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So I've been trying to work this out. Previously I understood the idea "The passives are simply the average of the actives". So even if you had 99% passive, so long as the actives were doing their homework the system would work, but as you said you need to watch for exploits.

But then I had the question: When the world has gone passive, who is left as an active investor?

1. Wallstreetbets users who do poorly on average, and they are small

2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small

3. ... the company using debt to buyback its own shares

So the key behind this entire stock market is that its a beauty contest where you need to make guesses as to what everyone else will do. But as active investors shrink with the increase in passive, what we are allowing happen is that the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds.

I have not yet done the intensive research to understand how large 3 can effect a stock, does anyone here have any idea if this will be a problem, and if we are already seeing signs that this is happening already?

Think of it this way: if there are too many "free riders" in the form of passive investors, then ... it will become easier for active investors to make money, and beat the market, and more people will actively invest their money (or invest in actively managed funds).

Yep, there will usually be opportunities for arbitrage for active traders if there are too many passive investors. I suspect there will be some sort of equilibrium between active and passive at some point.

The thing is that I'd rather be doing other things with my time, so I'm a passive investing kind of guy. Imagine getting the market return for doing nearly nothing for dirt cheap. That's a high growth rate to level of effort ratio!

An equilibrium exists but expected returns of active and passive are unknown. Would it reach equilibrium or could there be a crisis due to passive allocating funds poorly.

I mean, I don't know, I'm a random guy on the internet saying stuff, not an analyst.

But I think a key point is that active investing already exists and dominates the market -- it's still like 85% active. People choosing to invest in passively managed funds are doing so because they see a higher return. Maybe the choice is sticky and people won't switch back if the returns begin to fall, but people still have to switch in.

So building up a surplus of passive investors requires people to continue to switch to a passive strategy after the returns between passive and active level out and reverse. And not just a little -- profits from investing are returned to investors, and reinvested. So if the equilibrium between active and passive investing is X% of the market passive, and we get up to passive investors at X+10% of the market, then the X+10% of passive investors will see a lower rate of return than the 90-X% of active investors. Which means -- unless those active investors take their surplus profits and dump them into then-less-profitable passive funds, before long the active investors will have 91-X% of the market and the passive investors will have 9+X%. Absent continued switching, the feedback of profit re-investment will push the balance back to equilibrium.

You'd probably be interested in listening to this talk by Michael Green: https://www.youtube.com/watch?v=x-rJciYZmi0

He goes into a lot of data around the idea that the market is "too passive", and he believes that we were already at that point last year before the pandemic.

I really enjoyed and learned a lot watching this, thanks.

You got some good replies to your question (which is a very good one!) but I'll take a stab at it like this:

A market is "too passive" when it becomes exploitable due to perfect predictability. But - that is the very thing that will keep it from ever reaching that level of passivity. Exploiting it is an active step, then someone else bets against the exploiter, etc.

> 2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small

Medallion usually does well, but hedge funds underperformed in the 2010's.

> Medallion usually does well

That's a bit of an understatement. The lowest yearly return since 1990 after fees and expenses has been 20%. Since 2005 their lowest yearly return has been 29%.

They practically print their own money. Their strategies appear to have low capacity, I'll give you that.

>the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds.

I've always found stock buybacks intriguing and confusing. Here's a hypothetical scenario that seems to go against what you're saying:

Company A buys back $1 work of stock. Since there is now $1 less in Company A's bank account, that company is now worth $1 less. So the market cap should in theory be $1 less. Since the market cap should be $1 less, and $1 of stock disappeared, those perfectly balance out and mean the stock price should stay the same.

Now the index investors take a look at the situation. Company A's market cap has shrunk, whereas other companies' market caps haven't. So Company A has a smaller share of the index than other companies than it had before. But the index investors still have the old ratio of Company A to other companies, so they are overinvested in Company A. They all sell a bit of Company A in order to get the correct balance according to the index. Company A goes down in value.

So a stock buyback caused the price to go down.

market cap = book value + discounted future cash flows = share price * number of outstanding shares

When you do a buyback, the book value drops (company loses cash), but the discounted future cash flows remains unchanged. The number of outstanding shares also drops.

The net result is the stock price increases as a company accumulates cash and uses it for buybacks because the number of outstanding shares drops.

Another way of thinking about it is that it's the same as dividends, but the dividend only goes to the sellers of the stock during a buyback.

Market cap = whatever the market decided at that time, and is determined by offer and demand.

The whole book value + discounted future cash flow does not reflect the real stock exchange at all. If that was the case no investor would want share buybacks because as you say it would only reward the ones who sell...

When taking into account offer and demand stock buybacks make more sense: the buyback increase the demand for the stock. The offer will increase a bit (a few might sell) but not in the same proportion because the offer is not very elastic (most of your investors are in for a long ride and are not going to sell), so the price goes up, you get rid of some short term investors, and the long term investors see their share increasing in value. Everybody's happy and the dividend ratios do not mean anything anymore.

