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I am a hedge fund guy who invests his own $$$$ passively so make of this what you will. There will always be a mix of active and passive. Fundamentally - pass

I am a hedge fund guy who invests his own $$$$ passively so make of this what you will. There will always be a mix of active and passive. Fundamentally - passive only works when it follows smart active. Actives do expensive research and trade against each other to arrive at the consensus price. Passives trade at that price for "free." Since both get the same price on average but passives incur no cost, they win on average This breaks down if passives outnumber actives, or if actives are exceptionally stupid. Imagine 100% is passive. That means any stock in an index will be bought tomorrow and forever regardless of price. I could exploit that in a ton of ways. For example, do a "squeeze" (think of the recent GME short squeeze but in reverse.) Or, imagine company X will obviously default but stock keeps going up because passives are obligated to buy. Very easy to exploit by going active! Finally - think about this. Does your index fund have any GME? That part of your portfolio trades at the price set by Reddit apes. The more of that goes on, the more tempting it is to go "active" on the other side.

hehaheha 6y ago
That’s not quite right about passive and active though. It almost always resets every quarter (or other liquidity events). Passive introduced delayed price discovery and as a result greater volatility around earnings (or liquidity events). But over medium to long term passive vs active should not matter.
- xyzelement 6y ago
  Why isn't it "quite right?" I spelled out 3 scenarios that can play out and obviously will given the structure and incentives. Where do you disagree?
  - hehaheha 6y ago
    Because passive does not necessarily mean index. You can be passive and concentrated (see ARKK). And more importantly real world indices are moving target to begin with. They’re just very rough approximation of market basket. SPX is not representative of market as it relates to mpt at all. In fact that’s likely one of the biggest myths in modern finance.
    - xyzelement 6y ago
      The fact that Arkk's own website refers to itself as an active equity etf should prompt you to reconsider your definition of these terms.
      - deleted 6y ago
        [deleted]
the_local_host 6y ago
"Imagine 100% is active" <- Did you mean "Imagine 100% is passive"? That said, I as a buyer-and-holder, I welcome the hordes of active traders willing to expend time, effort, and money to discover the price that I too will be able to trade at.
- xyzelement 6y ago
  Thanks! Fixed!
kreeben 6y ago
>> think of the recent GME short squeeze but in reverse Reverse how? There are so many axis I don't know which to use as the basis of my flip. If you care to, please explain a bit more in detail.
- xyzelement 6y ago
  Flip it on all axis, I guess :) But, sure. Let's say I know that you (index fun) are obligated to buy stock X tomorrow and over all foreseeable future. I am gonna hoard those shares at no risk and sell them to you at a VERY VERY painful price, since you have no room to say "that's too expensive, no thanks"
  - pedrocr 6y ago
    How are you going to hoard "at no risk"? You're trying to corner the market for a given stock in an index pushing it's price way up and thus exposing yourself to the price crashing down and wiping you out. Meanwhile the passives are routinely buying and selling index funds depending on their need to save or raise cash so the net inflows into that stock are positive or negative depending on that. And that stock is only a small part of the total portfolio. Depending on how their specific timing works out your scheme is a net positive or negative but it never wipes them out. Your risk is way worse, particularly if you need to leverage to buy the whole position. Even if your play was to corner the market completely and own almost the full company the end result would be it being removed from the index for there not being enough float around. Then all the index funds dump what they had of it, and you lose your shirt.
    - spywaregorilla 6y ago
      That's the point. An asset can't crash in a 100% passive market because the funds buying the assets are obligated to do so without any discretion. The point is that such a situation is unrealistic.
      - pedrocr 6y ago
        It can crash even more violently by being removed from the index, which would happen if someone actually cornered the market for that stock as I described. My point is that the situation is unrealistic but in a completely different way than what is being described.
pedrocr 6y ago
Your active strategies are not against passive traders, they're against other active traders. You can't create one of those differential bets trading only with index funds as they won't take the other side of the unbalanced position you want as they're obliged to follow the index. In your scenarios you'd be winning against some other active investor taking the other side of the bet. Active as a whole can only beat passive as a whole if the market becomes so screwed up there's too much tracking error for passive to work properly. At that point the passive index no longer represents the market average and the active traders can take a larger share of the gains.
- dan-robertson 6y ago
  In the scenario of a company that is obviously not a going concern you can sell stock short to passive investors. The company will then fail and it’s stock will be worth 0. You get to keep the money. I guess the worry would be that the company could raise money by selling shares and use that to avoid becoming insolvent, but at some point a company is going insolvent faster than it can issue new stock.
  - pedrocr 6y ago
    You can't sell stock short specifically to passive investors. You have to sell it into the market. And since you're trying to sell only that stock and passive investors are buying the whole market your actual net counterparty is a set of some other active traders that hold the mirror position to yours, not the passive traders. The passives will always get the average of the market in that scenario and your above average returns have to come from someone else's below average returns.
    - xyzelement 6y ago
