The article is interesting. We replaced the baity title with representative language from the text. Hopefully that will spare us all yet another boring flamewar about the c-word.
If anyone can suggest a more accurate and neutral title, we can change it again.
Edit: ok, you guys didn't like "When analysts are replaced with index funds, the market stops allocating capital", so I dug up another representative sentence from the article.
The best way to complain about a title is to offer a better one, so if you don't like this one either, maybe take a crack at it?
The "index funds" thing is throwing people off the track of the article, which is more about robots than index funds proper. Perhaps "when human analysts are replaced with algorithmic robots, capital markets will feature less activity but what about efficiency?".
This article brings up a point I used to worry about - if people are just automatically pumping money into a list of stocks, how does the price remain connected to reality?. But apparently the answer is that mis-priced stocks present an arbitrage opportunity (https://www.investopedia.com/terms/i/indexarbitrage.asp), so as long as a few people are paying attention, the price remains rational, and the remaining people paying attention are rewarded for doing so. The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.
I assume you are talking about Amazon. Who cares about past income? What matters is future earnings and it's clear they have lots of earnings potential.
Yeah they do. But a $1T valuation implies a crazy amount of cash flow growth. They're top-line is increasing at 20%-30% per year right now but how long can that continue
> The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.
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.
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.
They’re already an order of magnitude or more lower on fees - I don’t think there’s even room for them to go much lower. What would be nice if if funds lowered their fees to be closer to the index ETFs
Also, I'd like to note, it probably depends on the maturity of the market you're looking it. It will probably be harder to beat passive investing in US fixed income than frontier economies equities.
Edit to add: A few big & cheap index funds and a couple of rock star active managers sounds good to me, actually.
It also very much depends on who is doing the investing. If you're CALPERs with ~$320bn you don't want to put it all into the S&P 500. Diversification through exposure to other, ideally uncorrelated, equity types or asset classes.
The best asset managers charge low fees, they make up for it very comfortably in volume and long term holdings. Warren Buffet famously doesn't sell, he doesn't need to make thousands of deals a year to eke a small profit from each, he needs to judiciously pick fewer things that are going to do well in the long term. All too often people don't want to properly invest however, they want to speculate.
Index arbitrage is a mechanism that corrects mispricings between an index and its constituents. That isn't the mispricing being discussed. What is being discussed here is the potential for the prices of individual stocks to deviate from any reasonable level because of their inclusion in an index.
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.
Apparently, to call the saying old is an understatement. Quote from Wikipedia:
> The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham (1519–1579), who was an English financier during the Tudor dynasty. However, there are numerous predecessors. The law had been stated earlier by Nicolaus Copernicus; for this reason, it is occasionally known as the Gresham–Copernicus law.[3] It was also stated in the 14th century, by Nicole Oresme c. 1350,[4] in his treatise On the Origin, Nature, Law, and Alterations of Money,[5] and by jurist and historian Al-Maqrizi (1364–1442) in the Mamluk Empire;[6] and noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC.
The distinction, as I understand it, are that active funds are legally free to invest in more abstract concepts. E.g. that oil will rally under these sets of economic conditions, and oil companies with these fundamentals are preferable.
Whereas passive index funds' concepts are much simpler. E.g. all companies that are this large.
This gets summed up as "less trading", but is really just trading on simpler criteria.
I'd be really curious to hear from someone in the area about the opposite -- what keeps passive funds (in the "no human" sense) from behaving more like active funds, with targeted, complex investment concepts?
If I wanted to start an algorithmically traded fund, cut my expense ratio by not having to pay humans, are there legal barriers currently standing in the way?
Yeah, even more intuitively, there will just be a Nash equilibrium:
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).
This contradicts (correctly) the supposed proof that you cannot beat the market on average (since the index funds are the average). Clearly the index funds must be slower to the punch in some sense and thereby lose out to active investors.
What you say could be true for the nominal return, but actively managed funds typically have to do ~2% better to just compete with index funds considering the total return (i.e., including management fees). Some Vanguard funds have fees as low as 0.01%.
I’m talking about a Nash equilibrium for the investor who decides to invest in an index fund or an active fund for their own profit. So management fees are subtracted from either choice. Intuitively what I’m saying is pretty trivial: if one choice is obviously better then everyone would go for it, making the other choice better.
What makes index funds average? In fact, what does 'average' mean in this context? A money-weighted average over all market participants before management fees but after trading costs? It's not clear to me that index funds do earn an 'average' return.
Index funds are (slightly below) average by definition.
The index itself defines the average (it's the benchmark that all funds use to measure performance), so a fund perfectly tracking the index has almost zero alpha. The "almost" is whatever fees the index fund charges, which lead the funds returns to be slightly below the average if they otherwise track perfectly.
Edit: Just to add, by the above definition, where you take the total return on the index as the average, most investors do significantly worse than average, a few do a lot better than average and investors in index funds make almost exactly the average.
But the parent's comment was "you cannot beat the market on average (since the index funds are the average)". If you take a particular index fund to define an average then this just asserts that you can't beat a particular index.
GP might be trying to argue that alpha generation is a zero-sum game, but alpha and beta are notoriously slippery concepts. If you want to define beta as the index return, I think you're going to have a hard time convincing me that alpha is zero sum without assuming the EMH or something similar.
Yes, the point you're referencing is wrong. Your last point is correct. We can't extrapolate the fact that indices are designed to return averages of some market to the claim that indices can't be beaten without assuming the EMH first.
This is a mathematical fact. Let’s say you do better than the market because you deviate from the market weights. For each position that you have, relative to the market, there is someone somewhere that holds the complementary position. Because the agregate of all the positions is the market portfolio, by definition.
> GP might be trying to argue that alpha generation is a zero-sum game, but alpha and beta are notoriously slippery concepts. If you want to define beta as the index return, I think you're going to have a hard time convincing me that alpha is zero sum without assuming the EMH or something similar.
Alpha is zero sum because the total return of the market is the total return of the market. So the money-weighted average return to stockholders must equal the money-weighted average growth of stocks.
Index funds are designed to passively track specific markets. The S&P 500 tracks ostensibly tracks the approximate total average equity market growth in a reasonably diversified manner, for example.
However you can design any kind of index fund for any kind of market. Many other indices aside from the S&P 500 exist which are more or less passive depending on the process and criteria used for inclusion.
Since no index has absolutely no fees, it's considered acceptable to state that indices return an average of some sort of market - with the proviso that it's actually slightly less fees and costs.
EDIT: Based on your reply to a sibling commenter it seems like you're taking issue with the claim that indices tracking a market can't be beaten by active investing in that market. I agree; to wit: that's not a defensible claim without assuming EMH, as you say elsewhere. But that doesn't change the fact that indices (ostensibly) return an approximate average of a market.
>the market on average (since the index funds are the average).
This statement is potentially confusing because it depends on what the word "average" is referencing.