Buyback increases the value of the outstanding shares, which is great for those in the company with stock options.

I don't understand your reasoning for why the price increases. To use your equation with my original example:

Initially:

market cap = $100

book value = $20

discounted future cash flows = $80

share price = $1

number of outstanding shares = 100

After the buyback:

market cap = $99

book value = $19

discounted future cash flows = $80

share price = $1

number of outstanding shares = 99

So the market cap didn't change.

I agree it's effectively the same as dividends (although I think buybacks are slightly better for the taxes of stockholders).

If you consider #3 and don’t limit it to only debt-driven buybacks, then the price increase can be absolutely insane.

The best example is Berkshire Hathaway stock (BRK A share) which currently trades at $402,620 per share.

For those that are interested, this is known as the Grossman-Stiglitz Paradox. See their original paper, "On the Impossibility of Informationally Efficient Markets" (1980). In my opinion, this is one of the most important econ papers ever written. The paper itself is not too technically difficult: the model consists of CARA (i.e. exponential) utility functions and normal random variables, which results in linear demand functions. Solving for the equilibrium is possible with a little bit of linear algebra.

For more recent (and much more technically difficult) treatment, you can take a look at Garleanu and Pederson (2018) ("Efficiently Inefficient Markets for Asset and Asset Management").

Your active strategies are not against passive traders, they're against other active traders. You can't create one of those differential bets trading only with index funds as they won't take the other side of the unbalanced position you want as they're obliged to follow the index. In your scenarios you'd be winning against some other active investor taking the other side of the bet. Active as a whole can only beat passive as a whole if the market becomes so screwed up there's too much tracking error for passive to work properly. At that point the passive index no longer represents the market average and the active traders can take a larger share of the gains.

In the scenario of a company that is obviously not a going concern you can sell stock short to passive investors. The company will then fail and it’s stock will be worth 0. You get to keep the money. I guess the worry would be that the company could raise money by selling shares and use that to avoid becoming insolvent, but at some point a company is going insolvent faster than it can issue new stock.

You can't sell stock short specifically to passive investors. You have to sell it into the market. And since you're trying to sell only that stock and passive investors are buying the whole market your actual net counterparty is a set of some other active traders that hold the mirror position to yours, not the passive traders. The passives will always get the average of the market in that scenario and your above average returns have to come from someone else's below average returns.

I just wrote to you the same thing the parent of your post did. You are missing the part of the scenario where "everyone" except the one player is passive. Both I and the poster broke down the mechanics step by step for you...

You didn't break down anything step by step. If you actually start with an 100% passive market and try having a single active investor in it nothing works. Funds can no longer buy and sell the basket of stocks they need. At that point they'd just trade among themselves and simply not trade with you. To actually be able to trade in the way you describe you'd need a 99.9% passive market where there are still some active traders you are trading with and together you are creating tracking error for the passives siphoning off their gains, which is what I described.

I think your use of theory and terms is right but you aren't visualizing how it would work in the world where nearly everyone is passive.

Simplest example I cited already: it becomes obvious that company X will default in short order, but it's a member of an index and the market will "buy" it anyway: I can short it (by borrowing from the passives and selling it to them next time they buy the index) and never have to cover since it's bankrupt. That's a simple example of a single-player active skewering the passives.

You can try to figure out what this means in terms of tracking error but it's kinda irrelevant to my point.

In your hypothetical 99.9% passive scenario that doesn't work either because passive funds have long ago disallowed borrowing their stocks to short. If you start with a ~100% passive premise the reality is so different to what a normal market looks like you can't just propose a normal strategy and expect any of it to work.

Hi, I'm not sure I follow this idea that passive investors don't lend their shares. Is that meant to describe the hypothetical world of no active traders, as discussed above, or is it meant to describe the present situation in the investing world today?

In the world as it stands today, passive ETFs and index mutual funds are a huge source of shares to lend. It's one of the ways they can lower the cost of the passive fund (or slightly increase returns above the passive benchmark), as the proceeds from lending shares are returned to investors in the fund. (Not always, but the good ETF operators do this.)

If passive funds made this tradeoff then how would they be influenced by a company going bankrupt? They would just change the tradeoff when that becomes a problem since this is not part of the passive investment strategy.

I'm 95% passive, but I think a place where active strategy was observed was with TSLA. actives knew it was on it's way to the index and piled on into it, once it got into index, it got bid up some more and then actives cashed out. passives didn't enjoy the ride up, but suffered the cost of the ride down.

This is what "getting priced-in" looks like. There are strategies around buying shares of companies where their acquisition has been announced, but hasn't closed. Buying is basically a bet that everything goes smoothly.

This is becoming less true as technology has made total market indexes easy and cheap. Instead of buying the S&P 500, I can buy VTI, so TSLA was in my portfolio before and after, to no real effect.

