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Comment by lr4444lr | Hacker News Reader

If you're a Vanguard customer (buying the flagship fund classes, I presume), you're expressing faith in CAPM[0] and EMH[1] on a significant level. Some active investors will probably in the long term scoop up some extra gains, but the question still remains: which of them, over what time horizon, and is that a risk you want to take? Vanguard gives you lots of no-commission funds with 1 day liquidity even in the mutual funds - plenty of room for you to try and time the market if you think you can have a go at active trading around some predictable flows if too many people are passively investing. Nothing stops you.

[0]http://www.investopedia.com/terms/c/capm.asp [1]http://www.investopedia.com/terms/e/efficientmarkethypothesi...

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Say more. Why do I believe in the Capital Asset Pricing Model and Efficient Markets (both proven wrong) if I invest in Vanguard's cheap S&P 500 ETF?

I invest in their S&P 500 ETF because it's the cheapest way to get diversified exposure to the 500 largest American companies, and I believe that the 500 largest American companies will be more valuable in the future as a combination of valuation, scale, and cash flows to owners, than they are right now.

The S&P 500 is a reasonable, good investment. I think Efficient Markets is saying "you can't do better". That claim may be false. And yet, it may be close enough to true, especially for a small investor, that Vanguard's ETF is good enough (that is, it's not worth the time and effort to try to find something better).

While you may not believe in CAPM and EMH and still invest in Vanguard funds, many do both. I used to participate in the Bogleheads forum and encountered many doctrinaire EMH proponents there. It's not an unreasonable inference to connect the two.

If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks within the S&P 500 and thereby outperform the index. A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.

I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.

You say "A disbeliever in EMH should look to identify these managers and pay them some fee".

In the next breath you say that even if the EMH is false "individuals investors should act as if it were true".

This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it."

Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)

Here's perhaps a better way to say what I'm getting at: identifying and investing with a manager that predictably outperforms a benchmark is just as difficult an intellectual challenge as constructing a portfolio that outperforms that same benchmark. Both of these tasks are so difficult as to be essentially impossible for an unsophisticated retail investor.

I'll throw you a better analogy, identifying and hiring an outperforming programmer should be much simpler than identifying and hiring outperforming investment managers because there is relatively little effect of chance on programming output and measurement of success is mostly objective.

Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide.

Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers.

Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.

Is it really worth saying that Lotto winners "Identified the correct lottery numbers"? It's true, I guess. But it doesn't really have any value, if that's all you mean.

(And yes, I understand that you agree with the conclusion there. But I'm saying what's the point of the verbal gymnastics in the first place?)

Logically even if the EMH is false that doesn't necessarily imply the existence of investment managers who can reliably identify mispriced securities. It's entirely possible that the EMH is false and yet no one is able to take advantage of that. But your recommendation makes sense either way.

Right, those anomalies could simply exist unexploited until the market is better understood. For example, you used to be able to earn money buy buying the 501st largest company in the US: if it happened to become the 500th largest, all the S&P 500 index funds would be forced to buy its stock, and it would outperform the other stocks that had already been in the index. Similarly, the 500th largest stock would be a good sale candidate: if it becomes the 501st largest company, the index funds will become forced sellers. Now this effect is very well known, and there's no more money to be made by exploiting it.

> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate.

I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of.

Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate

New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders

https://www.zacks.com/stock/news/250937/warren-buffett-on-ac...

> If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks

This isn't how causation works.

> A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.

It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly.

> Furthermore, a smart manager will charge fees that are equal to the alpha they generate.

Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him.

That would seem to contradict your point.

> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate.

Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't!

It seems more plausible to me that (handwavy):

1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research)

2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record)

3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds)

Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.

I think the other commenters hit on the important points and anticipated my distinctions. Note that I said "on a significant level". That did not imply blind or absolute faith. There are other investment options to match your bullish outlook if you think CAPM and EMH are wrong to the approximation that suits your involvement, knowledge, and risk profile, but you chose an index ETF. Why?

Perhaps GP believes he does not have the skills to identify market inefficiencies, or believes he does not have the skills to identify fund managers who have the skills to identify market inefficiencies. Those would seem to rule out picking securities himself or choosing an actively-managed fund.

Or maybe he just believes the market might stay irrational longer than he can stay solvent.