If we're talking about _all_ investors's returns including active and passive investors, the S&P 500 index has historically provided above average returns[1]. The math allows the S&P 500 index to be above average because so many investors lose money. Think of the unsophisticated investors losing money on the bitcoin crash, or buying Snapchat at $27 last year and selling it today at $8, or trying naive strategies at day trading. And most mutual funds, hedge funds, and VC funds also provide lower returns than the S&P 500. All those money losers mathematically "bring the average down" such that the S&P500 ends up providing above average returns. This "better than average" performance of S&P 500 is why Warren Buffet confidently bet that the passive index would beat the hedge fund managers at Protégé Partners.[2]
On the other hand, S&P 500 index is often a proxy for "market average" also sometimes called "beta" or "benchmark return". The distinction is that "market average" is a different concept from "all investors' average". This means that "market average" has turned out to be "above average" which sounds like a contradiction but the math of including all the money losers shows it isn't.
to further clarify, beta is the statistical volatility of a stock compared to the market return (which has a beta of 0, by definition). volatility is our proxy for the riskiness of a stock; note that higher risk results in potentially higher (or lower) returns (we reward higher risks with potentially greater returns).
the true market return is unknowable because it has to include both public and private offerings, and by definition, we can't know (in most cases) the returns on private investments, such as fine art and the like.
that's why we use the S&P 500 (or another index) as a proxy for the market return to calculate a security's beta. we don't have enough historical data to truly know how good of a proxy the S&P is (we'd need hundreds of years of data for that, iirc), but most studies consider the margin of error acceptable for research purposes.
edit: and in the long run, you can't beat the market (unless you have consistently good insider info).
Yes, I think a more accurate statement is: “you’re unlikely to consistently beat the market (i.e. do better than index funds) assuming not too many people are using index funds”. Also, given the Nash equilibrium above, it follows that the best you can do is indeed follow the market.
Indices will necessarily get the same net return as the average active investor, by definition.
For extant index funds there are trading costs and tracking error. The more correlated the markets become, the more index funds are going to be liquidity takers (paying to trade) and the further fund performance will fall behind the indices they're supposedly tracking.
All you need to do is buy cheap leap puts on whichever stocks you feel have a PE ratio that is unsustainable, and wait.
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.
This is not entirely true. Passive funds only perform transactions in response to change in market cap. Market cap value change for any company is entirely controlled by active funds. In other words, you can think of passive funds as observers in market who follows what active funds will do in aggregate. The entire reason passive funds out perform active funds is because they sort of act like ensemble of active funds.
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.
The conclusions here seem to be based on a) a purely passive market, and b) a static amount of capital.
I’d like to see an analysis that offsets the potential inefficiency of a partially passive market with the gains to the economy from additional capital being available to invest.
Are we better or worse off with a market that is n% less efficient, but that has y% more capital from passive investors than a purely active market would have?
Once they've found the perfect capital allocation algorithm to replace markets, they can work on the perfect policy calculating algorithm to replace democracy
I think they will never find the perfect capital allocation algorithm or solve the economic calculation problem.
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.
I'd be more concerned about the potential conflict of interest having such algorithms control major functions of other's lives. My post was meant to be sarcastic, however I'm getting a lot of downvotes, so perhaps the sarcasm wasn't clear.
To me, the interesting question is: if the market is mostly index funds, what does that do?
Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is forced to follow you. Sell some, and they will follow you, too.
It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.
But essentially, as % of market on index funds increases, the returns on arbitrage-seeking actively managed portfolios will increase (vs. the market) to the point that they provide higher returns than the index funds (due to index funds no longer accurately capturing all information available in the market), resulting in a shift of money out of index funds to active funds, decreasing the returns in active funds and keeping the market in equilibrium.
The "you" refers to the "index fund manager", yes?
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.
... and thus the rise of “smart Beta” funds. The fact that many market indices are price-weighted is considered a flaw - consider, for example, that a stock with a 3x higher price in the DJIA will move the index 3x as much, regardless of market cap. Smart Beta funds attempt to adjust capital allocation by using different criteria to determine how much of each security to hold - for example, dividend yield rate, or volatility. Overall, this means that moves in and out of a particular security by a passive smart Beta fund become somewhat separated from the moves of its parent index.
More generally, the interesting thing about optimal portfolio funds is that they move counter to price. Appreciation in a particular asset class will cause that asset to be over-weighted in the portfolio, and the response will be to sell some of it, or buy more of everything else, to get back to the target ratios. Conversely, you find yourself buying into asset classes that keep falling (like natural resources over the past 5 years or so...), with the implicit assumption that some day they will rebound.
Not quite. One reason why many passive indices are market-cap weighted is so they do not have to regularly trade. Suppose a fund needs to be 1% AMZN. Now you fire up a hype train and the price of AMZN doubles. It now represents twice as much of the index, market-cap weighted, so the fund wants to be 2% into AMZN, but their stake has doubled with the price so there’s no trading needed!
That said, you can generally pick up an extra point or two of returns by equally weighting and trading against the daily volatility, and some funds do this, but they cannot scale up to have as large capacity.
If you went to a financial advisor 30 years ago, they would have said "give me your money and I'll make you a portfolio". He/she would then have bought most of the S&P 500 or some other exchange in a diversified manner buying equities and bonds. They would have shifted around your allocations ever so slightly every quarter, buying some stocks and selling others. But really, the strategy was to buy and hold. Bonds were similar.
Indexing was very common, it just wasn't called indexing. It was called "active investing" but the reality is it wasn't as active or as smart as people think it was. It was very similar to today's indexing where you would funnel your money into the Facebook, Google, Amazon's of the day and collect a fat fee. This is how index funds work today, when you invest in a S&P 500 index fund it's really weighted towards the huge hitters. The dirty secret of active investing is every active investor had some kind of index-like fund going that constituted a large percentage of their portfolio.
That graph is precisely my point, it's all about how we're measuring what it means to be an "index". You could engage in index-like behavior but be an "active investor". Indexing is just a label.
Of course the market as a whole has been always indexing by mathematical necessity. Indexing is just a label, true, but it happens to be the label applied to investing exactly in proportion to the weight of each stock in the index. As opossed to "active investing".
But the subtler point is that your index fund is mostly invested in a few big companies,plus noise. AAPL ($1T) itself is 3% of the entire US stock market ($30T).
The first index fund was in 1975, and people did scoff at it and call it "un-American". But that was over 40 years ago. By the time you're thinking of, index funds were common, even if not as large a portion of the market as today. I'm not sure exactly how much Vanguard had taken in by 1988, but I read[1] that their growth rate was about 53% in the early years, so their first fund that started with about $11 million would have been one of the larger ones by then, around $1 billion or more. By that time they had a dozen competitors.
Something can be common without being a large percentage, or a majority, of the market.
