4 ms·

This is a really good explanation, but you would think market forces would kick in. If a company drops 20% (or even 3%!) from an event that doesn't effect the b

This is a really good explanation, but you would think market forces would kick in. If a company drops 20% (or even 3%!) from an event that doesn't effect the business itself, you're going to get smart money buying. I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. This is under the assumption that there will be capital available to flow, if there isn't because of a truly bad scenario, yes it's a downward spiral, but it will take quite an event to get us to that point.

AlanYx 7y ago
The "smart money" would start buying, but I imagine the concern is that as passive instruments become the majority of the market, there wouldn't be a deep enough pool of assets held by "smart money" to provide offsetting liquidity in the way you describe.
- mox1 7y ago
  But wouldn't this reach some sort of equilibrium point? IE if a smart person with a lot of money think there is no "smart money" left, wouldn't (s)he just start their own smart money hedge fund to provide / do this? If nobody is left to do thing X AND thing X is basically guaranteed profit, isn't it natural for people to step in and do thing X?
  - pas 7y ago
    But we already have that. Gold. Or CHF. The problem is that it takes roughly 10 years to outshine the stock market.
- SubiculumCode 7y ago
  I know next to nothing about investing, but I thought the article said that passive instruments are a very small portion of the market...and also that in house indexing has always been a thing.
- chawco 7y ago
  But doesn't it seem like that, as total ownership of the market shifts towards passives, higher returns would be driven by funds running active strategies such as these, thus making them more attractive investments? It seems like this sort of thing chases an equilibrium.
dcolkitt 7y ago
> I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting. E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock. Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release. Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk. The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio. [0] http://web.mit.edu/Alo/www/Papers/august07.pdf http://web.mit.edu/Alo/www/Papers/august07.pdf

AlanYx 7y ago

The "smart money" would start buying, but I imagine the concern is that as passive instruments become the majority of the market, there wouldn't be a deep enough pool of assets held by "smart money" to provide offsetting liquidity in the way you describe.

mox1 7y ago
But wouldn't this reach some sort of equilibrium point? IE if a smart person with a lot of money think there is no "smart money" left, wouldn't (s)he just start their own smart money hedge fund to provide / do this? If nobody is left to do thing X AND thing X is basically guaranteed profit, isn't it natural for people to step in and do thing X?
- pas 7y ago
  But we already have that. Gold. Or CHF. The problem is that it takes roughly 10 years to outshine the stock market.
SubiculumCode 7y ago
I know next to nothing about investing, but I thought the article said that passive instruments are a very small portion of the market...and also that in house indexing has always been a thing.
chawco 7y ago
But doesn't it seem like that, as total ownership of the market shifts towards passives, higher returns would be driven by funds running active strategies such as these, thus making them more attractive investments? It seems like this sort of thing chases an equilibrium.

dcolkitt 7y ago

> I'd have a hard time believing some niche hedge fund somewhere wouldn't make a killing off this by providing liquidity. Typically the opportunists here would be stat-arb hedge funds. They bread and butter of their strategy is to isolate the non-explainable ("idiosyncratic") movement in single name stocks, then bet on that factor mean-reverting. E.g. if Microsoft goes down 0.5%, but the market's up 1%, and the tech stocks are up 1.2%, and various other factors that move Microsoft don't explain it being down. Then they'll bet that the movement is driven by random noise, and buy Microsoft, betting that it will re-converge with where it's expected to be. They'll also use various techniques to isolate whether idiosyncratic movements are likely driven by company specific factors or market noise. Like NLP on a newsfeed to look to see if there are any breaking stories, or tracking recent analyst revisions on the stock. Suffice to say that stat-arb funds in this day and age are very very good at this. In a liquidity unwind event, the signals stat-arb traders use would absolutely be lighting up. The biggest question would be whether stat-arb funds in aggregate have enough capital to counter the absolutely humongous flows that a potential index fund unwinding would release. Another complicating wrinkle is that most stat-arb desks are no longer independent hedge funds, but units within larger multi-strategy funds (like Two Sigma or Millennium). There's good and bad. The good is that if there's all of a sudden massive opportunity the multi-strat fund can quickly reallocate more capital to the stat-arb desk. The bad part is that stat-arb desks may be unwound due to arbitrary contagion in other parts of the market. If the multi-strat fund sees a big loss in another unit, it may pull capital from the stat-arb desk to meet margin calls or redemptions. For example this happened in August 2007 [0]. The subprime mortgage market blew up, then all of a sudden a bunch of esoteric stocks started behaving crazy for the next weeks. And that was largely because multistrat funds were pulling capital to meet margin calls on their mortgage portfolio. [0] http://web.mit.edu/Alo/www/Papers/august07.pdf http://web.mit.edu/Alo/www/Papers/august07.pdf