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Index funds definitely have a free rider problem. Warren Buffett lucidly pointed out that the average performance of active investors will be....the market ave
by graeme 7y ago
Index funds definitely have a free rider problem.
Warren Buffett lucidly pointed out that the average performance of active investors will be....the market average. You cannot, by definition, have a majority of investors beating the market.
And once you add in fees, index funds produce above average performance, as they have low fees.
So far so good. But, the index funds are free riding on the decisions taken by active investors. Active investors do a useful service to the world by moving capital away from inefficient companies and towards efficient companies.
If the market gets worse at this capital allocation, we can expect overall lower returns.
In other words, there's average market performance but also the factor of efficiency in capital allocation.
This is related to but separate from what Burry talked about, I think. His central point seemed to be that valuations were based on very thin trading, and that when money is taken out of index funds, it will be very hard to find sufficient buyers without a large drop in prices. Add in to that complex derivatives etc used in making all the etfs work.
That bit is somewhat beyond me though. Anyone got a good analysis of how that may play out?
- sokoloff 7y ago> You cannot, by definition, have a majority of investors beating the market. You cannot have a majority of money beating the market. It is mathematically possible for a majority of investors (each relatively small) beat the overall market (albeit unlikely). (I agree with your overall post, but not that line.)
- graeme 7y agoOh true
- sriram_sun 7y ago> But, the index funds are free riding on the decisions taken by active investors. I'm sure there is a pretty clear criteria for making it to the S&P 500 or the Nasdaq 100. Which means it can be coded up. Index funds don't track the investments of other active investors. They track the performance of companies (typically market leaders) based on some transparent and objective criteria. These performances could be tied to a multitude of factors - Founder managed, innovative, market focus, sales & marketing, slave labor, good copycats who knows (or cares?). The point is they've made it to the top of some list and are generating revenue within a system of "acceptable" checks and balances. If the company doesn't meet that criteria, it will be booted off of that list. The bet is always focused on objective criteria. None of that is free riding on active traders.
- graeme 7y agoThis is not correct. According to wikipedia, the s and p (for example) has eight criteria: market capitalization, liquidity, domicile, public float, sector classification, financial viability, and length of time publicly traded and stock exchange. Market cap and liquidity are determined entirely by active traders. Domicile, public float and sector classification are more negative criteria than positives. They exclude a company from the index for not meeting them, but by themselves are not reason for inclusion. Many american companies meet them. The same applies to length of time traded. That leaves only one criterion, financial viability. Meanwhile, the purpose of the index is to track the performance of the 500 largest companies. That's market cap, determined entirely by the price of shares outstanding multiplied by their number.
- sriram_sun 7y agoOk. Thanks I see your point. Active traders set current market value. So if the price of AAPL goes to $1MM, then the indexes adjust accordingly. Cool!