The Financial Industry Is Having Its Napster Moment
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Actively managed mutual funds are going away fast and that's to everyone's benefit. Some were charging 2% yearly plus a fee when you bought or when you sold( redemption fees). I can't think of a single reason that anyone should have any money in an actively managed mutual fund.
If there is a continuum of hedge funds to ETF's, actively managed mutual funds are literary the worst of both worlds. High fees and low ability to make returns.
From where I sit, the biggest jobs that are in danger are sales jobs. There used to be teams of people at mutual fund companies whose sole job was to sell their products to Investment advisers at brokerages with the hopes that the advisor would put their clients money into these funds.
As someone who is on the side of actively managing money, I see this as a strong positive. The more passive money there is sloshing around the more arb opportunities there are!
This is (Canadian) RBC - Direct Investing.
In addition this particular fund also significantly outperformed other ETFs during 2008-09.
Anything sold by the big banks in Canada is almost always a ridiculous rip-off.
Even better might be something like Wealthsimple.
(Not affiliated with either company except as a customer)
It will depend on your bank, but anecdotally it seems commission free mutual funds are more common than commission free ETFs. If you are the type who wants to invest X% of every paycheck (i.e. making multiple trades a month), are only investing a small amount of money, or are only investing for the short to medium term, you are likely better off with the the higher fee and lower commission. Retirement savings tend to be none of those three categories, so ETFs are almost universally better in that regard.
Roboadvisors like Wealthfront solve this problem more elegantly and at lower cost.
https://personal.vanguard.com/us/whatweoffer/stocksbondscds/...
In the medium term active and passive management will eventually reach equilibrium. Passive funds cannot perform price discovery as well and rely on active funds to do this. However the ability of computers to discover prices will eventually exceed that of humans not possessing insider knowledge. My money is, literally, with the computers.
Is it? I mean, I see how it's reflexive (and so chaotic) but NP-hard is the halting problem: given a program and it's input, decide if it halts. E.g. what is the input to your market function? It's like asking if the world halts.
The thing about all complexity analysis is that it ignores input/output.
Just that its NP-hard doesn't mean it's as hard as the halting problem, it could be easily decidable in exponential time.
Complexity analysis is all about the size of the input, it doesn't ignore it.
An academic analysis like what you linked to has to assume everybody have settled on the same definitions and valuations.
See my other comment describing what a perfect answer looks like.
I solve huge NP-hard problems every day, I've never seen any suggestion there is a useful way to solve marking pricing.
You have not seen any suggestion to solve this problem, does not mean it isn't NP-hard.
>> we just might not have to computing power to calculate it.
There is a perfect answer, and there will almost never be enough computing power to calculate it. It is always approximated.
So you'll have more "perfect" answers than people, and no way to select any one of them.
It's not a valid argument against the fact that everyone does have their marginal benefit and marginal costs for every good and service that can translate to a binary decision of whether they would purchase a good or service at a given price.
Just because you can't see it doesn't mean it's not there. And I'm not saying it's impossible to find out individuals marginal benefits and costs, because in markets you very well can. Stock traders, when evaluating whether a stock would go up or down, would often buy a bunch of stock, see how the market takes it, then sell a bunch, and by measuring how fast the market eats his orders, he can estimate the aggregate marginal benefit and cost of holding the stock, and then speculate accordingly.
I think this fact is more like an axiom.
With NP-hard problems like Sudoku, that's easy. Slightly simplifying, the definition of NP-hard is "easy to check the answer, hard to find it".
EDIT: Added rabbit ears for simple.
You don't need to solve an NP hard problem to beat human intervention. You just have to be faster and more accurate.
I do think that computers could outperform humans on the supply side, calculating the costs of production relative to competitors better than humans. The demand side is trickier but again computers would do a better job calculating available cash and then ranking marginal goods' likelihood of being purchased based on existing prices.
As long as prices and production processes are public knowledge computers will do better than people at modeling the economy. Humans only gain an advantage through insider knowledge and trade secrets.
I am not against ETF, in fact that's what I would use, but it comes with its own problems.