When Vanguard's fund had $11 million and was the first and only of its kind, I think it's fair to say indexing was not common or popular. When they had competitors and there were billions of dollars being indexed (keeping in mind a billion dollars used to be worth more than now), I think it's reasonable to say investing in index funds was growing common.
By analogy, a small percentage of the national or global population used the internet circa 1996, but it was becoming a common activity in the sense that millions were discovering it.
You're getting downvoted, but this is exactly what happens with most active managers these days. Seriously, go to a local branch of a big bank, start a managed investment account, they'll give you a 1-1.5% fee portfolio and tell you about how well diversified and well organized it is for your risk level. And it is both those things! But dig into the investments and you'll see... Vanguard, Vanguard, iShares, Vanguard, Vanguard, iShares, Blackrock, Blackrock, iShares, etc.
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.
The market already doesn't allocate capital. Companies almost never issue new shares, indeed they buy them back. Given that dividends are also trifling, the market is mainly a large scale gambling scheme. Not entirely, but mainly.
> The function of the capital markets is to allocate capital.
I never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered "allocating capital"?
Every purchase of a share rewards the previous owner with some cash. Follow that chain of trades backward and eventually you end up rewarding the founder, the early employees, the VCs, etc. It's a long, tenuous chain, but it's there.
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 understand the concept of liquidity and the reward mechanism you describe but it doesn't ultimately answer my question, which why is the process of buying an existing share called "capital allocation"? Let's say I buy a GOOG share from Larry Page. Is it the idea that I "allocated capital" to Larry Page's bank account? It seems to me like the correct thing to say would be that I provided liquidity to Larry, not that I allocated capital. Or is it the idea that I allocated some of my own capital to the stock market?
Two points, one going to your question and one is of general interest.
Buying existing shares is "capital allocation" with respect to the _buyer's capital_. So I might allocate 20% of my capital (ie, gross financial worth) to being in shares of some company. The seller is allocating their capital somewhere other than the share. So you allocate your capital to GOOG, pay Larry and notify Alphabet that you are one of their capitalist overlords. If the price of Alphabet stock goes up, you now have more capital even though if you do a quick count you'll discover you have no new currency/cash. The reason this is important is that the people with a good ability to allocate capital will end up with more capital hence control. Eventually, the people in charge will be the people with a good grasp of what is changing (which I'll claim is desirable with no support).
For general interest, I've no insight into the intricacies of the US system, but in Australia every so often a company creates and sells new shares directly on the market. The upshot of this is a company can access the market directly for capital.
This is one thing that frustrates me about investing in the stock market. The idea of calling trading "investing" feels so inaccurate. I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder. I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back. That's investing.
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.
Sounds like the bond market is right up your alley; that's how bonds work. (N.B. read first, invest later.)
The thesis above also neglects dividend investing, where you buy a share of Ford Motor Company from someone for ~$9, and as long as Ford can do so, they'll probably give you $0.15 every quarter.
>I wish investing was more like selling small corporate loans. I'll give Amazon $50 today if they pay me $100 in 10 years. Sounds great to me, take my money, do something with it, and pay me back.
That’s a bond. Corporations do issue bonds but it’s just one way to invest, and generally you’re just betting they’ll pay their debt to you (and you’ll tend to get less over time but it’s more guaranteed). With a stock you’re betting that the value of the company will increase over time and you get paid as it increases in size and income.
This is basically Warren Buffett's conception of a stock: a bond with a variable interest rate.
It gets easier when you think of a share as a fractional claim on a cashflow (profits - what's "left over"). Bondholders are generally promised a specific amount upfront. Stockholders get what's left over -- the amount of that is anyone's guess.
It gets pretty abstracted when you start talking about firms that don't pay out profits but the basic idea is sound.
I don't agree. In a farming village centuries ago, a man bought a second hoe from an estate sale. He would go on to lend it to others who needed a hoe, and charge rent for the use of that hoe. Over the seasons, his hoe brought him good rent, but then it came time to sell it. Because many of the hoes in town had been made by the blacksmith's apprentice, several had broken over the years, and the old master blacksmith's arthritis had prevented him from making new ones. But our hero's was one of the few crafted by the master, so over the intervening time, and with careful maintenance, it had actually appreciated as an asset, in addition to the investment income it generated.
This was unquestionably an investment on his part, in the traditional sense of the word. Our hero bought a productive asset and earned returns from that asset. It was nice that it also appreciated, but that's not necessarily what he bought it for. Or maybe he did. It doesn't fundamentally change the nature of his effort.
Buying a stock is very much like that, with lower transaction costs and risks. Only the productive asset you're buying is not a physical one, but a legal one and social one.
Also, you can buy corporate bonds. They don't pay shit because everyone wants a safe investment like what you're describing, and money is real cheap right now.
You are correct in that there is no net new creation of equity capital in a secondary market trade.
I look at it this way: there is a fixed amount of equity capital floating in the world at any given moment. At any point in time, someone has foregone consumption (decided to forego eating a pizza today), at some point in the past (distant or recent) in order to own a piece of that equity.
Also keep in mind companies issue and retire equity on a more or less ongoing basis through employee stock grants and buybacks. So it really is a question of how much you want cash vs. shares of stock, and how that tradeoff works for others.
> I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder.
You just provided a (simplistic) definition of investing. I don’t see how that supports your claim that it’s not investing. All investing is just buying something that you think will be worth more over time. You buy a share of a company because you think the share will be worth more. You buy a bond because you think the issuer will be able to pay back the debt and interest. I can’t think of another definition of “investing.”
Not necessarily. A more general, yet more precise definition of investing might be, "Trading cashflows in a way that both parties find beneficial".
Those cashflows may be subject to (negotiated) differences in timing, risk of nonpayment, intrinsic uncertainty (most equities fall into this bucket), etc.
But at bottom it's all just cashflow.
This is a useful lesson to generalize about finance, in the larger sense. Don't think about "worth more". Just think of it as timed cashflows. Negative when you buy, positive when you sell or receive a dividend.
Trading is when your speculating day or week to week.
Investing is saying "ok big warehouses for distribution companies like amazon is a growing market therefore I will buy shares in a company that owns warehouses (BBOX) - this is sort of how Warren Buffet works
Eh, that distinction is ambiguous at best. There's a far larger overlap between speculation and investing. It would be more accurate to say that value investing is different from speculation - but even then, speculation is fundamentally inseparable from investing.
It might be helpful to take a look at what Graham called a “Net-Net.” If other investors perpetually undervalue your investment in a company that produces earnings, eventually the cash generated from those earnings could be given to shareholders as a dividend, etc. In an extreme example, imagine a company that the market values at $1B with $1B in assets that produces $1B in earnings. The following year, the company would have an extra billion on its balance sheet even if the share price didn’t change.
> I didn't invest in your fortune 500 company, I bet on the idea that other people down the line would bet on the same company but that they'd bet even harder.