      I just wrote to you the same thing the parent of your post did. You are missing the part of the scenario where "everyone" except the one player is passive. Both I and the poster broke down the mechanics step by step for you...
ItsMonkk 6y ago
So I've been trying to work this out. Previously I understood the idea "The passives are simply the average of the actives". So even if you had 99% passive, so long as the actives were doing their homework the system would work, but as you said you need to watch for exploits. But then I had the question: When the world has gone passive, who is left as an active investor? 1. Wallstreetbets users who do poorly on average, and they are small 2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small 3. ... the company using debt to buyback its own shares So the key behind this entire stock market is that its a beauty contest where you need to make guesses as to what everyone else will do. But as active investors shrink with the increase in passive, what we are allowing happen is that the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds. I have not yet done the intensive research to understand how large 3 can effect a stock, does anyone here have any idea if this will be a problem, and if we are already seeing signs that this is happening already?
- saalweachter 6y ago
  Think of it this way: if there are too many "free riders" in the form of passive investors, then ... it will become easier for active investors to make money, and beat the market, and more people will actively invest their money (or invest in actively managed funds).
  - orojackson 6y ago
    Yep, there will usually be opportunities for arbitrage for active traders if there are too many passive investors. I suspect there will be some sort of equilibrium between active and passive at some point. The thing is that I'd rather be doing other things with my time, so I'm a passive investing kind of guy. Imagine getting the market return for doing nearly nothing for dirt cheap. That's a high growth rate to level of effort ratio!
  - acover 6y ago
    An equilibrium exists but expected returns of active and passive are unknown. Would it reach equilibrium or could there be a crisis due to passive allocating funds poorly.
spywaregorilla 6y ago
> Imagine 100% is passive. That means any stock in an index will be bought tomorrow and forever regardless of price. I could exploit that in a ton of ways. For example, do a "squeeze" (think of the recent GME short squeeze but in reverse.) With more and more assets going into passive funds, when might we actually see them owning such large fractions of companies that a play like this is possible? Google suggests that 10-15% of the SP500 is owned by mutual funds. Presumably there's going to be an inflection point where this becomes problematic.
- skybrian 6y ago
  If you’re holding then you’re neither buying nor selling, and so you don’t participate in setting the price at all, until the day you sell. Only the people (and machines) that are trading have any say. So it seems like it wouldn’t be the percentage of free-riders that’s an issue, but rather that the size of the active market shouldn’t be too small. Index funds need to rebalance so they’re not just holding, but it seems like for passive investors, they approximate holding? Maybe the rebalancing would tend to exaggerate the effects of active trading?
penstroma 6y ago
For those that are interested, this is known as the Grossman-Stiglitz Paradox. See their original paper, "On the Impossibility of Informationally Efficient Markets" (1980). In my opinion, this is one of the most important econ papers ever written. The paper itself is not too technically difficult: the model consists of CARA (i.e. exponential) utility functions and normal random variables, which results in linear demand functions. Solving for the equilibrium is possible with a little bit of linear algebra. For more recent (and much more technically difficult) treatment, you can take a look at Garleanu and Pederson (2018) ("Efficiently Inefficient Markets for Asset and Asset Management").
jessriedel 6y ago
> Actives do expensive research and trade against each other to arrive at the consensus price. Passives trade at that price for "free." Since both get the same price on average but passives incur no cost, they win on average No, actives can make money on average. If the actives do expensive research and learn things, they can buy good stocks at low (below-fair-value-given-new-knowledge) prices, drive up the price, and the passives follow later, buying at high (fair) prices. No one needs to lose, but actives accrue a disproportionate fraction of the gains. > This breaks down if passives outnumber actives Hypothetically there is a level of passive investing where the system breaks, but (1) this has nothing to do with 50% threshold (a small active minority can be fine) and (2) the are natural strong forces that prevent this from happening (as the fraction of passives increases, the reward for being active increases, drawing in more actives).
jamesmark 6y ago
Hello am mark barger from USA, i james mark . to say a very big thanks to Dr Macaulay for saving my soul from dying of Herpes Virus,i have being suffering from this Herpes Virus for two years now, i saw Dr Macaulay email address on a comment of someone who he has helped i was so encourage with the testimony been shared, i took the man email address and also contacted him for help he replied me and ask for some of my details which i provided and also ask for some useful Materials Needed for the herbal herbs which also did not cost me much, i provided all he needed from me to God be blessed this Dr prepared a parcel and send it to me followed with the instruction on how to take the herbal herbs medicine for 14 days. So surprisingly after taking the herbal herbs i went to the hospital for checkup to my greatness surprise my result came out (negative),i will never stop sharing my testimony of how i was cured from my Herpes Virus by Dr Macaulay you can also write him for any type of help you may need (Via:Dr.Macaulayherbalhome@yahoo.com) here his whatsapp https://wa.me/message/HJO6BWJEP4CFJ1mobile https://wa.me/message/HJO6BWJEP4CFJ1mobile number (+2349067522465) for help....
hackerbabz 6y ago
Why would a company ever default if it’s stock price can’t go down. Couldn’t it just sell more stock to cover it’s debts?