Tomorrow I will buy 10 shares of XYZ at any price, and everyone knows this. XYZ is worth $100/share and today that is the price. If one other person in the world owns XYZ shares they can sell it to me for $200,$300, whatever price they name. If 2 people own shares, there will be competition, and I'll buy at the cheapest price available. If 1000 people own shares I will still have to pay more then $100, but if there is true competition on price then I should only pay slightly over $100.
Say company X is getting bigger, and pretty much qualifies to get into the S&P500 at the next revision of the index, it currently trades around 100.
When it gets into the S&P500 all the ETF buyers will buy this stock, that will push the price up to 110. Some of them will buy it at 100, some will buy it at 110 and some anywhere in the middle.
Now a bunch of hedge funds anticipate the ETF will do that and start buying it ahead of the stock going to the index. The price of that stock will rise to 102, 105, perhaps 107 if you have lots of people doing this arbitrage.
When the ETFs buyers pile in, they will be picking up the stock somewhere between 105 and 110, not 100 and 110.
Now one can argue this is the problem of the bank maintaining the ETF, because as far as the ETF investors are concerned, they own something that tracks the index, if it costs more to replicate the index, it is not their problem. But the way I see it is that the new stock will enter the index at an inflated price, and the price will converge again to the fair value when all the buying is done (instead of the price going up after the stock joins the index and converge again). That means that the ETF investors will have a lower performance than what they would get if no one was arbitraging them.
I kinda agree with you. However, theoretically, I would have been more than happy to put my money in an actively managed fund IF that fund was managed by someone with a very high intelligence and who was able to sit still. By sitting still, I mean not buying and selling all the time. Often, it's far more profitable to sit on shares for many years, rather than buy and sell all the time. But I guess those fund managers are expected to come into some office every day at least from 9 to 5, regardless of whether there is anything to do. Also, they probably have co-workers and bosses who ask them what they're doing. Maybe it would be kinda boring to answer "nothing" every day for like 2 years in a row.
Good sysadmins as well.
Somewhere along the way operators think that if they don't push a button every fifteen minutes they aren't earning their pay (I blame bad management and production pressure). So when in doubt, look busy. It has awful and confusing effects on processes, leading to long term hard-to-diagnose noise in otherwise stable systems.
I think the same principle applies here. We want vigilant, patient, and wise did managers. Not just super active and excitable ones.
I watched a documentary recently that suggested that they gain % for every X period they add value (over risk-free rate?), but don't pay back any % for losses they make? This the situation?
They could do things other money managers couldn't - short stocks (i.e. hedging against a fall, hence their names), better analysts, investments in more diversified instruments, early HFT.
They would often take a fee of two and twenty - that is to say 2% of the money you lent them (every year), plus 20% of the profit they made from that money.
If you gave them $10 million, they'd take $200k as a fee every year, then 20% of the profit they made. So let's say they made you $1 mill a year, they'd be paid in the first year $200k fees and $200k performance fees.
However nowadays there's millions of them, and almost all of them lose money as there weren't that many profitable niches to begin with, and a lot of them were lucky anyway (survivorship bias).
Of course any reported results on hedge fund returns are kinda funky for the reason of bias that you mention.
Survivorship bias is huge in this industry. There have been plenty of funds with awesome runs, but few have lasted 20+ years.
PS: The financial industry also loves to point at old funds as being above average while quietly killing off lot's of tiny funds and growing others over time. IMO, this goes past survivorship bias and into the old con where you mail 1024 people the results of a game, then 512 people you got right, then 256... Until you have great history with your last sucker.
There are hundreds of strategies in hedgefunds from HFT to Macro to volatility trading to commercial ground rents to God Knows What™ - so I'd really like to see what was being done for this kind of analysis (and who by and what data they had access to).
Past performance is a lot like the false positive problem in medical testing. A 99% correct test on a condition affecting 1% of the population is not useful. Similarly looking at past performance for a hedge fund is a poor way of identifying those with "alpha" (if you believe true alpha exists at all, which is entirely dependent on your point of view).
