Passive Investing and Market Efficiency

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Passive Investing and Market Efficiency

Postby stockfreak » Tue Jan 22, 2013 11:27 pm

I recently transferred my Roth IRA from Dodge & Cox (fund: Global Stock) to Vanguard (fund: LS Growth), but I’m not 100% comfortable with my move because I’m not sure how wise it is to hold only index funds (401(k) funds: Spartan 500/Spartan International/Vanguard Total Bond).

There are $100s of billions of dollars in index funds. At some point, I would think the size of assets invested passively would reach a tipping point and begin to affect markets in terms of efficiency. I’m about four decades out from retirement and am concerned that at some point during the way, with the rising popularity of passive investing (at the expense of active investing), that passive investing will, in effect, become the market and massively gum up the works.

Am I wrong to be concerned that passive investing will become too big to function effectively?
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Re: Passive Investing and Market Efficiency

Postby Random Walker » Tue Jan 22, 2013 11:33 pm

Look up a short article by Larry Swedroe (might be a chapter or in the appendix of one of his books) called "what if Everybody Indexed?".

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Re: Passive Investing and Market Efficiency

Postby NYBoglehead » Tue Jan 22, 2013 11:45 pm

The passive investing/market efficiency argument is a straw man created by active managers. Yes, indexing has dramatically increased in popularity. That said, much of it is in ETFs which are traded way too much and miss the entire point of indexing to begin with. Hedge funds still have something like $2 trillion in AUM and aren't going to go away as the uber wealthy believe that having access to investment vehicles that the rest of us aren't privvy to somehow equals enhanced returns.

There will always be active funds that attract new money AFTER beating the index for a year or two on the unreasonable hope that they can do so in perpetuity.

If you are concerned about being 100% in passive funds, ask yourself this: how much more am I willing to pay to have active management, and do I really believe that the active manager will outperform the index NET OF FEES for the next four decades? If the answer to the second half is NO, then there is no reason not to have all your money in passive funds.

If you need further convincing dedicate 10% of your 401k allotment into an active fund and never rebalance. Don't be surprised when the underperformance of the fund gradually erodes its percentage of your AA.
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Re: Passive Investing and Market Efficiency

Postby larryswedroe » Wed Jan 23, 2013 12:15 am

Random Walker
It's in my book Wise Investing Made Simple Tale 21
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Re: Passive Investing and Market Efficiency

Postby Professor Emeritus » Wed Jan 23, 2013 12:42 am

I have no fear at all that we will be confronted by vast numbers of sensible intelligent and non gullible investors.
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