The growth in passive funds has caused markets to become more correlated?

If that's the case it should drive most fund managers out of business since most of them don't beat the S&P over time.

https://www.cnbc.com/2017/02/27/active-fund-managers-rarely-...

And as more money gets funneled to index funds, the vanguards and fidelitys of the world could lower fees on their index funds which should put even more pressure on most fund managers which could create a vicious cycle. Maybe we'll be left with just index funds and a handful of rock star fund managers.

To some extent, it's just a matter of supply and demand. Because so many people are investing passively, inclusion in an index with highly traded ETFs can cause huge demand for a stock that no one would have particularly cared about otherwise. There are tons of examples of this around the Russell indices, but stocks in most popular indices carry higher multiples than similar companies outside of them. There is also what George Soros called reflexivity - this increase in stock price makes it more likely that your business will survive because it makes financing the business easier. A large market cap both means you can issue shares cheaply, and it makes banks more likely to lend to you. That helps the business stay alive, but it doesn't necessarily improve their underlying business. Without anyone fundamentally evaluating these companies, such situations can persist indefinitely. Short selling is also made hard by the heavy demand created by additional inflows to these indices. Even if you identify a mispriced company, its continued inclusion in the index might prevent the price action that would remedy the situation.

In the end, I don't think this is the end of the world, but there is the old saying that bad money drives out good. This kind of mania makes it hard for normal feedback mechanisms to function appropriately. The most direct costs will be born by those who invest in such instruments, but it also adds greatly to the correlation of the markets, since price movements are now implicitly tied to inflows of money from markets.

1. Everyone wants to make money.

2. People will look for the best way to make money.

3. If enough people are in index funds, the best way is to go active. If enough people are active, it is best to do index funds. Therefore we’ll have an equilibrium where it doesn’t matter too much which you choose (as long as you’re reasonably smart not to get ripped off).

I don't know if Sears received a lot of index funding but I'm sure TGT did. It's day of judgment came last summer. AAPL is next. It will take years, but you can only screw customers secretly for so long.

Now think of a world where passive funds dominates investments and very few active funds survive. Now the market cap variance increases and small changes induced by active funds gets hugely amplified by passive funds. For example, a hedge fund may decide to liquidate their position on XYZ due to random reason and can trigger 1% change in price (because active funds willing to buy might not be high in number). This then immediately changes market cap and all passive funds will rush to liquidate as well which will tank that company. This obviously can be gamed by clever active funds.

As more and more investment becomes passive, I think the ROI for those investors reduces significantly compared to active investors. I am working on theory part for this. If anyone is interested, please feel free to email me.

In the end: technical analysis is useless by definition.

https://www.ishares.com/us/products/271054/ishares-msci-acwi...

I agree with the general point that most trades of mature companies don't seem to have a material effect on the expectations of today's founders, early employees, VCs, etc. Though in theory if liquidity dried up enough or valuations fell, those signals would noisily backpropagate through prices and shift expectations of rewards.

I've grown much more comfortable investing in real estate as a result of this. When I invest in something I want to see how that investment was used, how it helped, and get returns based on how successful my ideas were. If I renovate a house or invest in my buddy's business, I get exactly that. It may fail, but at least my money mattered and I saw what it did to help. When I invest in the stock market I get none of this.

Then whenever a company needs capital for future expansion - whether it be for secondary stock offerings, new factories, or stock options to entice key researchers or executives - they have an accurate price on the stock with which to judge the cost of capital. If their stock price is low and capital expense is high, they may decide that the capital investment won't increase the value of the company enough to be worth it; the market has prevented capital from flowing to inefficient businesses. (Again, if they guess irrationally, they go out of business, and the system remains rational even if management isn't.) Similarly, if the market puts a high price on the stock because there's a belief that what they're doing is important and will reap big rewards in the future (eg. Tesla), they'll find it cheaper to make big capital investments.

The early-stage startup financing market - angels and VCs - is actually both quite illiquid and quite inefficient - prices at that stage are basically just guesses, which is why some companies rapidly increase in value and many others go to zero. It too depends upon the liquid secondary market after IPO to keep actors rational, though - if VCs could not sell their shares later on the public markets, they would have no incentive to invest in startups.

Because the company is made of capital. It has a plot of land with a factory, equipment for making brake pads, raw materials, a trade name that engenders goodwill with customers etc. When you buy a share, that share of ownership of the capital is allocated to you. You get a vote in how it's used. You could vote to keep making brake pads as ever, or mortgage the factory to expand into brake rotors, or cease operations and sell the individual assets to the highest bidder.

In principle you could be the deciding vote and someone else could have made a different decision than you.

I did this when the share price was low so I was taking a long term view that it would recover and I would capture that value and also have the dividend at an expressed yield on between 6-7%.

http://s18674.pcdn.co/wp-content/uploads/2015/05/Index-marke...