Take Mr Buffet as a spurious example. If he leaves the fund, it won't affect past performance for some time. So do you want to buy into B-H without him - just because it used to make money? Or would you go into his new fund because you think he has a process that works.
1. I think passive money is generally not taking any position on whether an asset is over or under priced, and as a class tends to be very inactive. I doubt it either increases or decreases arb that much.
2. I think what would increase arb opportunities would be:
A. A critical mass of misinformed active managers
B. So few active managers that the market is gameable
However, as the number of active managers decreases, one would think that the misinformed ones would go first (A), and that (B) won't be a linear progression, but a sudden tipping point at a very low level of active management.
Actually, I sort of think the final statement is reversed. As the number of active managers declines, and the average active manager becomes more competent, it will become harder for the active managers to find profitable arbitrage opportunities.
If someone (or some company) is claiming to be better than me at using my money to make money, surely they'd agree to put skin in the game, and only profit when I do?
If they don't feel confident enough about their choices making money (and hence, ensuring they get compensated), why should I?
edit: I was referring to the types of funds typical retail investors are in, not hedge funds.
True. Edited my comment.
Imagine you believe that mail order companies are poised for rapid growth in coming years. You don't know which ones specifically, and there are thousands. So you buy a mutual fund which holds hundreds of these companies. This gives you some diversification and lets you make your bet with only a single commission to buy and sell.
But the fund manager may disagree with your investment thesis. She may be fully convinced that online shopping has already destroyed the mail order business permanently. She would therefore gladly run a fund for you, but she would not bet on its performance herself.
For a somewhat more real-life example of this, watch or read "The Big Short." The protagonist wants to buy something that the banks think will lose money.
I'm referring to funds managed for me with the proposition that they will beat the market, i.e. the fund manager has a thesis which they agree with (because it is theirs.)
So while what you're referring to of course exists, it's not what I was talking about.
Apologies for being too vague in my post, however I thought the underlying assumption of this discussion of actively managed funds being chipped away by passive ones was that we were talking about the types of investment vehicles used by a "normal" person that wants to put their money in something that will grow over time, without having to pick stocks on their own.
If a person's only belief in the market is that they want to beat it, they are out of luck before the opening bell.
What about this, a mutual fund that users don't really care about what industry it goes into (as long as it is legal) and then the manager decides? In reality are grandma and grampa really deeply insistent that their money should go into mail order businesses so to speak or are they more interested into getting a certain return and would rather have a fund manager "professional" decide? I see the second choice as more plausable somehow.
The wall street journal interviews fund managers every year or so, and asks them, if someone gave you all their money in return for a fixed, guaranteed annual interest rate, how much would you promise them?
Generally the answers are in the 1-2% range
I like the argument that if anyone could pick stocks better than average, they'd end owning everything - but I don't pretend to understand the share market well enough to be confident investing everything according to that.
But if the very people who know most about the share market charge fixed fees, this seems to me to be an implicit recognition that they can't out-perform the market in any meaningful way. I once engaged a broker in an argument about this, and they ended up admitting that the only value they added was managing the whole shares-bonds-cash mix for people who couldn't or didn't want to do it for themselves.
And back to the point of the article, automating that management would not be difficult. I agree that there are hard times ahead for most brokers.
If they were paid solely based on performance then you would also pay points on the spread between what you lost vs. what some benchmark lost that year. I can't imagine many investors wanting to take on that kind of risk.
Do they though?
As far as I know, the premise of the public stock market is that there are companies that feel they have an idea/opportunity to make money, but it needs more capital than they have available to get going.
Going even further back to basics - it's like saying, "We all need to eat, and by myself I can't take down this big animal I've spotted to kill, but if we get together as a pack, I think we CAN do it together, and we'll all benefit (i.e. eat.)"
Given that view of the market, clearly some of the companies that wish to raise money from the public will succeed, and others will fail. In theoretical simpler times, we could evaluate companies based on the merits of their ideas (their prospectus), and decide whether or not to invest. Perhaps this "lightbulb" concept, or "horseless carriage", "telegram", or "Facebook" concept makes sense to us, and we choose to back the idea with our money.