The stock price does connect to the real world though. If a company is deciding whether to expand, or bring in new management, or exit an industry, their stock price will certainly factor into that. If they're looking to buy another company, or another company is looking to buy them, the stock price is even more relevant.
It's a price mechanism. The logic is that by having a liquid secondary market where investors are free to trade securities whenever they want, you always have an up-to-date price that reflects all information known about future prospects for that business. (If you didn't, then someone with superior information could trade based on that and reap a profit, which increases the amount of capital they have to trade on in the future, which means that eventually all the capital ends up in the hands of the firms with the best information.)
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.
Thanks for the elaborate reply but I was aware of all of this already. I wasn't questioning the utility of the stock market and understand its role as a price discovery mechanism and liquidity provider.
I was however questioning whether this sentence from the article was really accurate: "The function of the capital markets is to allocate capital".
I'd argue that trading existing shares, although it contributes to price discovery and liquidity, is not "capital allocation" (unless we're talking with respect to the buyer's capital like another commenter pointed out).
The Capital Market is more than just the stock market. The Bond market - the place where orders of magnitude more $$ volumes are traded is also a capital market. Both are allocating and reallocating capital to daily, and the price signals are just as important to future capital decisions of all participants.
Trading existing shares is not allocating capital (from a company POV), you are correct. But a company issuing new shares, for example, is an example of such. The markets set a price, and the company can take advantage of this liquidity to raise money
One possible way is if we consider capital allocation in terms of acquisitions, where one company acquires other companies by giving them stock instead of cash (which is what a lot of pre dot-com era telecom companies did to acquire customers + coverage like Verizon or the notorious Worldcom) and the ease of those acquisitions was largely based on the demand of that stock and thus the stock price.
> However, why is trading existing shares considered "allocating capital"?
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.
Ah, it makes a bit more sense when interpreted that way. So the capital that is described as being allocated is really the company's capital to the investor, not the investor's cash to the company.
If I buy shares in a company say RDSB (Shell) I am allocating my capital to that company and someone else is selling theirs as they don't want to own that asset any more.
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%.
A functional capital market provides liquidity and higher valuation to an investment. Without these two you would have less capital going into companies. Trading shares may have little immediate effect, but certainly do for the next share offering.
This is fearmongering. If the market approached an allocation to index funds that enabled arbitrage, more actors would switch to arbitrage eliminating such arbitrage.
It is a self-balancing situation. A scenario of "oh my god, everyone is just putting their money on index funds" would never happen.
Another way to think about it is in terms of evolutionary stable strategy. Index funds and arbitrage-seeking reach a Nash equilibrium at some point (far more index-allocated than today's market) where arbitrage-seekers will reap returns almost equal to index funds, as index allocation starts o not capture all available market information.
If the market deviates from that point, forces push it back into that point. If the market starts over-allocating into arbitrage-seeking (like today), returns on index funds will beat arbitrage, pushing capital back into index funds. If the market over-allocates in index funds, index funds will return below arbitrage, pushing money out of index funds.
Edit: Right now, the market is still far over-allocated into the arbitrage-seeking side, resulting in a natural shift to index funds.
To initiate a transaction an arbitrageur, though, needs a counter-party that's also engaged in arbitraging, but has an opposite opinion.
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.
>It is a self-balancing situation. A scenario of "oh my god, everyone is just putting their money on index funds" would never happen.
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.
Of course you'll get oscillations (but the business cycle doesn't have anything to do with it), and you don't even need differential equations.
But the point of equilibrium is a Nash Equilibrium, meaning that any deviation from it will create forces that push back to it (you can think of it as a valley). So while there will be oscillations, you won't expect large deviations.
It seems to me obvious, yet implicitly overlooked, that people who hold stocks and don't trade aren't affecting the price one way or another. It's only the traders that set prices.
Anyone who holds stocks bought them, and if they are still generating net wage income will buy more, and presumably will eventually sell them when hey retire.
All that time, however many years they own the stock, they are putting in neither bids nor offers, so they are completely uninvolved with the price. You put in an order, and it influences the price slightly for a matter of seconds. But if nobody traded, there would be no market price.
If you carefully read the article, it is very much not about the "What if 100% of assets were indexed" argument you often see. It's about what happens as more and more assets are robotically allocated via algorithms. Matt Levine is not a clickbait writer, and he deals seriously with the arbitrage-seeking nature of capital markets including robots which will seek to dominate by predicting what the winners will be.
I think the article deserves a fuller and fairer reading than your comment indicates you've given it.
Come on. Enough of this. For some odd reason,
every week there is a levine article here and every time someone goes out of their way to praise levine. The guy works for bloomberg. Clickbait is part of nature of the beast whether you think levine is great or not. Is levine a writer or a cult leader. What's with all the worship?
Maybe he is praised because he is a good and thoughtful finance writer. And if there’s any financial news site which would have an incentive to avoid clickbait it would be Bloomberg because it’s subsidized by the rents it extracts from its terminal and data business, and this is one service they provide to those customers so they have an incentive to provide value.
> Maybe he is praised because he is a good and thoughtful finance writer.
Could be. But there are a lot of good and thoughtful finance writers. I don't see their articles spammed here on the weekly like clockwork along with the fawning worship. It's almost like the article is just posted to talk about how great levine is and not the actual article. Just seems odd to me that's all.
> And if there’s any financial news site which would have an incentive to avoid clickbait it would be Bloomberg because it’s subsidized by the rents it extracts from its terminal and data business, and this is one service they provide to those customers so they have an incentive to provide value.
You responded to the only phrase of my original comment that had to do with Levine the person. If this is your concern, perhaps you could have chosen to substantively engage with the article?
Levine is great, but the headline (both the ones in the article, and the one here especially — which differ) suggest that there is no middle ground between status quo five years ago and 100% index funds, no active investors at all. (Often journalists don't get to write their own headlines.)
I.e., grandparent commenter is responding reasonably to the headline, if not the article itself.
Not really, 2/3rds of the entire article, plus the title and subtitle are about index funds:
> Are Index Funds Communist?
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
As I explained elsewhere to you, not all passive or quasi-passive money is in indexed products. And furthermore, reading the article as I encouraged you originally to do, reveals it is not about index funds.
> It's about what happens as more and more assets are robotically allocated via algorithms.
Algorithms don't have anything to do with index funds.
And again, as more and more funds move to index funds, the returns on active managed funds will increase due to information asymmetry, and the market will move towards an equilibrium.
The allocation between index and active is a continuum, not a step function.
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
It's definitely possible, as evidenced by this case where the article is actually not about index funds! Also passive and quasi-passive is in no way necessarily "index funds"
I'm sorry but I don't understand what you are getting at. Besides index funds not being impacted by algorithm trading that much, the author of that article also notes that trading stock doesn't to much to allocate capital anymore, like it used to. They get some money at ipo, but after that most companies aren't selling stock to get more capital for expansion. I think we would be better off without the financial industry taking a pointless large cut of the economy, and reducing their stake at least seems sensible.
