this all fit into the "active managers don't earn their keep" narrative? I think what we've seen is a long term drop in the alpha available to the active share due to things like narrowing spreads, faster response to new news, etc. So effectively active management is in a secular decline, which allows for (1) bad results for active managers on net, and (2) failure of poor performers and their removal from the market, and (3) continued real value generation by the better and remaining active managers. So this idea of conservation of alpha is also silliness because the market will always be slightly oversaturated (net negative value for money managers) or undersaturated (net positive value for money managers). If you doubt this, read Ben Graham's the "Intelligent Investor" -- In 1949 he thought it was quite easy (EASY!) for an average Joe to earn outsized returns with a little stock research (and I think history proved him right until at least the late '70s).
- jyriand 9y agoI think the main reason someone chooses to invest money into index funds is either they just want stable returns without too much hassle, or they believe in efficient market theory that basically states that you can't beat the market, so no point in even trying(and that's true for most of the mutual funds). But looking at value investors, it seems you can consistently beat the market. Also, what bothers me about indexing, is that a lot of money is going into same companies(S&P500). Look at any S&P500 companies Top Institutional Holders and without a doubt Vanguard is on top(wild guess). Not sure what happens with the price, when company is excluded from S&P500. In conclusion, indexing is fun in the bull market, it's just you can't retire in the recession years.
- bcoates 9y agoPrices are set at the margin. This article is concerned with the average skill of investors, an entirely meaningless metric that determines nothing. The marginal investor determines prices not the mean one.
- jamez1 9y agoThis is dumb, the point of the stock market is the return the stocks give you in dividends etc. Here, he treats those returns as not being a factor, and as stocks having no intrinsic value. If they have no intrinsic value of course passive management makes sense!