13 ms·

To me, the interesting question is: if the market is mostly index funds, what does that do? Lots of passive money means that the market is an amplifier for the

by ISL 8y ago

To me, the interesting question is: if the market is mostly index funds, what does that do? Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is forced to follow you. Sell some, and they will follow you, too. It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.

ucaetano 8y ago
> To me, the interesting question is: if the market is mostly index funds, what does that do? This will never happen. It might be interesting, but isn't a realistic scenario.
- prostoalex 8y ago
  Why?
  - ucaetano 8y ago
    I posted it here: https://news.ycombinator.com/item?id=18145067 https://news.ycombinator.com/item?id=18145067 But essentially, as % of market on index funds increases, the returns on arbitrage-seeking actively managed portfolios will increase (vs. the market) to the point that they provide higher returns than the index funds (due to index funds no longer accurately capturing all information available in the market), resulting in a shift of money out of index funds to active funds, decreasing the returns in active funds and keeping the market in equilibrium.
brisance 8y ago
The "you" refers to the "index fund manager", yes? If so, then your thesis doesn't make sense. The index fund manager's job is to maintain the fund's allocation according to the index calculation to the best of his ability, not "go out and buy some $AMZN cos it looks cheap" (which opens up the fund for civil lawsuits for not adhering to the prospectus), or to "manipulate the herd". Tracking errors happen, but those are incidental to the need for re-balancing and are not outright actions undertaken by the fund manager for the purposes stated above.
- URSpider94 8y ago
  ... and thus the rise of “smart Beta” funds. The fact that many market indices are price-weighted is considered a flaw - consider, for example, that a stock with a 3x higher price in the DJIA will move the index 3x as much, regardless of market cap. Smart Beta funds attempt to adjust capital allocation by using different criteria to determine how much of each security to hold - for example, dividend yield rate, or volatility. Overall, this means that moves in and out of a particular security by a passive smart Beta fund become somewhat separated from the moves of its parent index. More generally, the interesting thing about optimal portfolio funds is that they move counter to price. Appreciation in a particular asset class will cause that asset to be over-weighted in the portfolio, and the response will be to sell some of it, or buy more of everything else, to get back to the target ratios. Conversely, you find yourself buying into asset classes that keep falling (like natural resources over the past 5 years or so...), with the implicit assumption that some day they will rebound.
masterjack 8y ago
Not quite. One reason why many passive indices are market-cap weighted is so they do not have to regularly trade. Suppose a fund needs to be 1% AMZN. Now you fire up a hype train and the price of AMZN doubles. It now represents twice as much of the index, market-cap weighted, so the fund wants to be 2% into AMZN, but their stake has doubled with the price so there’s no trading needed! That said, you can generally pick up an extra point or two of returns by equally weighting and trading against the daily volatility, and some funds do this, but they cannot scale up to have as large capacity.
- ISL 8y ago
  Ah -- you are correct. Thanks!

by ISL 8y ago

ucaetano 8y ago

> To me, the interesting question is: if the market is mostly index funds, what does that do? This will never happen. It might be interesting, but isn't a realistic scenario.

prostoalex 8y ago
Why?
- ucaetano 8y ago
  I posted it here: https://news.ycombinator.com/item?id=18145067 https://news.ycombinator.com/item?id=18145067 But essentially, as % of market on index funds increases, the returns on arbitrage-seeking actively managed portfolios will increase (vs. the market) to the point that they provide higher returns than the index funds (due to index funds no longer accurately capturing all information available in the market), resulting in a shift of money out of index funds to active funds, decreasing the returns in active funds and keeping the market in equilibrium.

brisance 8y ago

The "you" refers to the "index fund manager", yes? If so, then your thesis doesn't make sense. The index fund manager's job is to maintain the fund's allocation according to the index calculation to the best of his ability, not "go out and buy some $AMZN cos it looks cheap" (which opens up the fund for civil lawsuits for not adhering to the prospectus), or to "manipulate the herd". Tracking errors happen, but those are incidental to the need for re-balancing and are not outright actions undertaken by the fund manager for the purposes stated above.

URSpider94 8y ago
... and thus the rise of “smart Beta” funds. The fact that many market indices are price-weighted is considered a flaw - consider, for example, that a stock with a 3x higher price in the DJIA will move the index 3x as much, regardless of market cap. Smart Beta funds attempt to adjust capital allocation by using different criteria to determine how much of each security to hold - for example, dividend yield rate, or volatility. Overall, this means that moves in and out of a particular security by a passive smart Beta fund become somewhat separated from the moves of its parent index. More generally, the interesting thing about optimal portfolio funds is that they move counter to price. Appreciation in a particular asset class will cause that asset to be over-weighted in the portfolio, and the response will be to sell some of it, or buy more of everything else, to get back to the target ratios. Conversely, you find yourself buying into asset classes that keep falling (like natural resources over the past 5 years or so...), with the implicit assumption that some day they will rebound.

masterjack 8y ago

Not quite. One reason why many passive indices are market-cap weighted is so they do not have to regularly trade. Suppose a fund needs to be 1% AMZN. Now you fire up a hype train and the price of AMZN doubles. It now represents twice as much of the index, market-cap weighted, so the fund wants to be 2% into AMZN, but their stake has doubled with the price so there’s no trading needed! That said, you can generally pick up an extra point or two of returns by equally weighting and trading against the daily volatility, and some funds do this, but they cannot scale up to have as large capacity.

ISL 8y ago
Ah -- you are correct. Thanks!