> And the bigger indices grow, the larger the opportunities for active traders to profit.
I'm having trouble understanding why this is the case. Care to clarify?
I'm having trouble understanding why this is the case. Care to clarify?
That being said, consider what would happen if stock prices did start to vary randomly - if you had actual research suggesting the price was too high or too low, you could trade accordingly. This would net you a profit, and also help push the price in the opposite direction, towards whatever a reasonable price is.
The larger the deviation from the "correct" price, the larger the potential profits are to be had. So if the problem ever starts to be significant (i.e. a few cents of deviation caused by index funds), this means a very large potential profit for any active funds or traders out there. And so we would expect the system to reach an equilibrium - where there are just enough active funds and traders to snatch up the profits that arise from tiny price errors and distortions caused by index funds. In effect, the index funds are paying those remaining active funds and traders a tiny "management fee" (in the form of exploitable trading behavior) to figure out the appropriate price of stocks for them!
The implication of the random walk theory is that current information is already uilt into the price of the stock. That is only true insofar as there are active traders acting on that information. The parent is merely explaining why those traders will exist, and why you only need a small part of the market to actively trade.
Good stock pickers > Index Funds (blind money) > Bad stock pickers
By investing on index funds you are betting in the average of the average (a fund is already an average of undervaluated and overvaluated stocks).
However, by investing on managed funds your probability of having profits over index funds is low: even if stock pickers that beat the market (by definition) amount to 50%, extra fees make most of them still less profitable to investors than passive funds.
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You can only tell them after the fact
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Imagine that 99.98% of all investors are index funds, and there is a company BigCo that is at some point is at the top of the market. So pretty much every index fund invests in it.
Then suppose BigCo makes some move that would traditionally be a mistake. Like it has some scandal, the sales drop off, etc. Say it even has a bad quarter.
How do I, an active investor (among the remaining 0.02%), make profit from the arbitrage? For the stock price of the company to fall, there'd have to be no buyers at the given price. But the index funds will keep investing in it. Why would it drop off even a little?
This would require a long-term view similar to how Berkshire Hathaway is acquiring businesses. If active investors' short-term price speculation were reduced in favor of long-term bets, that might be a good thing for businesses and the economy overall.
And of course, if this situation actually becomes commonplace, chances are the market for index funds is going to self-correct since a well-performing stock needs either solid dividends or above-average growth. A market with 100% indexing can not give you above-average growth, and dividends depend on actual business performance.