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Comment by charlesdm | Hacker News Reader

I had an interesting conversation with a very smart investor last year, and basically his idea was that while active managers will sell certain specific stocks (less volatile stocks) to fulfill redemptions in the event of a decline and/or crash, ETFs will generally just hit an (automated) sell on everything across the board. So proportionally they will sell off significantly more volatile small and midcaps vs large caps.

Every since I have had that conversation, I no longer invest in passive index funds or ETFs.

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>>basically his idea was that while active managers will sell certain specific stocks (less volatile stocks) to fulfill redemptions in the event of a decline and/or crash,

This is true and leading to very good insight.

>>ETFs will generally just hit an (automated) sell on everything across the board. So proportionally they will sell off significantly more volatile small and midcaps vs large caps.

This is absolute nonsense and something you hear from active investors pitching you an anti-index fund strategy. Index funds and ETFs tracking indexes will not have some absurd sell off that disrupts equilibrium, they will... just proportionally adjust to the index, since that is what they do.

Did your smart investor friend go into detail how this massive disruption could occur (what conditions would cause such a cyclical crash, because the only thing we have in our past that even comes close is the Great Depression, and had index funds existed then, it's not likely this activity would occur) or what the details are?

This is incorrect, especially with ETFs. With an ETF, the seller/buyer (the individual, not the fund) pays all of the transaction costs. So buying and holding an ETF doesn't expose you to the problems which the behavior of panicking investors^. The same is not always true for mutual funds.

caveat: Vanguard index funds may be special and this doesn't apply to the same extent because the ETFs are a dual share class of the larger mutual fund.

But you are still exposed to the market, which can decline significantly. People will withdraw money from their passively managed funds when the market starts tanking. We have no idea what will happen in the next 'fear trade' when everyone starts dumping shares.

Stocks can go crazy and this could create a death spiral on the ETFs, because an ever more frequent decline can lead to significantly more volatility in small and midcaps, and more people withdrawing funds from their ETFs, which in turn will cause more liquidations.

All reasoning (to some extent) is lost as to which assets to liquidate. Actively managed funds will generally liquidate assets that don't cause too much swings in share prices in a downturn. Liquidating $50MM worth of Google won't make a big difference, but liquidating $50MM worth of SmallCap generally will put significant pressure on the share price. On the flipside: imo it does create a significant buying opportunity when it comes to small cap stocks.

Tl;dr: in my view, the more money that ends up being managed passively, the easier it will become to beat the market as an active investor.

There are two concerns: transaction costs (tracking error relative to index return) and index return.

Those who believe in generally efficient markets want to capture the market return, however volatile, with as little tracking error as possible. Since the ETF holders don't actually sell any stocks when the prices decline, their returns are temporarily depressed. If and when prices recover so too will their value.

There is nothing unique about ETFs in this respect. Your critique is more about index funds in general, not ETFs specifically. ETFs practically differ from mutual funds only in things like transaction costs.

re your tl;dr: Sharpe's theorem shows that active investors will underperform passive investors after costs. Notice that this does not depend on the number of passive investors (and certainly at this point we're nowhere near any of the percentages of passively managed assets which people say may be worrying).

Overall, I do not think your critique is well-informed by the facts.

To each their own investment style (and there are many), but markets (in my view, and in the view of many others) are not efficient. (More than) half of what determines the stock price is psychology and herd mentality. It's not just numbers, and more an art than it is a science. Larger cap stocks however are generally priced more correctly than small- or mid cap stocks.

Second to that is that your returns will also depend on the risk you are willing to take. Investing through index funds and ETFs will correlate with a certain alpha, but that doesn't mean returns can't be higher if you are less diversified (and thus taking more risk).

Depending on the type of companies you are investing in, you might be comfortable taking a bigger risk with the goal of achieving a higher return.

Say you're working in technology and truly understand it, you can probably outperform the market significantly by investing in 3 to 5 technology stocks. Is it riskier? Yes. Is it worth it? Some people will say yes, others say no. And that is absolutely fine.

> Investing through index funds and ETFs will correlate with a certain alpha

Thank you for showing others that you do not know what you are talking about.

>>Investing through index funds and ETFs will correlate with a certain alpha

This sentence actually means nothing.

>>People will withdraw money from their passively managed funds when the market starts tanking.

Yes, some will. Many will also counter this by buying up the same assets as the price drops.

>>in my view, the more money that ends up being managed passively, the easier it will become to beat the market as an active investor.

This is absolutely true but also has nothing to do with your friend's legitimately unbelievable scenario.

So Buffett's $1M bet wasn't enough to convince you that passive beats active?

Hedge fund are basically a compensation scheme masquerading as some sort of smart money management thing.

What's great is that the debate of passive vs active will go on forever - There will be periods where one outperforms the other - sure. But in the end, net of fees - active cannot win consistently, on average. Its human nature to believe we can beat the casino.

ETF funds themselves do not buy or sell anything. They exchange their own units for the indexed basket of shares.

Why is that a problem? Because it gets less diversified?

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