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.
It isn't just the title, 2/3rds of the article are about index funds:
> Are Index Funds Communist?
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
The biggest danger of all this money in index funds is that the market becomes to big to fail and the government has to keep propping it up. In fact, it becomes a way to actually disburse wealth - enact policies such that they go to people in the market.
"...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. "
It’s not index funds that cause the market to be too big to fail. Pension fund investments and 401k investments also go to the same place, index funds just take out the middle man and reduce costs.
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).
This narrative is such a joke, and such a profound misunderstanding of economics i'm surprised Bloomberg would publish it. Simple rule: if your argument implies that there is or will be free money to be made in the stock market, your argument is probably wrong.
It's actually a great article with a HN title that misrepresents what it is actually about. Anyway, with that proviso, here is my take:
So long as the bots aren't conscious there will be no bot-dominated stock market. Too much information is wrapped up in conscious thought that isn't easily expressed in stock market pattern matching. The article mentions that the line between active and passive isn't as clear as people that make it out to be say it is, and that is true, but it's also incomplete. Certain events are conceivable to humans that are not conceivable to machines. Short of simulating humans, anyway.
For example, I as a human know that there is a non-zero chance that the DPRK and USA get into a nuclear war. I can know that Trump defaulting on Chinese held US debt is something that is at least on the table. The quants can try to pull in percentages from experts all they want (and they were calling my nuclear weapons arms control friends a year ago asking for percentiles) but it isn't the same thing because the model is still fundamentally concerned with statistics and many of the events we understand as humans have implicit dependence to each other that is hard to model.
It's far easier to employ a small number of smart people and have the models serve and be tuned by them than to have the models actually run everything. Plus you don't even really need them sometimes. Take Bitcoin, for example. The gains were obvious. The incentives were completely aligned and the friction was in the buy side and it was temporary. I didn't need to model out Bitcoin to buy it at $4 CAD. I just had to think about it from first principles, something that is currently not possible with ML.
You strike me as someone who has thought very deeply about this.
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.
Interesting. When I click on the article, this is not the headline I see. I get "Are Index Funds Communist?" with a byline of "There won't be much left to do once the investment robots perfect capitalism."
If it were meant as clickbait, the communist headline would be better :)
This is a common refrain. Passive indexing is killing the market. ETFs are killing the market.
I take a very cyclical approach on everything. The rise of passive actually creates huge opportunities for active managers. We see this already in the ETF landscape: you can invest in any product today for very cheap. This creates a new challenge to manage the portfolio of the future. 60/40 allocations are the exposures of yesterday.
A pet theory of mine: if everybody starts investing in passive funds replicating indexes, then the creativity will go into increasingly more sophisticated indexes.
You might for instance want to make the bet that the market at large is systematically underestimating the risks related to global warming in particular, and the environment in general. Said differently, it is entirely possible that governments will start to tax the hell out of various externalities, like CO2 emissions, or plastic garbage generation. Or maybe courts will ask companies to pay to clean up after their own mess.
If you believe that this is true, then indexes (existing or being created) weighting in those risks will over-perform the S&P 500 in the medium term, until a couple of companies are wiped out and analysts start to correctly price in these risks...
That's just one example of the kind of creative index that could be created.
I disagree with your definition strongly. An investment portfolio at the end of the day is just a collection of securities, and an index is a frictionless way to measure and evaluate a collection of securities, typically to a predefined methodology. You could run a S&P 500 like separately managed account to replicate a passive index, and this would have nothing to do with being invested in a fund. Meanwhile, Yoi could create a commingled fund, mutual fund, or active ETF that has no index.
The commenter's point is that the "predefined methodology" can be indistinguishable from active investing if it's sufficiently complex and frequent. It starts getting pretty silly to call it passive. Otherwise an active investor could simply codify their entire investing methodology into an algorithm and start following it passively, then declare that they're just adhering to a very complex index. But quantitative investors are still active investors.
If you take a widely accepted, reasonably broad market definition and an index to track it (such as the S&P 500 for equities), then sure, you're investing passively. The portfolio reallocation and equity inclusion happens according to rules which organically rise from the market definition itself.
But you can creatively define a market for any kind of security and then an index methodology for tracking that market which may involve a complicated set of inclusion rules that are arguably just active investing. This is something Matt Levine has talked about in his column on a number of occasions - some active investors are now rebranding their funds as index funds for creative, synthetic indices.
The practical distinction between beta and "smart beta" is a lot larger than the distinction between "smart beta" and alpha, regardless of philosophical underpinnings.
>>> A "creative index" is another term for a "fund."
I agree with what you are saying, but I'm referring to the previous commenter conflating that a "creative index" or passive investing strategy is a fund, or needs to be implemented through a fund structure.
Smart beta is really just factor investing with very tight constraints around index tracking error. i.e. It's seeking out high beta and low alpha by design, so given it is aiming for some variation in alpha, I think your argument makes sense.
I have thought for a while that most of the financial advisers are just middlemen on the stock market, getting a small amount of my money by trading for me. If I just buy index funds I'll do fine. My financial adviser who charges me at 0.75% management fee didn't protect me from huge losses in 2008 and 2009. I don't necessarily blame her, but she was not really different than buying an index fund or a managed year retirement fund.
"A Random Walk Down Wall Street" is another good one. Doesn't take much reading/investigation to figure out how bad of a deal most investment "management" services are, at least for the average person. It's not too unlike a casino: in the long run the house always wins. You're not the house.
Since the public stock market is no longer a place where companies sell stock to raise capital to build things to make even more capital (Tesla excepted), is seems unproductive to give people who can do well in a prediction market of the future cash flow of public companies (the stock market, basically) lots of resources for doing that. It would be cooler and more useful if we supported prediction markets in all kinds of things that people want to know about. The average yearly temperature at 50 known recording stations in Europe from 2020-2030, 2030-2040, 2040,2050, 2060-2070, etc., would be one many governments, corporations, and people would like to know about.
We changed the title, in keeping with the site guidelines: "Please use the original title, unless it is misleading or linkbait." Please see https://news.ycombinator.com/item?id=18144886 for more explanation. I'll add a question mark to indicate that agreement isn't implied.
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.
I'm not sure what the concern is with index funds. For now they're a better deal than active funds but if they take over too much of the market that will leave more opportunities for active investors to succeed.
The issue is that in the long run, index funds or passive investors do outperform hedge funds or active investment management as shown by Warren Buffett:
There are a lot of factors at play but simply for your non-analyst mom-and-pop investors, they don't have time and the know-how to investigate stocks and index funds are just much more accessible and as they say, in the long run we are all dead.
