4 ms·

I think the contrast is between active and passive funds. If your money is in an active fund, there's a manager exerting his intelligence in trying to make goo

I think the contrast is between active and passive funds. If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets. A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants. As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. This means that the market is becoming less and less efficient, and prices are deviating more and more from where they should be. Passive investors are essentially leeching returns off the work of the active investors. This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds take advantage of the situation to start to make more money than before. That's pretty much what the article says he's doing.

davidw 7y ago
> This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds start to make more money than before. This makes sense to me - I would see returns to active investors increasing gradually, as there are fewer of them. At which point, more people take their passive investments and give them to the active investors. At some point you maybe reach some sort of equilibrium. Why would it not be a well-functioning feedback loop like this? > If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets. Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.
- kybernetikos 7y ago
  > Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market. Excellent point. Indeed, I believe the academic view is that due to decreasing returns to scale, funds flow in and out of active funds, with an equilibrium only when any alpha (performance above the norm) is entirely swallowed by fees.
_bxg1 7y ago
Where do robo-advisors like Betterment fall into this? It seems like they combine a variety of different funds; do they typically stick with only passive funds or a mixture?
whatshisface 7y ago
>As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.
- vkou 7y ago
  Or, if the fund managers that survive aren't smarter - but are luckier than the ones being replaced by indices, the intelligence of the market will remain static. Anyone can go all-in on red five times at the roulette table. One out of every 33 players will see 3100% returns from this investment 'strategy'!
mattnewport 7y ago
He seems to be implying that the naive idea of passive funds of actually holding a basket of the indexed stocks is not the reality and that there are various financial shenanigans going on analogous to the issues seen in the run up to the last financial crisis. He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices. That's just my layman's interpretation though, I'm not an expert on this stuff.
lunchables 7y ago
Thank you, this clarified so many things.
wcunning 7y ago
The problem with that interpretation is the following: Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?
- kybernetikos 7y ago
  > If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well. Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance. And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors. You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.

davidw 7y ago

> This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds start to make more money than before. This makes sense to me - I would see returns to active investors increasing gradually, as there are fewer of them. At which point, more people take their passive investments and give them to the active investors. At some point you maybe reach some sort of equilibrium. Why would it not be a well-functioning feedback loop like this? > If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets. Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.

kybernetikos 7y ago
> Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market. Excellent point. Indeed, I believe the academic view is that due to decreasing returns to scale, funds flow in and out of active funds, with an equilibrium only when any alpha (performance above the norm) is entirely swallowed by fees.

_bxg1 7y ago

Where do robo-advisors like Betterment fall into this? It seems like they combine a variety of different funds; do they typically stick with only passive funds or a mixture?

whatshisface 7y ago

>As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.

vkou 7y ago
Or, if the fund managers that survive aren't smarter - but are luckier than the ones being replaced by indices, the intelligence of the market will remain static. Anyone can go all-in on red five times at the roulette table. One out of every 33 players will see 3100% returns from this investment 'strategy'!

mattnewport 7y ago

He seems to be implying that the naive idea of passive funds of actually holding a basket of the indexed stocks is not the reality and that there are various financial shenanigans going on analogous to the issues seen in the run up to the last financial crisis. He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices. That's just my layman's interpretation though, I'm not an expert on this stuff.

lunchables 7y ago

Thank you, this clarified so many things.

wcunning 7y ago

The problem with that interpretation is the following: Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?

kybernetikos 7y ago
> If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well. Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance. And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors. You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.