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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

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?

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?