This is true right now, but it's situational, not a constant that is guaranteed to remain unchanged. If passive investments continue growing as a percentage of all investment capital, they will eventually underperform actively managed investments because market prices will cease to be reflective of value.
Nitpick: it would be more correct and precise to say that index funds tracking the total market beat the average aggregate performance of hedge funds on a long enough timeline. In practice that timeline tends to be quite short in the current market climate.
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.
Theoretically, I think the concern is reasonable. The "concern" here being if everyone switches to passive funds, then the behavior of markets will change. However, when you look at the numbers, it doesn't seem like this concern is actually a reality.
> The market capitalization of the S&P 500 is roughly $22 trillion as I write this. The entire ETF market in the U.S. is $3 trillion. That’s 14%. Even the whole industry—about $4 trillion, would only be 18%.
This statistic was actually a big wake up call for me about 6 months ago. For a long time I had been investing based on theoretical ideas, like the one mentioned in this Bloomberg article that we're discussing. After I saw this statistic, I realized that I needed to look closer at the numerical reality when making investing decisions. This is probably obvious to many of you. I'm just sharing the moment when this insight really hit home for me.
Right, the concern is true. However, when that happens, arbitrage opportunities arise elsewhere (based on that correlation). As a matter of fact, one can start "betting" on the correlation being high and the only way for the "opponent" to win is to dislodge that correlation.
In the end: technical analysis is useless by definition.
Right. It’s difficult to get the full picture. We’d have to account for passive mutual funds, and people who have a passive portfolio by buying a lot of individual stocks. But the point is that this “passive investing is changing market behavior” meme is being spread around with few people actually knowing what percentage of the market is active versus passive. The ETF statistic helped me consider that the passive market might still be small compared to the market as a whole.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
Oh yeah? which benefits? When you know that on average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.
I recently read the Little Book Of Common Sense Investing, and it was brilliant.
If nobody is actually analyzing the companies to discover their intrinsic value, stock prices will detach from fundamentals and we will see much bigger crashes than we ever saw before.
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.
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[ 4.6 ms ] story [ 193 ms ] threadIf anyone can suggest a more accurate and neutral title, we can change it again.
Edit: ok, you guys didn't like "When analysts are replaced with index funds, the market stops allocating capital", so I dug up another representative sentence from the article.
The best way to complain about a title is to offer a better one, so if you don't like this one either, maybe take a crack at it?
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.
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3247356
Also, I'd like to note, it probably depends on the maturity of the market you're looking it. It will probably be harder to beat passive investing in US fixed income than frontier economies equities.
Edit to add: A few big & cheap index funds and a couple of rock star active managers sounds good to me, actually.
The best asset managers charge low fees, they make up for it very comfortably in volume and long term holdings. Warren Buffet famously doesn't sell, he doesn't need to make thousands of deals a year to eke a small profit from each, he needs to judiciously pick fewer things that are going to do well in the long term. All too often people don't want to properly invest however, they want to speculate.
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.
https://en.wikipedia.org/wiki/Gresham%27s_law
Apparently, to call the saying old is an understatement. Quote from Wikipedia:
> The law was named in 1860 by Henry Dunning Macleod, after Sir Thomas Gresham (1519–1579), who was an English financier during the Tudor dynasty. However, there are numerous predecessors. The law had been stated earlier by Nicolaus Copernicus; for this reason, it is occasionally known as the Gresham–Copernicus law.[3] It was also stated in the 14th century, by Nicole Oresme c. 1350,[4] in his treatise On the Origin, Nature, Law, and Alterations of Money,[5] and by jurist and historian Al-Maqrizi (1364–1442) in the Mamluk Empire;[6] and noted by Aristophanes in his play The Frogs, which dates from around the end of the 5th century BC.
1. list of stocks changes less frequently
2. the list is public
3. less trading
There's nothing preventing an "active" manager from behaving in the same/similar manner.
Whereas passive index funds' concepts are much simpler. E.g. all companies that are this large.
This gets summed up as "less trading", but is really just trading on simpler criteria.
I'd be really curious to hear from someone in the area about the opposite -- what keeps passive funds (in the "no human" sense) from behaving more like active funds, with targeted, complex investment concepts?
If I wanted to start an algorithmically traded fund, cut my expense ratio by not having to pay humans, are there legal barriers currently standing in the way?
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).
The index itself defines the average (it's the benchmark that all funds use to measure performance), so a fund perfectly tracking the index has almost zero alpha. The "almost" is whatever fees the index fund charges, which lead the funds returns to be slightly below the average if they otherwise track perfectly.
Edit: Just to add, by the above definition, where you take the total return on the index as the average, most investors do significantly worse than average, a few do a lot better than average and investors in index funds make almost exactly the average.
GP might be trying to argue that alpha generation is a zero-sum game, but alpha and beta are notoriously slippery concepts. If you want to define beta as the index return, I think you're going to have a hard time convincing me that alpha is zero sum without assuming the EMH or something similar.
This is a mathematical fact. Let’s say you do better than the market because you deviate from the market weights. For each position that you have, relative to the market, there is someone somewhere that holds the complementary position. Because the agregate of all the positions is the market portfolio, by definition.
Alpha is zero sum because the total return of the market is the total return of the market. So the money-weighted average return to stockholders must equal the money-weighted average growth of stocks.
However you can design any kind of index fund for any kind of market. Many other indices aside from the S&P 500 exist which are more or less passive depending on the process and criteria used for inclusion.
Since no index has absolutely no fees, it's considered acceptable to state that indices return an average of some sort of market - with the proviso that it's actually slightly less fees and costs.
EDIT: Based on your reply to a sibling commenter it seems like you're taking issue with the claim that indices tracking a market can't be beaten by active investing in that market. I agree; to wit: that's not a defensible claim without assuming EMH, as you say elsewhere. But that doesn't change the fact that indices (ostensibly) return an approximate average of a market.
This statement is potentially confusing because it depends on what the word "average" is referencing.
If we're talking about _all_ investors's returns including active and passive investors, the S&P 500 index has historically provided above average returns[1]. The math allows the S&P 500 index to be above average because so many investors lose money. Think of the unsophisticated investors losing money on the bitcoin crash, or buying Snapchat at $27 last year and selling it today at $8, or trying naive strategies at day trading. And most mutual funds, hedge funds, and VC funds also provide lower returns than the S&P 500. All those money losers mathematically "bring the average down" such that the S&P500 ends up providing above average returns. This "better than average" performance of S&P 500 is why Warren Buffet confidently bet that the passive index would beat the hedge fund managers at Protégé Partners.[2]
On the other hand, S&P 500 index is often a proxy for "market average" also sometimes called "beta" or "benchmark return". The distinction is that "market average" is a different concept from "all investors' average". This means that "market average" has turned out to be "above average" which sounds like a contradiction but the math of including all the money losers shows it isn't.
[1] https://medium.com/@akshay_m/stock-market-gives-you-above-av...