Things are clearly more complicated in this day and age. Because of this complexity, we have a new breed of companies - meta-companies, if you will - that promise to do the evaluation of other companies for us, and tell us which ones to put our money into. The product of these companies is not the actual product itself - the lightbulb, car, or social network - but instead, the return on investment itself.
For traditional companies - when the product flops, we stop investing, and the company eventually ceases to exist. Sometimes you get General Electric or Ford, and other times you get Pets.com.
To me, one of these meta-companies whose products is returns, that fails to produce said returns - should stop receiving capital. It seems to me that actively managed funds that continually fail to beat the market should not continue to collect people's money in the form or fees - and therein lies the madness of the current situation.
(Note - I realize that investments do not provide returns immediately or overnight, and therefore timeframes should be attached to any sort of promises an investment company might offer. If they don't believe they are able to do so, even with a reasonably sized window of time - then I fail to see how they are any better than a roulette table.)
Pay for performance creates an incentive for outsize risks. Sure, our Subprime Mortgages Fund and Greek Bond Opportunities Fund were down this year, but Powerball Tickets Fund and Vegas Bet Everything On Red Fund more than covered those losses.
If you're a risk-averse investor, your most likely match is some variant of slow-growth, growth-at-reasonable-rate or dividend-reinvestment strategy. Paying for assets under management motivates the advisor to at least not lose all your money and keep you as a client.
Simple, As Warren Buffet said when he created an investment firm, he expected to be judged over the general market wave, that is if the market crashes 75%(like in 2008 or the great depression) just maintaining the funds worth(or loosing small) is a great deal and you are a genius. If the market skyrockets 50% per year and you get 10%, you are not so good.
Putting it another way, they are already based on performance over the market.
http://www.theguardian.com/books/2014/jun/13/how-not-to-be-w...
>Here's a cautionary tale. A broker sends you 10 free stockmarket predictions in a row that all come true, and then asks for money for an 11th. The stockbroker's offer seems reasonable enough. His strike rate is 10 out of 10, so surely he will be right the next time, too? Don't do it! If you pay for the 11th tip, you will have fallen victim to the oldest scam in the book. Unknown to you, the stockbroker has been sending every combination of possible predictions to tens of thousands of other people, and you are one of the unlucky few who got 10 good ones in a row.
>Imagine you are considering investing in a mutual fund. Before funds are opened up to the public, they are often monitored in-house. Funds that don't perform well can be shut down, without the public ever knowing. Ellenberg warns that if you are seduced by funds with an eye-popping rate of return, then you are walking into the Baltimore stockbroker's trap: "You've been swayed by the impressive results, but you don't know how many chances the broker had to get those results."
So that should definitely open up some opportunities to beat the passive funds.
It's a significant subplot of the book, Ugly Americans
https://en.wikipedia.org/wiki/Ugly_Americans:_The_True_Story...
If your concern is that it's active you can always check to see how well the fund tracks the index. The reality is that they track the indexes so well that it doesn't matter. At least for total market or S&P 500 funds.
There are problematic indexes that don't seem to get tracked well by funds.
[1] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2663398
So if ETFs are taking over, it may be an improvement overall, but it's worth thinking through the black swans, the new low probability high impact risks that this creates.
Bloomberg has had a few comments about liquidity risks for ETFs on their site and in the Odd Lots podcast.[0] On the other hand, they've made these comments for a few years now, so maybe this is a chicken little story. Or maybe it only kicks in under certain conditions, like if we saw interest rates, demand for goods, and inflation spike, people start moving to other investments, potentially causing a sudden run on funds that are stuck holding only bonds without any real returns or way to offload them?
[0] http://www.bloomberg.com/news/articles/2014-09-23/etf-liquid...
I'm honestly not that concerned about it at all, because it seems like an unlikely problem. But to whatever extent I am, the question wouldn't be "how do I protect my own investments?" It would be, "how should we protect all the retirement savings across the country that are placed under passive management automatically?"
To really answer that question though, we'd probably have to know the actual level of risk and the timing of any crisis, which aren't trivial questions.
