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Index arbitrage is a mechanism that corrects mispricings between an index and its constituents. That isn't the mispricing being discussed. What is being discuss

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.
pbreit 8y ago
I've always wondered if there's a much differentiation between active and passive as is suggested. The main differences are: 1. list of stocks changes less frequently 2. the list is public 3. less trading There's nothing preventing an "active" manager from behaving in the same/similar manner.
- ethbro 8y ago
  The distinction, as I understand it, are that active funds are legally free to invest in more abstract concepts. E.g. that oil will rally under these sets of economic conditions, and oil companies with these fundamentals are preferable. Whereas passive index funds' concepts are much simpler. E.g. all companies that are this large. This gets summed up as "less trading", but is really just trading on simpler criteria. I'd be really curious to hear from someone in the area about the opposite -- what keeps passive funds (in the "no human" sense) from behaving more like active funds, with targeted, complex investment concepts? If I wanted to start an algorithmically traded fund, cut my expense ratio by not having to pay humans, are there legal barriers currently standing in the way?

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.

pbreit 8y ago

I've always wondered if there's a much differentiation between active and passive as is suggested. The main differences are: 1. list of stocks changes less frequently 2. the list is public 3. less trading There's nothing preventing an "active" manager from behaving in the same/similar manner.

ethbro 8y ago
The distinction, as I understand it, are that active funds are legally free to invest in more abstract concepts. E.g. that oil will rally under these sets of economic conditions, and oil companies with these fundamentals are preferable. Whereas passive index funds' concepts are much simpler. E.g. all companies that are this large. This gets summed up as "less trading", but is really just trading on simpler criteria. I'd be really curious to hear from someone in the area about the opposite -- what keeps passive funds (in the "no human" sense) from behaving more like active funds, with targeted, complex investment concepts? If I wanted to start an algorithmically traded fund, cut my expense ratio by not having to pay humans, are there legal barriers currently standing in the way?