[2] https://www.google.com/search?q="s%26p+500"+index+warren+buf...
the true market return is unknowable because it has to include both public and private offerings, and by definition, we can't know (in most cases) the returns on private investments, such as fine art and the like.
that's why we use the S&P 500 (or another index) as a proxy for the market return to calculate a security's beta. we don't have enough historical data to truly know how good of a proxy the S&P is (we'd need hundreds of years of data for that, iirc), but most studies consider the margin of error acceptable for research purposes.
edit: and in the long run, you can't beat the market (unless you have consistently good insider info).
For extant index funds there are trading costs and tracking error. The more correlated the markets become, the more index funds are going to be liquidity takers (paying to trade) and the further fund performance will fall behind the indices they're supposedly tracking.
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.
Something something, don't bet the farm.
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.
I’d like to see an analysis that offsets the potential inefficiency of a partially passive market with the gains to the economy from additional capital being available to invest.
Are we better or worse off with a market that is n% less efficient, but that has y% more capital from passive investors than a purely active market would have?
Edit: /s
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.
Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is forced to follow you. Sell some, and they will follow you, too.
It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.
This will never happen. It might be interesting, but isn't a realistic scenario.
https://news.ycombinator.com/item?id=18145067
But essentially, as % of market on index funds increases, the returns on arbitrage-seeking actively managed portfolios will increase (vs. the market) to the point that they provide higher returns than the index funds (due to index funds no longer accurately capturing all information available in the market), resulting in a shift of money out of index funds to active funds, decreasing the returns in active funds and keeping the market in equilibrium.
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.
More generally, the interesting thing about optimal portfolio funds is that they move counter to price. Appreciation in a particular asset class will cause that asset to be over-weighted in the portfolio, and the response will be to sell some of it, or buy more of everything else, to get back to the target ratios. Conversely, you find yourself buying into asset classes that keep falling (like natural resources over the past 5 years or so...), with the implicit assumption that some day they will rebound.
Is that not indexing under another name?
http://s18674.pcdn.co/wp-content/uploads/2015/05/Index-marke...
That graph is precisely my point, it's all about how we're measuring what it means to be an "index". You could engage in index-like behavior but be an "active investor". Indexing is just a label.
[1]https://www.vanguard.com/bogle_site/lib/sp19970401.html
https://about.vanguard.com/img_files/who-we-are/remarkable-h...
I guess one can debate how "common" is "common". Maybe indexing was common in the late eighties, but now it's two orders of magnitude more common.
When Vanguard's fund had $11 million and was the first and only of its kind, I think it's fair to say indexing was not common or popular. When they had competitors and there were billions of dollars being indexed (keeping in mind a billion dollars used to be worth more than now), I think it's reasonable to say investing in index funds was growing common.
By analogy, a small percentage of the national or global population used the internet circa 1996, but it was becoming a common activity in the sense that millions were discovering it.
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 never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered "allocating capital"?
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.
Buying existing shares is "capital allocation" with respect to the _buyer's capital_. So I might allocate 20% of my capital (ie, gross financial worth) to being in shares of some company. The seller is allocating their capital somewhere other than the share. So you allocate your capital to GOOG, pay Larry and notify Alphabet that you are one of their capitalist overlords. If the price of Alphabet stock goes up, you now have more capital even though if you do a quick count you'll discover you have no new currency/cash. The reason this is important is that the people with a good ability to allocate capital will end up with more capital hence control. Eventually, the people in charge will be the people with a good grasp of what is changing (which I'll claim is desirable with no support).
For general interest, I've no insight into the intricacies of the US system, but in Australia every so often a company creates and sells new shares directly on the market. The upshot of this is a company can access the market directly for capital.
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.
The thesis above also neglects dividend investing, where you buy a share of Ford Motor Company from someone for ~$9, and as long as Ford can do so, they'll probably give you $0.15 every quarter.
That’s a bond. Corporations do issue bonds but it’s just one way to invest, and generally you’re just betting they’ll pay their debt to you (and you’ll tend to get less over time but it’s more guaranteed). With a stock you’re betting that the value of the company will increase over time and you get paid as it increases in size and income.
It gets easier when you think of a share as a fractional claim on a cashflow (profits - what's "left over"). Bondholders are generally promised a specific amount upfront. Stockholders get what's left over -- the amount of that is anyone's guess.
It gets pretty abstracted when you start talking about firms that don't pay out profits but the basic idea is sound.
This was unquestionably an investment on his part, in the traditional sense of the word. Our hero bought a productive asset and earned returns from that asset. It was nice that it also appreciated, but that's not necessarily what he bought it for. Or maybe he did. It doesn't fundamentally change the nature of his effort.
Buying a stock is very much like that, with lower transaction costs and risks. Only the productive asset you're buying is not a physical one, but a legal one and social one.
Also, you can buy corporate bonds. They don't pay shit because everyone wants a safe investment like what you're describing, and money is real cheap right now.
You are correct in that there is no net new creation of equity capital in a secondary market trade.
I look at it this way: there is a fixed amount of equity capital floating in the world at any given moment. At any point in time, someone has foregone consumption (decided to forego eating a pizza today), at some point in the past (distant or recent) in order to own a piece of that equity.
Also keep in mind companies issue and retire equity on a more or less ongoing basis through employee stock grants and buybacks. So it really is a question of how much you want cash vs. shares of stock, and how that tradeoff works for others.
This is absolutely not the case.
You just provided a (simplistic) definition of investing. I don’t see how that supports your claim that it’s not investing. All investing is just buying something that you think will be worth more over time. You buy a share of a company because you think the share will be worth more. You buy a bond because you think the issuer will be able to pay back the debt and interest. I can’t think of another definition of “investing.”
Those cashflows may be subject to (negotiated) differences in timing, risk of nonpayment, intrinsic uncertainty (most equities fall into this bucket), etc.
But at bottom it's all just cashflow.
This is a useful lesson to generalize about finance, in the larger sense. Don't think about "worth more". Just think of it as timed cashflows. Negative when you buy, positive when you sell or receive a dividend.
Investing is saying "ok big warehouses for distribution companies like amazon is a growing market therefore I will buy shares in a company that owns warehouses (BBOX) - this is sort of how Warren Buffet works
The stock price does connect to the real world though. If a company is deciding whether to expand, or bring in new management, or exit an industry, their stock price will certainly factor into that. If they're looking to buy another company, or another company is looking to buy them, the stock price is even more relevant.
Ultimately you are betting that the company will one day buy back stock, be acquired, issue dividends, etc.
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.
I was however questioning whether this sentence from the article was really accurate: "The function of the capital markets is to allocate capital".
I'd argue that trading existing shares, although it contributes to price discovery and liquidity, is not "capital allocation" (unless we're talking with respect to the buyer's capital like another commenter pointed out).
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%.