hehaheha 6y ago

That’s not quite right about passive and active though. It almost always resets every quarter (or other liquidity events). Passive introduced delayed price discovery and as a result greater volatility around earnings (or liquidity events). But over medium to long term passive vs active should not matter.

xyzelement 6y ago
Why isn't it "quite right?" I spelled out 3 scenarios that can play out and obviously will given the structure and incentives. Where do you disagree?
- hehaheha 6y ago
  Because passive does not necessarily mean index. You can be passive and concentrated (see ARKK). And more importantly real world indices are moving target to begin with. They’re just very rough approximation of market basket. SPX is not representative of market as it relates to mpt at all. In fact that’s likely one of the biggest myths in modern finance.
  - xyzelement 6y ago
    The fact that Arkk's own website refers to itself as an active equity etf should prompt you to reconsider your definition of these terms.
    - deleted 6y ago
      [deleted]

the_local_host 6y ago

"Imagine 100% is active" <- Did you mean "Imagine 100% is passive"? That said, I as a buyer-and-holder, I welcome the hordes of active traders willing to expend time, effort, and money to discover the price that I too will be able to trade at.

xyzelement 6y ago
Thanks! Fixed!

kreeben 6y ago

>> think of the recent GME short squeeze but in reverse Reverse how? There are so many axis I don't know which to use as the basis of my flip. If you care to, please explain a bit more in detail.

xyzelement 6y ago
Flip it on all axis, I guess :) But, sure. Let's say I know that you (index fun) are obligated to buy stock X tomorrow and over all foreseeable future. I am gonna hoard those shares at no risk and sell them to you at a VERY VERY painful price, since you have no room to say "that's too expensive, no thanks"
- pedrocr 6y ago
  How are you going to hoard "at no risk"? You're trying to corner the market for a given stock in an index pushing it's price way up and thus exposing yourself to the price crashing down and wiping you out. Meanwhile the passives are routinely buying and selling index funds depending on their need to save or raise cash so the net inflows into that stock are positive or negative depending on that. And that stock is only a small part of the total portfolio. Depending on how their specific timing works out your scheme is a net positive or negative but it never wipes them out. Your risk is way worse, particularly if you need to leverage to buy the whole position. Even if your play was to corner the market completely and own almost the full company the end result would be it being removed from the index for there not being enough float around. Then all the index funds dump what they had of it, and you lose your shirt.
  - spywaregorilla 6y ago
    That's the point. An asset can't crash in a 100% passive market because the funds buying the assets are obligated to do so without any discretion. The point is that such a situation is unrealistic.
    - pedrocr 6y ago
      It can crash even more violently by being removed from the index, which would happen if someone actually cornered the market for that stock as I described. My point is that the situation is unrealistic but in a completely different way than what is being described.

pedrocr 6y ago

Your active strategies are not against passive traders, they're against other active traders. You can't create one of those differential bets trading only with index funds as they won't take the other side of the unbalanced position you want as they're obliged to follow the index. In your scenarios you'd be winning against some other active investor taking the other side of the bet. Active as a whole can only beat passive as a whole if the market becomes so screwed up there's too much tracking error for passive to work properly. At that point the passive index no longer represents the market average and the active traders can take a larger share of the gains.

dan-robertson 6y ago
In the scenario of a company that is obviously not a going concern you can sell stock short to passive investors. The company will then fail and it’s stock will be worth 0. You get to keep the money. I guess the worry would be that the company could raise money by selling shares and use that to avoid becoming insolvent, but at some point a company is going insolvent faster than it can issue new stock.
- pedrocr 6y ago
  You can't sell stock short specifically to passive investors. You have to sell it into the market. And since you're trying to sell only that stock and passive investors are buying the whole market your actual net counterparty is a set of some other active traders that hold the mirror position to yours, not the passive traders. The passives will always get the average of the market in that scenario and your above average returns have to come from someone else's below average returns.
  - xyzelement 6y ago
    I just wrote to you the same thing the parent of your post did. You are missing the part of the scenario where "everyone" except the one player is passive. Both I and the poster broke down the mechanics step by step for you...