I mentioned in a previous thread about this -- I worked for several years in an asset management firm before moving on to other things. We frequently assisted clients in the process of firing us. We would prepare white papers for them, give them data and slick charts. Sometimes this would literally disrupt the quants and research team and we had to join in creating materials that would be used by client board members in their presentation of the decision to fire us. Sometimes we even had to provide examples of this kind of work when a client was hiring us -- our helpfulness and data services during the times when we are fired was actually a prominent selling point. We were basically saying, hire us now and you get to look fancy. Fire us later and we'll set you up to look principled and full of conviction to do the right thing as a sophisticated board member.
There are all kinds of laws restricting gifts you can give to clients or receive from clients, and just as many stories about how such-and-such a client took some regional sales manager out to a strip club, or flew them some place and got them a reservation at some exclusive restaurant or something.
It's all political. As a technical person, you are hired to look fancy on paper. I remember overhearing my boss bragging to a prospective client that the team had an "Ivy League graduate" leading up their quantitative software development ... on my second day of work! I had zero financial experience of any kind at the time. It was ludicrous.
It's painful to see everyone buying into this. I hope beyond all hope that clients do a better job of actually holding firms responsible for returns. Firms that don't engage in legitimate statistical research to determine an edge in investing will fold up, and firms that actually have a chance at superior returns might actually start letting their staff do real research work instead of bullshit marketing and catering to client political whims.
But that's a fairy tale world. This will all blow over and clients will continue dedicating huge blocks of their endowments or retirement funds to active managers for political reasons and will continue happily not holding those managers accountable for inferior returns.
There must be some lean way to exploit that.
In theory, you could manufacture status for your consulting firm. (So that's why BCG and McKinsey plaster German universities with their ads.)
Whether it's my grandma at the local bank or a huge endowment for a state teacher's union, people still want a handshake and a white-toothed car salesman smile when they hand over their money -- they want a false sense of security even if they are knowingly complicit in its falseness.
Since you can't pop up overnight and start claiming "Hey, we've been around for X years so trust us" it makes it very hard.
One exception is with small hedge funds that are created with a direct tie to a wealthy individual. That's almost always how small hedge funds start and few other types survive. Basically, there will be some semi-rich hot shot finance types who want to start a hedge fund, and then they have to convince some wealthy business contact, someone with usually > $100 MM in assets, who doesn't mind fronting the significant costs to get a small strategy up and running. Then, if it works, that wealthy person will effectively be the marketing department for a while and will recruit other wealthy connections to give somewhat small amounts of money, growing AUM slowly.
If you really succeed beyond the 5-8 year mark, then you can start trying to tap into more traditional client streams.
But basically, without a close connection to a significantly wealthy person, the status-based barriers to entry for things like management consulting and asset management are just too high.
The industry has gotten much tighter regulated since the GFC giving the incumbents an even stronger grip on their position.
And the specific low-cost index funds, the article is dealing with, have been around for decades now. I really don't think the headline is called for.
i understand what is being said here. i don't think it is revelatory.
on the other hand this article just adds another small contribution to my strong distaste for the practices of the financial industry overall.
investing money into funds to make more money seems great at first glance, but once you dig into the details and realise the number of people involved taking their cut, how many companies are effectively running off of weird loans through 'ownership', and how many piles of assets are owned by people as a mechanism to make more money... its all very distasteful to me. :(
then again, i don't like investment. i don't want it for my own company. it looks like a way to become beholden to others and introduce a risk of spending more money than you actually have.
Where there is a buck to be made, someone will make it. All this talk of index funds ruining capitalism just sounds like a bunch of whiny fund managers not getting their cut.
If 100% of retail investors were in "passively" managed funds, wouldn't that just be saying there's a giant fund of money available, to be split among public companies that meet certain criteria - and thus a set of concrete rules to be gamed?
It would just be another input into the market equation. Investors could then say, "I think the macro environment right now is going to lead to events X and Y happening, which will in turn ruin these 5 companies, which will cause a rebalance in the giant pool of passively managed fund money, and so I'm going to make this bet that that happens."
