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This article brings up a point I used to worry about - if people are just automatically pumping money into a list of stocks, how does the price remain connected

This article brings up a point I used to worry about - if people are just automatically pumping money into a list of stocks, how does the price remain connected to reality?. But apparently the answer is that mis-priced stocks present an arbitrage opportunity (https://www.investopedia.com/terms/i/indexarbitrage.asp https://www.investopedia.com/terms/i/indexarbitrage.asp), so as long as a few people are paying attention, the price remains rational, and the remaining people paying attention are rewarded for doing so. The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.

deleted 8y ago
[deleted]
prostoalex 8y ago
To quote somebody I heard on a Goldman Sachs podcast, "When everyone is seeking alpha, there's money to be made in beta, and vice versa".
erik_seaberg 8y ago
When $3B net income isn't an obstacle to a $1T market cap, reality is sort of optional.
- akvadrako 8y ago
  I assume you are talking about Amazon. Who cares about past income? What matters is future earnings and it's clear they have lots of earnings potential.
  - sinsterizme 8y ago
    Yeah they do. But a $1T valuation implies a crazy amount of cash flow growth. They're top-line is increasing at 20%-30% per year right now but how long can that continue
dustingetz 8y ago
idea: markets will never be rational. at best the balance of arbitragers against mass psychology will stencil the shape of the irrationality.
qubax 8y ago
> The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business. If that's the case it should drive most fund managers out of business since most of them don't beat the S&P over time. https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-beat-their-benchmarks-year-after-year.html https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-... And as more money gets funneled to index funds, the vanguards and fidelitys of the world could lower fees on their index funds which should put even more pressure on most fund managers which could create a vicious cycle. Maybe we'll be left with just index funds and a handful of rock star fund managers.
- taurath 8y ago
  They’re already an order of magnitude or more lower on fees - I don’t think there’s even room for them to go much lower. What would be nice if if funds lowered their fees to be closer to the index ETFs
- FabHK 8y ago
  Though some academics are challenging the conventional consensus that active management is not worth it: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356 Also, I'd like to note, it probably depends on the maturity of the market you're looking it. It will probably be harder to beat passive investing in US fixed income than frontier economies equities. Edit to add: A few big & cheap index funds and a couple of rock star active managers sounds good to me, actually.
- cmdkeen 8y ago
  It also very much depends on who is doing the investing. If you're CALPERs with ~$320bn you don't want to put it all into the S&P 500. Diversification through exposure to other, ideally uncorrelated, equity types or asset classes. The best asset managers charge low fees, they make up for it very comfortably in volume and long term holdings. Warren Buffet famously doesn't sell, he doesn't need to make thousands of deals a year to eke a small profit from each, he needs to judiciously pick fewer things that are going to do well in the long term. All too often people don't want to properly invest however, they want to speculate.
conjecTech 8y ago
Index arbitrage is a mechanism that corrects mispricings between an index and its constituents. That isn't the mispricing being discussed. What is being discussed here is the potential for the prices of individual stocks to deviate from any reasonable level because of their inclusion in an index. To some extent, it's just a matter of supply and demand. Because so many people are investing passively, inclusion in an index with highly traded ETFs can cause huge demand for a stock that no one would have particularly cared about otherwise. There are tons of examples of this around the Russell indices, but stocks in most popular indices carry higher multiples than similar companies outside of them. There is also what George Soros called reflexivity - this increase in stock price makes it more likely that your business will survive because it makes financing the business easier. A large market cap both means you can issue shares cheaply, and it makes banks more likely to lend to you. That helps the business stay alive, but it doesn't necessarily improve their underlying business. Without anyone fundamentally evaluating these companies, such situations can persist indefinitely. Short selling is also made hard by the heavy demand created by additional inflows to these indices. Even if you identify a mispriced company, its continued inclusion in the index might prevent the price action that would remedy the situation. In the end, I don't think this is the end of the world, but there is the old saying that bad money drives out good. This kind of mania makes it hard for normal feedback mechanisms to function appropriately. The most direct costs will be born by those who invest in such instruments, but it also adds greatly to the correlation of the markets, since price movements are now implicitly tied to inflows of money from markets.
- dmos62 8y ago
  > old saying that bad money drives out good https://en.wikipedia.org/wiki/Gresham%27s_law https://en.wikipedia.org/wiki/Gresham%27s_law Apparently, to call the saying old is an understatement. Quote from Wikipedia: > The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham (1519–1579), who was an English financier during the Tudor dynasty. However, there are numerous predecessors. The law had been stated earlier by Nicolaus Copernicus; for this reason, it is occasionally known as the Gresham–Copernicus law.[3] It was also stated in the 14th century, by Nicole Oresme c. 1350,[4] in his treatise On the Origin, Nature, Law, and Alterations of Money,[5] and by jurist and historian Al-Maqrizi (1364–1442) in the Mamluk Empire;[6] and noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC.
Moodles 8y ago
Yeah, even more intuitively, there will just be a Nash equilibrium: 1. Everyone wants to make money. 2. People will look for the best way to make money. 3. If enough people are in index funds, the best way is to go active. If enough people are active, it is best to do index funds. Therefore we’ll have an equilibrium where it doesn’t matter too much which you choose (as long as you’re reasonably smart not to get ripped off).
- lsd5you 8y ago
  This contradicts (correctly) the supposed proof that you cannot beat the market on average (since the index funds are the average). Clearly the index funds must be slower to the punch in some sense and thereby lose out to active investors.
  - supahfly_remix 8y ago
    What you say could be true for the nominal return, but actively managed funds typically have to do ~2% better to just compete with index funds considering the total return (i.e., including management fees). Some Vanguard funds have fees as low as 0.01%.
    - Moodles 8y ago
      I’m talking about a Nash equilibrium for the investor who decides to invest in an index fund or an active fund for their own profit. So management fees are subtracted from either choice. Intuitively what I’m saying is pretty trivial: if one choice is obviously better then everyone would go for it, making the other choice better.
  - soVeryTired 8y ago
    What makes index funds average? In fact, what does 'average' mean in this context? A money-weighted average over all market participants before management fees but after trading costs? It's not clear to me that index funds do earn an 'average' return.
    - 8y ago
retube 8y ago
this is fine, and probably true, in benign markets. the risk is in stressed markets. the reduced diversification can result in amplified shocks.
anoncoward111 8y ago
All you need to do is buy cheap leap puts on whichever stocks you feel have a PE ratio that is unsustainable, and wait. I don't know if Sears received a lot of index funding but I'm sure TGT did. It's day of judgment came last summer. AAPL is next. It will take years, but you can only screw customers secretly for so long.
- village-idiot 8y ago
  The market can remain irrational longer than you can remain solvent.
  - anoncoward111 8y ago
    It can, but if you accurately scope your bet then you aren't exposed to as much risk. Something something, don't bet the farm.
sytelus 8y ago
This is not entirely true. Passive funds only perform transactions in response to change in market cap. Market cap value change for any company is entirely controlled by active funds. In other words, you can think of passive funds as observers in market who follows what active funds will do in aggregate. The entire reason passive funds out perform active funds is because they sort of act like ensemble of active funds. Now think of a world where passive funds dominates investments and very few active funds survive. Now the market cap variance increases and small changes induced by active funds gets hugely amplified by passive funds. For example, a hedge fund may decide to liquidate their position on XYZ due to random reason and can trigger 1% change in price (because active funds willing to buy might not be high in number). This then immediately changes market cap and all passive funds will rush to liquidate as well which will tank that company. This obviously can be gamed by clever active funds. As more and more investment becomes passive, I think the ROI for those investors reduces significantly compared to active investors. I am working on theory part for this. If anyone is interested, please feel free to email me.