Sure there are traders on wall street looking to beat the index funds with manual trading, and these guys will always exist. But most active managers these days are just buying index funds and slapping on an useless fee. This is why when I pulled my money out of my bank's managed investment account and into a Vanguard account, I didn't suddenly change a portion of the market from active to passive investing, I just removed an unnecessary 1.25% fee that got me nothing and did nothing positive for the economy.

I mention this because (regardless of your intention in particular) Warren Buffett's famous bet is extremely overused and cited as evidence for many claims it doesn't really support. Someone's takeaway from your comment could be that all hedge funds fail to beat the market - but that's not even what Warren Buffett believes (Buffett doesn't believe in the efficient market hypothesis).

This is to say that index funds are generally a superior investment vehicle for modal investors. But that shouldn't be used to extrapolate broader truths about active versus passive management, except that active management is a lot harder.

An (imperfect) analogy I like to use is that of a kid whose dream is to get drafted into the NBA. You'd probably tell them to have a solid backup plan for a more realistic way to make a living, because approximately no one is drafted into the NBA. Vastly more people try and fail than are actually drafted. But that doesn't tell us the NBA is itself a fiction.

Similar parallels exist in venture capital investment, startup success, acting and making music.

This will never happen. It might be interesting, but isn't a realistic scenario.

If so, then your thesis doesn't make sense. The index fund manager's job is to maintain the fund's allocation according to the index calculation to the best of his ability, not "go out and buy some $AMZN cos it looks cheap" (which opens up the fund for civil lawsuits for not adhering to the prospectus), or to "manipulate the herd".

Tracking errors happen, but those are incidental to the need for re-balancing and are not outright actions undertaken by the fund manager for the purposes stated above.

"...forced state-owned brokers to promise to buy stocks until the index reached a higher level, mobilized state-controlled funds to purchase equities, and promised unlimited support from the central bank. "

https://www.brookings.edu/opinions/making-sense-of-chinas-st...

And yes, that’s why you should be long on mid-large cap equity indexes, because they will always get bailed out, since too many voters are too invested in them. Either more money will be printed or cash infusion or loans from taxpayer, but in any case, the biggest sectors will never fail completely as they will always be re-inflated (in the US, as long as its currency and military continue to have the most power).

Price discovery. Price discovery is directly facilitated by trading. The more frequent the trading, the more efficient the pricing mechanism (all else being equal). Active trading also facilitates higher liquidity.

Neither of these things can be properly facilitated by a passive index. Buying and selling (bidding and asking) is a mechanism for expressing optimistic and pessimistic sentiment about an asset's price. The only thing a passive index can convey is neutral sentiment, because it's just holding.

For a specific example of why this is important, let's look at something slightly different. Indices are only capable of expressing neutral sentiment in a market. It lacks the buying and selling functions. But private equity - such as venture capital investing, likewise lacks certain price discovery functions that public markets have. Private companies cannot be directly shorted regardless of how large their valuation. Likewise since liquidity is low it's easier to buy more shares than it is to sell shares. This naturally leads to a positive pressure on the pricing mechanism, resulting in inflated valuations that don't take into account pessimism.

Regardless of whether or not you feel tech is in a bubble, this is one reason why tech valuations have skyrocketed. There are credible arguments that similar distortions could happen to public markets if passive indices capture the vast majority of investing. But that's by no means a certainty.

I think of it as being too much context. There is just way too much real-world context for computers to assimilate. We humans might be terrible at understanding things like abstract algebra but evolution has left us with pretty well-optimized systems for understanding social cues, complex behavioral networks, and other nuance of human behavior.

I completely agree with your thesis.

Thought experiment - let's say there's an imaginary country that has 100 companies listed publicly, each floating 1,000 shares. Most citizens prefer indexing so 99,000 shares are owned by a bunch of Country 100 index funds. Those index funds will only trade on inflow/outflow into their own fund, never on corporate earnings, board changes, product announcements or other external event.

What opportunities are there for arbitrageurs?

Such a situation is not stable if the speed of information is not fast enough. If the market is unable to produce information quickly enough, or market actors don't act fast enough, basic differential equations dictate that you will get oscillations. See e.g., the business cycle.

I think the article deserves a fuller and fairer reading than your comment indicates you've given it.

Spoiler, the article is actually a playful response to a fear-mongering article titled "The Silent Road To Serfdom," with a bit of inspiration from Asimov at the end.

The title is bait for misinterpretation, because the title is the original article's thesis that Matt is riffing on.

Matt Levine is a really fun writer, and I recommend the click to anyone who skipped it because they thought the title was the main and uninteresting point of this piece.

There's just too many self-interested market actors to possibly be able to predict what their future wants will be to throw out the function that the entrepreneur provides, those who predict future wants correctly make money and those who don't lose their investment.

Unless, of course, all they want is a static model of current consumption at the expense of human progress.

Just read that phrase again and think about how it comes across.

If you can suggest a better (i.e. more accurate and neutral) title, preferably using representative language from the article, we'll happily change it.

Please see https://news.ycombinator.com/item?id=18144886 for more explanation.