I think the parent commenter is more concerned about the economy's overall stability, and believes passive investors could be exploited due to mis-pricing index fund underlyings. I didn't interpret it as a worry about missing out on active investment, but I could be wrong.

^^ Effectively this.

My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing.

(We started out letting active players make the market by placing good/bad bets and winning/losing. We got a market that was at least trying to find the right price and we did well due to the low expense ratios. Now that we're in the majority, I'm concerned that no-one is trying to find the right price anymore.)

tldr; I have mixed feelings about passive investing over the long term if we're no longer small fish in a big ocean.

I don't understand the fear. If index funds dominate the market to the point of a near risk-free rate because that's what everyone's doing, you've effectively democratized the capital system to the benefit of the regular joe: companies still turn profits, and those become dividends. Dividends are why we buy stocks. That's what drives the whole system - not a zero-sum bilking of active investors. Yes, major growth spurts will probably be concentrated into a fewer select group of niche sectors and active traders, but that'll be their voluntary risk profile.

EDIT - I highly recommend watching some of Robert Schiller's Financial Markets lectures on Yale Coursera about general investment theory. Bogle is saying good things, but he simplifies it in a way that I can see might sound disconcertingly incomplete. You're not wrong to ask these questions if you're conscientious and smart enough to want more in-depth answers.

But then, say you come a long with a new company going public... you're not large enough to be in the S&P 500, so if everyone only invests in S&P 500 index funds, no one will buy your stock. Similarly, if you're Apple (the largest company), and you have a really bad quarter, say you lose $100B, no one would sell your shares, because they're passive investors.

Obviously, these are edge cases (we'll never be 100% passive), but there is some concern that there will be a lock-in effect for companies currently in the S&P... It will be harder to grow if you're not in it, and it'll be harder to fail if you are.

It's a perfectly valid question. In my very cautious humble opinion, I think what it means is that the style/size matrix[0] will get squeezed more into a single spectrum: large companies will be pressured into stabilizing and delivering dividends and small ones will compete to grow large enough to get a piece of the passive investment gravy train. Apple can have a bad quarter, but it's just one company. It can't keep having a bad quarter. And if they start to and have to downsize to stay alive, they would by doing that hasten themselves out of a market cap that would qualify them for the index.

There's also no reason why passive indices have to reflect the total market weighted for market cap.

[0]https://corporate.morningstar.com/US/documents/MethodologyDo...

As per the article, Vanguard's biggest fund is the Vanguard Total Stock Market Index which tries to track the CRSP U.S. Total Market Index. That index is "Nearly 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market." I don't think you have to worry much about a bifurcation between large and small companies. My worry would be that the "investable equity market" is shrinking and that most the growth in the future will come from companies pre-IPO where non-accredited investors cannot invest.

The number of total publicly traded companies isn't projected to get anywhere close to historical levels in the near future. There are steps being considered to change the current definition of accredited investors and/or to permit non-accredited investors to participate in private investments. See helpful reading/viewing:

- http://www.investmentnews.com/article/20170224/FREE/17022994... - https://equityzen.com/blog/alternatives-part-of-investment-p... - http://video.cnbc.com/gallery/?video=3000598150

Disclaimer: Links #2-3 are affiliated with my own company, so you should decided whether or not to believe me.

"My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing."

I'm intrigued by your suspicion ... but I can't put my finger on the exact manner that this might play out ... it's really hazy.

It seems to me that the effect of everyones money going into index funds would be that firms large enough to be in the index would have less and less pressure to issue dividends ... if there is a ready market of buyers of your stock based solely on your size then why bother ?

If money flows, by autopilot, into an asset class wouldn't we expect that asset class to return less and less as time goes on ?

Size-based index funds are just one type, there are others, including ones that track stock of high dividend yielding companies. Just because passive investors aren't trading daily doesn't mean they won't adjust to better funds, forcing companies to pay out.

what's a good hedge against this?

I think the long long term problem is that the stock market has an increasing disconnect between investment in new businesses doing anything well new, and to an increasing degree novel business practices in existing businesses.

Yes, there are some IPOs, but overall new business starts are still in decline, and large portions of financial markets seem both too systematically risk averse, and yet willing to follow other risks blindly.

faith in EMH[1]: This is only true if you make a single lump sum investment into Vanguard without looking at the price.

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