deleted 8y ago

[deleted]

prostoalex 8y ago

To quote somebody I heard on a Goldman Sachs podcast, "When everyone is seeking alpha, there's money to be made in beta, and vice versa".

erik_seaberg 8y ago

When $3B net income isn't an obstacle to a $1T market cap, reality is sort of optional.

akvadrako 8y ago
I assume you are talking about Amazon. Who cares about past income? What matters is future earnings and it's clear they have lots of earnings potential.
- sinsterizme 8y ago
  Yeah they do. But a $1T valuation implies a crazy amount of cash flow growth. They're top-line is increasing at 20%-30% per year right now but how long can that continue

dustingetz 8y ago

idea: markets will never be rational. at best the balance of arbitragers against mass psychology will stencil the shape of the irrationality.

qubax 8y ago

> The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business. If that's the case it should drive most fund managers out of business since most of them don't beat the S&P over time. https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-beat-their-benchmarks-year-after-year.html https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-... And as more money gets funneled to index funds, the vanguards and fidelitys of the world could lower fees on their index funds which should put even more pressure on most fund managers which could create a vicious cycle. Maybe we'll be left with just index funds and a handful of rock star fund managers.

taurath 8y ago
They’re already an order of magnitude or more lower on fees - I don’t think there’s even room for them to go much lower. What would be nice if if funds lowered their fees to be closer to the index ETFs
FabHK 8y ago
Though some academics are challenging the conventional consensus that active management is not worth it: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356 Also, I'd like to note, it probably depends on the maturity of the market you're looking it. It will probably be harder to beat passive investing in US fixed income than frontier economies equities. Edit to add: A few big & cheap index funds and a couple of rock star active managers sounds good to me, actually.
cmdkeen 8y ago
It also very much depends on who is doing the investing. If you're CALPERs with ~$320bn you don't want to put it all into the S&P 500. Diversification through exposure to other, ideally uncorrelated, equity types or asset classes. The best asset managers charge low fees, they make up for it very comfortably in volume and long term holdings. Warren Buffet famously doesn't sell, he doesn't need to make thousands of deals a year to eke a small profit from each, he needs to judiciously pick fewer things that are going to do well in the long term. All too often people don't want to properly invest however, they want to speculate.

