4 ms·

This is a great explanation. Can you explain why this isn't a problem for actively managed funds, though? Do they just avoid stocks like CB?

dcolkitt 7y ago
No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock. Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations. But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors. As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.
- hyperpape 7y ago
  I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active funds scenario, what you're describing in the previous post doesn't happen? Why doesn't a 20% marketwide downturn cause chaos in these smaller stocks? Is it because there would be higher volumes if those stocks were held by active funds? Or because the active funds wouldn't hold stocks like that? Basically, I'm asking for a comparison of the scenario you described with what happens in a no-index world, because I can't quite think through the difference myself.
  - pas 7y ago
    The difference is hypothetical, because if enough people exit the active fund, even if the fund manager thinks it's a folly, eventually they have to sell whatever makes up the fund, and eventually those sells will push prices down. That's why crashes are fast and hard. Yes in theory the manager can try to alter the composition of the fund by selling the stocks that are still going strong. But why would they? That just exposes them to known hazards even more. So, probably the active funds will be the first ones to drop the small stocks first in a crash.
  - dcolkitt 7y ago
    That's an interesting point. While it's definitely true that any major unwind of that size will disrupt the market, there's some reasons to believe an ecosystem dominated by active investors would do better. First as mentioned before, active investors have discretion. There's strong reason to believe that as the sell-off's happening that they'd move into the most dislocated stocks. That acts as kind of a negative feedback loop. It wouldn't stop a market-wide selloff, but would keep things more balanced between single-name stocks vis-a-vis the rigid rules governing passive index managers. Second, by definition active funds are more differentiated from one another. Passive indexing produces a mono-culture with analogous ecological risks to what we see in nature. The typical active fund only holds about 50 positions at any given time. So, on the whole while active investors in aggregate hold 0.3% of their portfolios in Chubb, at an individual level most funds hold zero. And some minority may hold 1%, 5%, 10% or more of their assets in Chubb. So if one fund fails, that's less likely to spread contagion to every other fund in the universe. In that type of unwind scenario, some funds will do pretty decently, and some funds will do horribly. But the point is there will be a dispersion of results. That makes the market as a whole more robust. Panicking investors are more likely to re-allocate their capital from the bad funds to the good funds, rather than pull all their out in a flight to quality.
    - jancsika 7y ago
      Wouldn't a random selection process for basket assets and/or weights do just as well as active fund management to stave off this systemic risk?
BryanBigs 7y ago
When I actively managed money for mutual funds, we had limits on both total % ownership and how many days of volume we could own. We were small cap growth, so sometimes we could be stopped from owning as much of a company as we wanted because it was too illquid. Passive doesn't care - it buys what it needs to replicate the returns of the underlying. Also, it's well known that if a hedge fund (or mutual fund) is in trouble, they sell more of what they CAN rather than what they want. That's one reason why we always knew who else owned the stocks we did. Index funds have no leeway here. They need to sell - whether there is liquidity available or not. My gut is, there will be much less liquidity available during the next crisis than you'd expect. A lot of "non passive" investment is quant driven, which ends up becoming very homogenous in nature across different firms. Many also have momentum factors in play, where they buy short term positive momentum and sell the reverse. Once again,vthey don't have a lot of leeway for humans to say "this market is different".

dcolkitt 7y ago

No, I think in such a scenario active investors would wind up getting just as whalloped as passive investors. By definition active investors in aggregate have the same average exposure as cap-weighted indexers to any given stock. Arguably, after the crash they might be able to take advantage of the opportunity. If they concentrate into the stocks with the biggest price displacements, then as those stocks return to normal, they may make up some or all of their initial losses. Passive indexers can't do this, because they don't have the mandate to deviate from their pre-defined allocations. But I think the broader issue is that excessive amounts of indexing present potential systematic risks for everybody. Burry's hypothesis is more relevant for policymakers than it is for investors. As an individual, long-term buy-and-hold investor, low-cost index funds are without question the best option for investing. The problem is behavior that's rational on an individual level, may produce irrational results at the collective level.

hyperpape 7y ago
I'm not sure I stated my question clearly enough. I'm not asking whether active funds would fare better than index funds in a downturn, though it's interesting to hear. I'm asking for a comparison of two scenariors. In the index fund scenario, we're in the world where index funds represent a large and growing chunk of the market. In the active funds scenario, index funds aren't a thing. Why is it that in the active funds scenario, what you're describing in the previous post doesn't happen? Why doesn't a 20% marketwide downturn cause chaos in these smaller stocks? Is it because there would be higher volumes if those stocks were held by active funds? Or because the active funds wouldn't hold stocks like that? Basically, I'm asking for a comparison of the scenario you described with what happens in a no-index world, because I can't quite think through the difference myself.
- pas 7y ago
  The difference is hypothetical, because if enough people exit the active fund, even if the fund manager thinks it's a folly, eventually they have to sell whatever makes up the fund, and eventually those sells will push prices down. That's why crashes are fast and hard. Yes in theory the manager can try to alter the composition of the fund by selling the stocks that are still going strong. But why would they? That just exposes them to known hazards even more. So, probably the active funds will be the first ones to drop the small stocks first in a crash.
- dcolkitt 7y ago
  That's an interesting point. While it's definitely true that any major unwind of that size will disrupt the market, there's some reasons to believe an ecosystem dominated by active investors would do better. First as mentioned before, active investors have discretion. There's strong reason to believe that as the sell-off's happening that they'd move into the most dislocated stocks. That acts as kind of a negative feedback loop. It wouldn't stop a market-wide selloff, but would keep things more balanced between single-name stocks vis-a-vis the rigid rules governing passive index managers. Second, by definition active funds are more differentiated from one another. Passive indexing produces a mono-culture with analogous ecological risks to what we see in nature. The typical active fund only holds about 50 positions at any given time. So, on the whole while active investors in aggregate hold 0.3% of their portfolios in Chubb, at an individual level most funds hold zero. And some minority may hold 1%, 5%, 10% or more of their assets in Chubb. So if one fund fails, that's less likely to spread contagion to every other fund in the universe. In that type of unwind scenario, some funds will do pretty decently, and some funds will do horribly. But the point is there will be a dispersion of results. That makes the market as a whole more robust. Panicking investors are more likely to re-allocate their capital from the bad funds to the good funds, rather than pull all their out in a flight to quality.
  - jancsika 7y ago
    Wouldn't a random selection process for basket assets and/or weights do just as well as active fund management to stave off this systemic risk?

BryanBigs 7y ago

When I actively managed money for mutual funds, we had limits on both total % ownership and how many days of volume we could own. We were small cap growth, so sometimes we could be stopped from owning as much of a company as we wanted because it was too illquid. Passive doesn't care - it buys what it needs to replicate the returns of the underlying. Also, it's well known that if a hedge fund (or mutual fund) is in trouble, they sell more of what they CAN rather than what they want. That's one reason why we always knew who else owned the stocks we did. Index funds have no leeway here. They need to sell - whether there is liquidity available or not. My gut is, there will be much less liquidity available during the next crisis than you'd expect. A lot of "non passive" investment is quant driven, which ends up becoming very homogenous in nature across different firms. Many also have momentum factors in play, where they buy short term positive momentum and sell the reverse. Once again,vthey don't have a lot of leeway for humans to say "this market is different".