> passives didn't enjoy the ride up

Passive investors who only invest in the S&P 500 didn't enjoy the ride up. But there are plenty of other indexes that people invest in passively that would have held TSLA prior to being added to the S&P 500.

I own SCHB, for example, which tracks the Dow Jones U.S. Broad Stock Market index, and would have owned shares in TSLA long before it was added to the S&P 500.

"Imagine 100% is active" <- Did you mean "Imagine 100% is passive"?

That said, I as a buyer-and-holder, I welcome the hordes of active traders willing to expend time, effort, and money to discover the price that I too will be able to trade at.

Thanks! Fixed!

> Imagine 100% is passive. That means any stock in an index will be bought tomorrow and forever regardless of price. I could exploit that in a ton of ways. For example, do a "squeeze" (think of the recent GME short squeeze but in reverse.)

With more and more assets going into passive funds, when might we actually see them owning such large fractions of companies that a play like this is possible? Google suggests that 10-15% of the SP500 is owned by mutual funds. Presumably there's going to be an inflection point where this becomes problematic.

If you’re holding then you’re neither buying nor selling, and so you don’t participate in setting the price at all, until the day you sell. Only the people (and machines) that are trading have any say. So it seems like it wouldn’t be the percentage of free-riders that’s an issue, but rather that the size of the active market shouldn’t be too small.

Index funds need to rebalance so they’re not just holding, but it seems like for passive investors, they approximate holding? Maybe the rebalancing would tend to exaggerate the effects of active trading?

>> think of the recent GME short squeeze but in reverse

Reverse how? There are so many axis I don't know which to use as the basis of my flip. If you care to, please explain a bit more in detail.

Flip it on all axis, I guess :)

But, sure. Let's say I know that you (index fun) are obligated to buy stock X tomorrow and over all foreseeable future. I am gonna hoard those shares at no risk and sell them to you at a VERY VERY painful price, since you have no room to say "that's too expensive, no thanks"

How are you going to hoard "at no risk"? You're trying to corner the market for a given stock in an index pushing it's price way up and thus exposing yourself to the price crashing down and wiping you out. Meanwhile the passives are routinely buying and selling index funds depending on their need to save or raise cash so the net inflows into that stock are positive or negative depending on that. And that stock is only a small part of the total portfolio. Depending on how their specific timing works out your scheme is a net positive or negative but it never wipes them out. Your risk is way worse, particularly if you need to leverage to buy the whole position. Even if your play was to corner the market completely and own almost the full company the end result would be it being removed from the index for there not being enough float around. Then all the index funds dump what they had of it, and you lose your shirt.

That's the point. An asset can't crash in a 100% passive market because the funds buying the assets are obligated to do so without any discretion. The point is that such a situation is unrealistic.

It can crash even more violently by being removed from the index, which would happen if someone actually cornered the market for that stock as I described. My point is that the situation is unrealistic but in a completely different way than what is being described.

I agree with you mostly, that there are spaces where active can make great bets. But this particular example isn't quite true. Passive Index funds are not automated 100% and have discretion on when/how closely they track the index. They DO have to try and track the index, but that doesn't mean they have to own every stock IN the index, nor does it mean they have to buy X stock tomorrow, regardless of price.

source: Any prospectus/annual report of a large index fund, such as VTI.

Why would a company ever default if it’s stock price can’t go down. Couldn’t it just sell more stock to cover it’s debts?

That’s not quite right about passive and active though. It almost always resets every quarter (or other liquidity events). Passive introduced delayed price discovery and as a result greater volatility around earnings (or liquidity events). But over medium to long term passive vs active should not matter.

Why isn't it "quite right?" I spelled out 3 scenarios that can play out and obviously will given the structure and incentives. Where do you disagree?

Because passive does not necessarily mean index. You can be passive and concentrated (see ARKK). And more importantly real world indices are moving target to begin with. They’re just very rough approximation of market basket. SPX is not representative of market as it relates to mpt at all. In fact that’s likely one of the biggest myths in modern finance.

The fact that Arkk's own website refers to itself as an active equity etf should prompt you to reconsider your definition of these terms.

> Actives do expensive research and trade against each other to arrive at the consensus price. Passives trade at that price for "free." Since both get the same price on average but passives incur no cost, they win on average

No, actives can make money on average. If the actives do expensive research and learn things, they can buy good stocks at low (below-fair-value-given-new-knowledge) prices, drive up the price, and the passives follow later, buying at high (fair) prices. No one needs to lose, but actives accrue a disproportionate fraction of the gains.

> This breaks down if passives outnumber actives

Hypothetically there is a level of passive investing where the system breaks, but (1) this has nothing to do with 50% threshold (a small active minority can be fine) and (2) the are natural strong forces that prevent this from happening (as the fraction of passives increases, the reward for being active increases, drawing in more actives).