5 ms·

This fallacy is discussed in detail in the article. Indexing (provided it is below 100%) does not increase the noise of prices, since the universe of active and

This fallacy is discussed in detail in the article. Indexing (provided it is below 100%) does not increase the noise of prices, since the universe of active and passive investors are not trading with each other (except for some edge cases which are not significant). This means that increasing in indexing does not necessarily harm the resource allocation service provided by investors, until everything becomes really weird close to 100% passive indexing.

cft 9y ago
Clearly at 0.0001% indexing is negligible, and at 100% there's no longer an effective stock market allocating resources based on microeconomics indicators. But what is the critical threshold of indexing that interferes with efficient resource allocation? 99%, 50%, 3%?
- peteretep 9y ago
  If you can accurately show it's interfering with resource allocation, you can make a huge huge profit by buying under valued stocks, and rebalance the market.
  - Armisael16 9y ago
    The market can stay irrational...
    - peteretep 9y ago
      It never needs to get rational to profit off its irrationality. Any company I can buy on the cheap because the market is irrational is all good by me; I still have voting rights and dividends.
- Retric 9y ago
  ~99%. Critically, prices change as a result of any imbalance in supply and demand for stocks. Also of note index funds do have feedback loops as they try to retain a balanced portfolio. If company A is worth 1 billion and company B is worth 2 billion yet they have equal dollar investments in both, then they sell some of A to buy some of B. This greatly magnifies the impact of active traders in a 99% ownership situation.
  - lend000 9y ago
    > ~99%. Critically, prices change as a result of any imbalance in supply and demand for stocks. > If company A is worth 1 billion and company B is worth 2 billion yet they have equal investments in both, then they sell some of A to buy some of B. This is a paradox -- both of these are examples of market movements which require the percentage of stocks held outside of index funds be equal to or greater than the volume required for the price movement. The critical point is much lower, and as more people buy into index funds, the active traders make more money rebalancing and therefore are able to increase their own positions, providing negative feedback and preventing the index fund ownership from rising more. I don't know what the asymptote is, but I suspect it's closer to or equal to 50%. Another way to think of it is that markets would be incredibly illiquid with 99% index fund ownership -- that's not much ownership for market makers, but their profits would be tremendous due to the thin order books, driving in more market makers and thereby increasing their market share until it's no longer easy money.
    - Retric 9y ago
      Edit: Put more simply if one fund owned 99% of every stock it would not buy or sell in response to price changes. So, if an active trader wants to buy or sell they would need to find another active trader to act as a counter party. This would then move the stock price. My point about ownership percentage was simply that passive traders and active traders only interact when the total amount of stock changes. But, passive traders are simply speeking a fixed ownership percentage which means they don't change the final price only the active traders who must end up with that same 1% based on price movements.
  - jacobkg 9y ago
    That is not generally the case. Most index funds are 'market cap weighted' which means that hold funds in ratio to their market capitalization. If stock A doubles in price, it's market cap also doubles and the index fund will continue to hold the same number of shares.
    - Retric 9y ago
- paulsutter 9y ago
  if indexing ever does make the market inefficient, active trading will become more and more profitable. And in turn more money will go into active management. For me, the most interesting observation in the article is that poor active returns are a sign of market efficiency.
- yourapostasy 9y ago
  Bogle has gone on record [1] that he's comfortable as long as indexing doesn't account for 75%+ of the market (I suspect he means 75%+ of market-wide AUM, but interpretation of "the market" can vary between people, like total daily trading volume or total daily trading buys, YMMV). [1] http://www.marketwatch.com/story/john-bogle-has-a-warning-for-index-fund-investors-2017-06-01 http://www.marketwatch.com/story/john-bogle-has-a-warning-fo...

cft 9y ago

Clearly at 0.0001% indexing is negligible, and at 100% there's no longer an effective stock market allocating resources based on microeconomics indicators. But what is the critical threshold of indexing that interferes with efficient resource allocation? 99%, 50%, 3%?

peteretep 9y ago
If you can accurately show it's interfering with resource allocation, you can make a huge huge profit by buying under valued stocks, and rebalance the market.
- Armisael16 9y ago
  The market can stay irrational...
  - peteretep 9y ago
    It never needs to get rational to profit off its irrationality. Any company I can buy on the cheap because the market is irrational is all good by me; I still have voting rights and dividends.
Retric 9y ago
~99%. Critically, prices change as a result of any imbalance in supply and demand for stocks. Also of note index funds do have feedback loops as they try to retain a balanced portfolio. If company A is worth 1 billion and company B is worth 2 billion yet they have equal dollar investments in both, then they sell some of A to buy some of B. This greatly magnifies the impact of active traders in a 99% ownership situation.
- lend000 9y ago
  > ~99%. Critically, prices change as a result of any imbalance in supply and demand for stocks. > If company A is worth 1 billion and company B is worth 2 billion yet they have equal investments in both, then they sell some of A to buy some of B. This is a paradox -- both of these are examples of market movements which require the percentage of stocks held outside of index funds be equal to or greater than the volume required for the price movement. The critical point is much lower, and as more people buy into index funds, the active traders make more money rebalancing and therefore are able to increase their own positions, providing negative feedback and preventing the index fund ownership from rising more. I don't know what the asymptote is, but I suspect it's closer to or equal to 50%. Another way to think of it is that markets would be incredibly illiquid with 99% index fund ownership -- that's not much ownership for market makers, but their profits would be tremendous due to the thin order books, driving in more market makers and thereby increasing their market share until it's no longer easy money.
  - Retric 9y ago
    Edit: Put more simply if one fund owned 99% of every stock it would not buy or sell in response to price changes. So, if an active trader wants to buy or sell they would need to find another active trader to act as a counter party. This would then move the stock price. My point about ownership percentage was simply that passive traders and active traders only interact when the total amount of stock changes. But, passive traders are simply speeking a fixed ownership percentage which means they don't change the final price only the active traders who must end up with that same 1% based on price movements.
- jacobkg 9y ago
  That is not generally the case. Most index funds are 'market cap weighted' which means that hold funds in ratio to their market capitalization. If stock A doubles in price, it's market cap also doubles and the index fund will continue to hold the same number of shares.
  - Retric 9y ago
paulsutter 9y ago
if indexing ever does make the market inefficient, active trading will become more and more profitable. And in turn more money will go into active management. For me, the most interesting observation in the article is that poor active returns are a sign of market efficiency.
yourapostasy 9y ago
Bogle has gone on record [1] that he's comfortable as long as indexing doesn't account for 75%+ of the market (I suspect he means 75%+ of market-wide AUM, but interpretation of "the market" can vary between people, like total daily trading volume or total daily trading buys, YMMV). [1] http://www.marketwatch.com/story/john-bogle-has-a-warning-for-index-fund-investors-2017-06-01 http://www.marketwatch.com/story/john-bogle-has-a-warning-fo...