ItsMonkk 6y ago

So I've been trying to work this out. Previously I understood the idea "The passives are simply the average of the actives". So even if you had 99% passive, so long as the actives were doing their homework the system would work, but as you said you need to watch for exploits. But then I had the question: When the world has gone passive, who is left as an active investor? 1. Wallstreetbets users who do poorly on average, and they are small 2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small 3. ... the company using debt to buyback its own shares So the key behind this entire stock market is that its a beauty contest where you need to make guesses as to what everyone else will do. But as active investors shrink with the increase in passive, what we are allowing happen is that the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds. I have not yet done the intensive research to understand how large 3 can effect a stock, does anyone here have any idea if this will be a problem, and if we are already seeing signs that this is happening already?

saalweachter 6y ago
Think of it this way: if there are too many "free riders" in the form of passive investors, then ... it will become easier for active investors to make money, and beat the market, and more people will actively invest their money (or invest in actively managed funds).
- orojackson 6y ago
  Yep, there will usually be opportunities for arbitrage for active traders if there are too many passive investors. I suspect there will be some sort of equilibrium between active and passive at some point. The thing is that I'd rather be doing other things with my time, so I'm a passive investing kind of guy. Imagine getting the market return for doing nearly nothing for dirt cheap. That's a high growth rate to level of effort ratio!
- acover 6y ago
  An equilibrium exists but expected returns of active and passive are unknown. Would it reach equilibrium or could there be a crisis due to passive allocating funds poorly.

spywaregorilla 6y ago

> Imagine 100% is passive. That means any stock in an index will be bought tomorrow and forever regardless of price. I could exploit that in a ton of ways. For example, do a "squeeze" (think of the recent GME short squeeze but in reverse.) With more and more assets going into passive funds, when might we actually see them owning such large fractions of companies that a play like this is possible? Google suggests that 10-15% of the SP500 is owned by mutual funds. Presumably there's going to be an inflection point where this becomes problematic.

skybrian 6y ago
If you’re holding then you’re neither buying nor selling, and so you don’t participate in setting the price at all, until the day you sell. Only the people (and machines) that are trading have any say. So it seems like it wouldn’t be the percentage of free-riders that’s an issue, but rather that the size of the active market shouldn’t be too small. Index funds need to rebalance so they’re not just holding, but it seems like for passive investors, they approximate holding? Maybe the rebalancing would tend to exaggerate the effects of active trading?

penstroma 6y ago

For those that are interested, this is known as the Grossman-Stiglitz Paradox. See their original paper, "On the Impossibility of Informationally Efficient Markets" (1980). In my opinion, this is one of the most important econ papers ever written. The paper itself is not too technically difficult: the model consists of CARA (i.e. exponential) utility functions and normal random variables, which results in linear demand functions. Solving for the equilibrium is possible with a little bit of linear algebra. For more recent (and much more technically difficult) treatment, you can take a look at Garleanu and Pederson (2018) ("Efficiently Inefficient Markets for Asset and Asset Management").

jessriedel 6y ago

> Actives do expensive research and trade against each other to arrive at the consensus price. Passives trade at that price for "free." Since both get the same price on average but passives incur no cost, they win on average No, actives can make money on average. If the actives do expensive research and learn things, they can buy good stocks at low (below-fair-value-given-new-knowledge) prices, drive up the price, and the passives follow later, buying at high (fair) prices. No one needs to lose, but actives accrue a disproportionate fraction of the gains. > This breaks down if passives outnumber actives Hypothetically there is a level of passive investing where the system breaks, but (1) this has nothing to do with 50% threshold (a small active minority can be fine) and (2) the are natural strong forces that prevent this from happening (as the fraction of passives increases, the reward for being active increases, drawing in more actives).

jamesmark 6y ago

Hello am mark barger from USA, i james mark . to say a very big thanks to Dr Macaulay for saving my soul from dying of Herpes Virus,i have being suffering from this Herpes Virus for two years now, i saw Dr Macaulay email address on a comment of someone who he has helped i was so encourage with the testimony been shared, i took the man email address and also contacted him for help he replied me and ask for some of my details which i provided and also ask for some useful Materials Needed for the herbal herbs which also did not cost me much, i provided all he needed from me to God be blessed this Dr prepared a parcel and send it to me followed with the instruction on how to take the herbal herbs medicine for 14 days. So surprisingly after taking the herbal herbs i went to the hospital for checkup to my greatness surprise my result came out (negative),i will never stop sharing my testimony of how i was cured from my Herpes Virus by Dr Macaulay you can also write him for any type of help you may need (Via:Dr.Macaulayherbalhome@yahoo.com) here his whatsapp https://wa.me/message/HJO6BWJEP4CFJ1mobile https://wa.me/message/HJO6BWJEP4CFJ1mobile number (+2349067522465) for help....

hackerbabz 6y ago

Why would a company ever default if it’s stock price can’t go down. Couldn’t it just sell more stock to cover it’s debts?