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In the limit, the market becomes completely detached from reality. In practice, the market will become increasingly irrational, leading to an increasing arbitr

In the limit, the market becomes completely detached from reality. In practice, the market will become increasingly irrational, leading to an increasing arbitrage opportunity for active investors. There may be a period where active investment gives a better ROI, even when accounting for fees; but in the long term, the amount of passive investment should reach an equilibrium where the benefits active investment is equal to its overhead.

satvikpendem 4y ago
This is my thought as well, that the alpha would increase until it's enticing enough for active investors, but then I thought, most people are lazy and won't want to actively invest, so will this alpha ever decrease to an equilibrium state?
- gizmo686 4y ago
  The more likely outcome is an increase in actively managed funds. Individuals will still contribute their money into the fund just like with index investing. However, instead of simply tracking an index, the fund would have a (team of) professional investors deciding how to invest on an ongoing basis, in exchange for a management fee. These exist today and are no more difficult to invest in than index funds. Of course, these also have higher overhead than index funds and, at the moment. Currently they are not popular because their performance relatively to an index does not justify their increased fees. If alpha gets high enough, this will stop being true and slowly the popular wisdom will update to saying that actively managed funds give a better ROI. There is also the Wall Street Bets class of active investors. In the current market, I'm not convinced they are actually helping. But, in a world where no one else is activly investing, they are probably better than nothing.
- ohgodplsno 4y ago
  The vast majority of the money in the stock market is not from individual investors, but from hedge funds, large asset management companies, etc. And these hyenas will be happy to jump on any potential way of making more out of their investment. Equilibrium will be reached almost instantly the moment they decide it's worth it.
  - Galanwe 4y ago
    > The vast majority of the money in the stock market is not from individual investors, but from hedge funds, large asset management companies, etc. That is outrageously wrong information. Half the ownership of the US stock market is from households and mutual funds, with a third from the former. The other half is mainly Etfs underlyings and pension funds. Hedge funds represent less that 5% of the total US market ownership.
- Buttons840 4y ago
  > most people are lazy Most people collectively hold less than 1 or 2 percent of the stocks. People and funds who have 100 billion invested won't be lazy.
BeFlatXIII 4y ago
> In the limit, the market becomes completely detached from reality One could say this happened anyway in the aftermath of the QE (a.k.a. money printing) response to the '08 crisis.
OscarCunningham 4y ago
> There may be a period where active investment gives a better ROI, even when accounting for fees; Where would those gains come from? It can't be that the index funds are matching the market and the active investors are doing better. Someone has to be doing worse in that situation.
- s1artibartfast 4y ago
  I think the implication is that the retail index investors will end up doing worse. One thought experiment is if being part of an index confers additional perceived value, the addition or removal from it index is an Arbitrage opportunity. Imagine trading against someone who will reliably pay a premium for an index of "top 10 stocks". Price will spike for a stock that goes from #11 to 10, and drop for every stock that goes from 10 to 11. Index investors will overpay for a newly listed stock and that money will go to an active investor that held it before the listing. Inversely, index investors will lose money whenever a stock is removed from the index.
  - carlmr 4y ago
    True, but what if people buy a bunch of indices, where all these jump in and jump out effects average out. Only buying indexes is different from only buying one index.
    - s1artibartfast 4y ago
      I think the point is that index holders lose money at every jump in and out event. You can't average a list of losses to make it zero. For example, someone willing to pay a $1 premium for an indexed stock. It is trading at $5 today and becomes indexed, so you pay $6 for it. It leaves the index so you can only sell it for $5. It doesn't matter how many times you average it, it is still a source of loss.
      - carlmr 4y ago
        Sorry, I think you misunderstood what I meant. If you only have one index, going from position 11 to 10 increases the value of the stock. But if you have a lot of indices, all these effects should average out to basically zero, since that stock might be in thousands of indices, and a drop out from a single index will only have a marginal effect.

satvikpendem 4y ago

This is my thought as well, that the alpha would increase until it's enticing enough for active investors, but then I thought, most people are lazy and won't want to actively invest, so will this alpha ever decrease to an equilibrium state?

gizmo686 4y ago
The more likely outcome is an increase in actively managed funds. Individuals will still contribute their money into the fund just like with index investing. However, instead of simply tracking an index, the fund would have a (team of) professional investors deciding how to invest on an ongoing basis, in exchange for a management fee. These exist today and are no more difficult to invest in than index funds. Of course, these also have higher overhead than index funds and, at the moment. Currently they are not popular because their performance relatively to an index does not justify their increased fees. If alpha gets high enough, this will stop being true and slowly the popular wisdom will update to saying that actively managed funds give a better ROI. There is also the Wall Street Bets class of active investors. In the current market, I'm not convinced they are actually helping. But, in a world where no one else is activly investing, they are probably better than nothing.
ohgodplsno 4y ago
The vast majority of the money in the stock market is not from individual investors, but from hedge funds, large asset management companies, etc. And these hyenas will be happy to jump on any potential way of making more out of their investment. Equilibrium will be reached almost instantly the moment they decide it's worth it.
- Galanwe 4y ago
  > The vast majority of the money in the stock market is not from individual investors, but from hedge funds, large asset management companies, etc. That is outrageously wrong information. Half the ownership of the US stock market is from households and mutual funds, with a third from the former. The other half is mainly Etfs underlyings and pension funds. Hedge funds represent less that 5% of the total US market ownership.
Buttons840 4y ago
> most people are lazy Most people collectively hold less than 1 or 2 percent of the stocks. People and funds who have 100 billion invested won't be lazy.

BeFlatXIII 4y ago

> In the limit, the market becomes completely detached from reality One could say this happened anyway in the aftermath of the QE (a.k.a. money printing) response to the '08 crisis.

OscarCunningham 4y ago

> There may be a period where active investment gives a better ROI, even when accounting for fees; Where would those gains come from? It can't be that the index funds are matching the market and the active investors are doing better. Someone has to be doing worse in that situation.

s1artibartfast 4y ago
I think the implication is that the retail index investors will end up doing worse. One thought experiment is if being part of an index confers additional perceived value, the addition or removal from it index is an Arbitrage opportunity. Imagine trading against someone who will reliably pay a premium for an index of "top 10 stocks". Price will spike for a stock that goes from #11 to 10, and drop for every stock that goes from 10 to 11. Index investors will overpay for a newly listed stock and that money will go to an active investor that held it before the listing. Inversely, index investors will lose money whenever a stock is removed from the index.
- carlmr 4y ago
  True, but what if people buy a bunch of indices, where all these jump in and jump out effects average out. Only buying indexes is different from only buying one index.
  - s1artibartfast 4y ago
    I think the point is that index holders lose money at every jump in and out event. You can't average a list of losses to make it zero. For example, someone willing to pay a $1 premium for an indexed stock. It is trading at $5 today and becomes indexed, so you pay $6 for it. It leaves the index so you can only sell it for $5. It doesn't matter how many times you average it, it is still a source of loss.
    - carlmr 4y ago
      Sorry, I think you misunderstood what I meant. If you only have one index, going from position 11 to 10 increases the value of the stock. But if you have a lot of indices, all these effects should average out to basically zero, since that stock might be in thousands of indices, and a drop out from a single index will only have a marginal effect.