Also, the S&P 500 is a market cap based index, which means that passive investors have to ape active investors. So even a small minority of active investors would dominate price formation.
Ultimately, I think, the impact of ETFs on correlations will be limited.
That's why confidentiality and anonymity is crucial to a functioning market.
But total markets will still have other downsides, like all the stocks become completely correlated if enough people are only making investment decisions on the total market instead of individual stocks, and prices become less meaningful.
- 55% Vanguard Total Market Index
- 35% Vanguard Total Market International Index
- 10% mixture of Vanguard bond domestic and international index funds
Is there a better strategy out there besides index funds that doesn't involve me getting eaten alive with active fund fees? A lot of what I read suggests that actively managed funds never consistently outperform the market index.
Nobody in their right mind would use funds like that if they bought them for their own IRA, but 401Ks create a captive audience, so this terrible funds exist, just to abuse companies that aren't paying attention, or are getting something in return of letting employee money get siphoned off.
So sometimes, you are paying a big premium no matter what you do.
Frequently, the people making 401k provider decisions (HR) are not well versed in finance or the incentives are misaligned (companies are looking for cheap vs good for their employees).
This is a situation that congress could easily fix, get rid of 401k plans that are attached to employers, and instead have employers contribute directly into employee IRAs.
To me this looks like a subsidy to the financial industry.
Like anything else, its lots of things put together and evolved.
"Active" brokerages are biting the dust? Well, good riddance! Moving people out of the loop is generally a good idea.
Now, passively managed funds are a good thing, during the growth market. However, once around every ten years, a recession comes. Then, suddenly, index-tracking funds become passé, and everyone wants a strategy to survive the market downfall.
And we have a lot of things to bring in from the current tech state of the art. Blockchain is ingenious, and the art of defining modern financial instruments using blockchain features is in its infancy. So, there is a lot of work to do, and lot of potential to grow.
The top end - flats worth a million and up - has a long way to fall, because there's a glut of new build coming onto the market.
The mid and lower ends have a lot more latent demand, but the end of cheap buy-to-let will force at least some landlords to sell up.
Prices would usually level off, but if sterling keeps drifting lower foreign money will dump a lot of its speculative holdings. That could crash prices by big numbers, and also drop rents because many speculative buys are currently left empty.
So once even the 200k/year lawyer down the street is suddenly homeless because he actually had negative net worth, then it will be too late, but the real point is that there is no more money to be extracted from the lower classes except by death by a thousand cuts (taxes), so all the middle men hedge funders etc are going to be mergered and acquisitioned away as the banks learn how to manipulate the blockchain market and take it over just like they have everthing else.
Digitalization of the financial industry is just the buzzword scapegoat they are going to use to get it done. The same way in which, you see the former director of NSA leaving and joining a bank, and then yelling doom and gloom about hackers zeroing out accounts. All that tells me is that is what they have already planned.
I can see the headline now: "Hacker breach $BANKS, transfer $BILLIONS. Another bailout unavoidable to prevent collapse."
I've said it before, and I'll say it again, the elite oligarchical international bankers are closer to terrorists than businessmen.
I have a strong feeling that the contents of the index (or at least weights) can still be manipulated. And also that the fees are just moving down the food chain somehow.
If you think I'm wrong, just consider that a public company can own stock in another public company.
This will all become more obvious when "passive funds" take over more of the market.
Those funds are trying to mimic the returns of a particular market segment. If a passive fund argued that a particular market segment had implicit fees & therefore they charged similar, it would still be passive.
People will still get phenomenally rich in the stock market, wealth inequality will still increase. The difference is that people have to work for it now, building up their own information advantage, rather than being able to siphon off large fees simply because they went to a good school and talked a fellow alum into hiring them. This is a plus in my book.
To me passive and active are ends of a spectrum which specify how much labor and trading is done with the fund's assets.
Index funds are investment funds which seek to match the performance of a target index.
The concepts are orthogonal. You can have index funds which aren't ETFs and you can have ETFs which aren't index funds.