conjecTech 8y ago

Index arbitrage is a mechanism that corrects mispricings between an index and its constituents. That isn't the mispricing being discussed. What is being discussed here is the potential for the prices of individual stocks to deviate from any reasonable level because of their inclusion in an index. To some extent, it's just a matter of supply and demand. Because so many people are investing passively, inclusion in an index with highly traded ETFs can cause huge demand for a stock that no one would have particularly cared about otherwise. There are tons of examples of this around the Russell indices, but stocks in most popular indices carry higher multiples than similar companies outside of them. There is also what George Soros called reflexivity - this increase in stock price makes it more likely that your business will survive because it makes financing the business easier. A large market cap both means you can issue shares cheaply, and it makes banks more likely to lend to you. That helps the business stay alive, but it doesn't necessarily improve their underlying business. Without anyone fundamentally evaluating these companies, such situations can persist indefinitely. Short selling is also made hard by the heavy demand created by additional inflows to these indices. Even if you identify a mispriced company, its continued inclusion in the index might prevent the price action that would remedy the situation. In the end, I don't think this is the end of the world, but there is the old saying that bad money drives out good. This kind of mania makes it hard for normal feedback mechanisms to function appropriately. The most direct costs will be born by those who invest in such instruments, but it also adds greatly to the correlation of the markets, since price movements are now implicitly tied to inflows of money from markets.

dmos62 8y ago
> old saying that bad money drives out good https://en.wikipedia.org/wiki/Gresham%27s_law https://en.wikipedia.org/wiki/Gresham%27s_law Apparently, to call the saying old is an understatement. Quote from Wikipedia: > The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham (1519–1579), who was an English financier during the Tudor dynasty. However, there are numerous predecessors. The law had been stated earlier by Nicolaus Copernicus; for this reason, it is occasionally known as the Gresham–Copernicus law.[3] It was also stated in the 14th century, by Nicole Oresme c. 1350,[4] in his treatise On the Origin, Nature, Law, and Alterations of Money,[5] and by jurist and historian Al-Maqrizi (1364–1442) in the Mamluk Empire;[6] and noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC.

Moodles 8y ago

Yeah, even more intuitively, there will just be a Nash equilibrium: 1. Everyone wants to make money. 2. People will look for the best way to make money. 3. If enough people are in index funds, the best way is to go active. If enough people are active, it is best to do index funds. Therefore we’ll have an equilibrium where it doesn’t matter too much which you choose (as long as you’re reasonably smart not to get ripped off).

lsd5you 8y ago
This contradicts (correctly) the supposed proof that you cannot beat the market on average (since the index funds are the average). Clearly the index funds must be slower to the punch in some sense and thereby lose out to active investors.
- supahfly_remix 8y ago
  What you say could be true for the nominal return, but actively managed funds typically have to do ~2% better to just compete with index funds considering the total return (i.e., including management fees). Some Vanguard funds have fees as low as 0.01%.
  - Moodles 8y ago
    I’m talking about a Nash equilibrium for the investor who decides to invest in an index fund or an active fund for their own profit. So management fees are subtracted from either choice. Intuitively what I’m saying is pretty trivial: if one choice is obviously better then everyone would go for it, making the other choice better.
- soVeryTired 8y ago
  What makes index funds average? In fact, what does 'average' mean in this context? A money-weighted average over all market participants before management fees but after trading costs? It's not clear to me that index funds do earn an 'average' return.
  - 8y ago

retube 8y ago

this is fine, and probably true, in benign markets. the risk is in stressed markets. the reduced diversification can result in amplified shocks.

anoncoward111 8y ago

All you need to do is buy cheap leap puts on whichever stocks you feel have a PE ratio that is unsustainable, and wait. I don't know if Sears received a lot of index funding but I'm sure TGT did. It's day of judgment came last summer. AAPL is next. It will take years, but you can only screw customers secretly for so long.

village-idiot 8y ago
The market can remain irrational longer than you can remain solvent.
- anoncoward111 8y ago
  It can, but if you accurately scope your bet then you aren't exposed to as much risk. Something something, don't bet the farm.

sytelus 8y ago

This is not entirely true. Passive funds only perform transactions in response to change in market cap. Market cap value change for any company is entirely controlled by active funds. In other words, you can think of passive funds as observers in market who follows what active funds will do in aggregate. The entire reason passive funds out perform active funds is because they sort of act like ensemble of active funds. Now think of a world where passive funds dominates investments and very few active funds survive. Now the market cap variance increases and small changes induced by active funds gets hugely amplified by passive funds. For example, a hedge fund may decide to liquidate their position on XYZ due to random reason and can trigger 1% change in price (because active funds willing to buy might not be high in number). This then immediately changes market cap and all passive funds will rush to liquidate as well which will tank that company. This obviously can be gamed by clever active funds. As more and more investment becomes passive, I think the ROI for those investors reduces significantly compared to active investors. I am working on theory part for this. If anyone is interested, please feel free to email me.