It is a self-balancing situation. A scenario of "oh my god, everyone is just putting their money on index funds" would never happen.
Another way to think about it is in terms of evolutionary stable strategy. Index funds and arbitrage-seeking reach a Nash equilibrium at some point (far more index-allocated than today's market) where arbitrage-seekers will reap returns almost equal to index funds, as index allocation starts o not capture all available market information.
If the market deviates from that point, forces push it back into that point. If the market starts over-allocating into arbitrage-seeking (like today), returns on index funds will beat arbitrage, pushing capital back into index funds. If the market over-allocates in index funds, index funds will return below arbitrage, pushing money out of index funds.
Edit: Right now, the market is still far over-allocated into the arbitrage-seeking side, resulting in a natural shift to index funds.
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.
But the point of equilibrium is a Nash Equilibrium, meaning that any deviation from it will create forces that push back to it (you can think of it as a valley). So while there will be oscillations, you won't expect large deviations.
I think the article deserves a fuller and fairer reading than your comment indicates you've given it.
Come on. Enough of this. For some odd reason, every week there is a levine article here and every time someone goes out of their way to praise levine. The guy works for bloomberg. Clickbait is part of nature of the beast whether you think levine is great or not. Is levine a writer or a cult leader. What's with all the worship?
Could be. But there are a lot of good and thoughtful finance writers. I don't see their articles spammed here on the weekly like clockwork along with the fawning worship. It's almost like the article is just posted to talk about how great levine is and not the actual article. Just seems odd to me that's all.
> And if there’s any financial news site which would have an incentive to avoid clickbait it would be Bloomberg because it’s subsidized by the rents it extracts from its terminal and data business, and this is one service they provide to those customers so they have an incentive to provide value.
I'm well aware of what bloomberg is.
I.e., grandparent commenter is responding reasonably to the headline, if not the article itself.
> Are Index Funds Communist?
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
This is not responsive to my comment?
Algorithms don't have anything to do with index funds.
And again, as more and more funds move to index funds, the returns on active managed funds will increase due to information asymmetry, and the market will move towards an equilibrium.
The allocation between index and active is a continuum, not a step function.
> Are Index Funds Communist?
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
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.
> Are Index Funds Communist?
> But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
> But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation
> The passive investors can't influence relative prices
> Their worry is that the growth in passive and quasi-passive products
> Or I guess pure indexing -- everyone passively throws money at everything that there is, with no judgment at all -- is an imaginable fourth answer, and is strictly worse than the others.
"...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).
Relevant past topic: https://news.ycombinator.com/item?id=12368136
So long as the bots aren't conscious there will be no bot-dominated stock market. Too much information is wrapped up in conscious thought that isn't easily expressed in stock market pattern matching. The article mentions that the line between active and passive isn't as clear as people that make it out to be say it is, and that is true, but it's also incomplete. Certain events are conceivable to humans that are not conceivable to machines. Short of simulating humans, anyway.
For example, I as a human know that there is a non-zero chance that the DPRK and USA get into a nuclear war. I can know that Trump defaulting on Chinese held US debt is something that is at least on the table. The quants can try to pull in percentages from experts all they want (and they were calling my nuclear weapons arms control friends a year ago asking for percentiles) but it isn't the same thing because the model is still fundamentally concerned with statistics and many of the events we understand as humans have implicit dependence to each other that is hard to model.
It's far easier to employ a small number of smart people and have the models serve and be tuned by them than to have the models actually run everything. Plus you don't even really need them sometimes. Take Bitcoin, for example. The gains were obvious. The incentives were completely aligned and the friction was in the buy side and it was temporary. I didn't need to model out Bitcoin to buy it at $4 CAD. I just had to think about it from first principles, something that is currently not possible with ML.
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.
Your Github activity seems like it's on a bit of a break. Are you on holiday or are you looking for something new?
If it were meant as clickbait, the communist headline would be better :)
Please see https://news.ycombinator.com/item?id=18144886 for more explanation.
I take a very cyclical approach on everything. The rise of passive actually creates huge opportunities for active managers. We see this already in the ETF landscape: you can invest in any product today for very cheap. This creates a new challenge to manage the portfolio of the future. 60/40 allocations are the exposures of yesterday.
You might for instance want to make the bet that the market at large is systematically underestimating the risks related to global warming in particular, and the environment in general. Said differently, it is entirely possible that governments will start to tax the hell out of various externalities, like CO2 emissions, or plastic garbage generation. Or maybe courts will ask companies to pay to clean up after their own mess.
If you believe that this is true, then indexes (existing or being created) weighting in those risks will over-perform the S&P 500 in the medium term, until a couple of companies are wiped out and analysts start to correctly price in these risks...
That's just one example of the kind of creative index that could be created.
If you take a widely accepted, reasonably broad market definition and an index to track it (such as the S&P 500 for equities), then sure, you're investing passively. The portfolio reallocation and equity inclusion happens according to rules which organically rise from the market definition itself.
But you can creatively define a market for any kind of security and then an index methodology for tracking that market which may involve a complicated set of inclusion rules that are arguably just active investing. This is something Matt Levine has talked about in his column on a number of occasions - some active investors are now rebranding their funds as index funds for creative, synthetic indices.
The practical distinction between beta and "smart beta" is a lot larger than the distinction between "smart beta" and alpha, regardless of philosophical underpinnings.
I agree with what you are saying, but I'm referring to the previous commenter conflating that a "creative index" or passive investing strategy is a fund, or needs to be implemented through a fund structure.
Smart beta is really just factor investing with very tight constraints around index tracking error. i.e. It's seeking out high beta and low alpha by design, so given it is aiming for some variation in alpha, I think your argument makes sense.
https://www.ishares.com/us/products/271054/ishares-msci-acwi...
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.
https://www.cnbc.com/2018/02/16/warren-buffett-won-2-point-2...
There are a lot of factors at play but simply for your non-analyst mom-and-pop investors, they don't have time and the know-how to investigate stocks and index funds are just much more accessible and as they say, in the long run we are all dead.
Then again this IT was started in 1888 and has increased its dividend every year for the last 51 years.
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.
> The market capitalization of the S&P 500 is roughly $22 trillion as I write this. The entire ETF market in the U.S. is $3 trillion. That’s 14%. Even the whole industry—about $4 trillion, would only be 18%.
https://www.etf.com/sections/blog/no-etfs-dont-own-37-sp-500
This statistic was actually a big wake up call for me about 6 months ago. For a long time I had been investing based on theoretical ideas, like the one mentioned in this Bloomberg article that we're discussing. After I saw this statistic, I realized that I needed to look closer at the numerical reality when making investing decisions. This is probably obvious to many of you. I'm just sharing the moment when this insight really hit home for me.
In the end: technical analysis is useless by definition.
Oh yeah? which benefits? When you know that on average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.
I recently read the Little Book Of Common Sense Investing, and it was brilliant.
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.