Index Investors getting a free ride

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Index Investors getting a free ride

Post by High Income Parent » Fri Feb 03, 2017 9:18 am

https://www.google.com/amp/seekingalpha ... ent=safari
If you and your neighbor have the same income and expenses except that he rides the bus for free every day while you pay a fare, he will be richer than you. Until recently, this was obvious: the neighbor is a free rider while you pay your way.

But now, the obvious is presented by some as a eureka moment. Now, plenty of people are extolling the benefits of free-riding without naming it as such and encouraging a large exodus from active to passive (or indexed) funds (like the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) or the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY)). The only problem is that proponents of this form of free-riding neglect to also mention the following corollary sub-plot.

Now your neighbor makes you feel like a fool and convinces you to also ride for free. Soon, your whole town has caught on to the idea and fewer and fewer people are willing to pay for the bus. After a while, the number of people supporting bus service with their dollars becomes so small that buses go out of business or fall into a state of disrepair.

Some will protest that indexed funds are free riding.
I think this is a false characterization. I think the index investor rides the bus for the cheapest fare but still pays. The active investor hops on and off the bus paying a fair each time and maybe takes a taxi or two in the middle that actually takes him back to his home so he has to start all over.
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Aptenodytes
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Re: Index Investors getting a free ride

Post by Aptenodytes » Fri Feb 03, 2017 9:28 am

This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum.

Wrapping the argument in free-riding terms only makes it sillier. Both active and passive investors are engaging in voluntary actions in pursuit of private gain. Both are using information derived from the aggregate actions of all investors. Neither is motivated by a desire to create a public good and neither is free riding.

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Re: Index Investors getting a free ride

Post by MrKnight » Fri Feb 03, 2017 9:41 am

gaspony wrote: I think this is a false characterization. I think the index investor rides the bus for the cheapest fare but still pays. The active investor hops on and off the bus paying a fair each time and maybe takes a taxi or two in the middle that actually takes him back to his home so he has to start all over.
I encountered a pay wall, but I do not think that this is what the article is contending.

The article is contending that active investors are ensuring that the capital markets are efficient by punishing and rewarding business decisions. I don't think that this is a contentious claim. Passive investors are not paying for this service but are reaping the rewards of efficient markets.

That said, in reality, it doesn't take that many active investors to ensure efficient markets. As long as there are opportunities to boost returns, there will always be active investors available to smooth out inefficiencies in the market.
Last edited by MrKnight on Fri Feb 03, 2017 9:47 am, edited 1 time in total.

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Re: Index Investors getting a free ride

Post by livesoft » Fri Feb 03, 2017 9:42 am

Yep, free riding is OK for me, but not for anyone else. I get it.
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Re: Index Investors getting a free ride

Post by nisiprius » Fri Feb 03, 2017 9:54 am

Aptenodytes wrote:...This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum. Wrapping the argument in free-riding terms only makes it sillier...
Conspiratorial thinking alert, warning, warning!

I think it's a little worse than that. I think that there is a serious effort on the part of some in the non-passive investing community to try to get regulations passed to rein in passive investing, on the grounds of it being unfair, or "free-riding," or making the market unstable.

Last year, a paper with the title “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism" was circulated by one Inigo Fraser Jones of Sanford C. Bernstein & Co., LLC. That's not trivial; them's fighting words. (The Silent Road to Serfdom is a famous 1944 book by... um... the Hayekian economist Friedrich von Hayek).

(In my 3 a.m. nightmares, I imagine mutual funds being required to demonstrate a certain percentage of "active share" or else be taxed 1% of assets per year for the purpose of reimbursing active funds for their yeoman work in price discovery... boosting the ER of passive funds to create a level playing field with active funds.)
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Re: Index Investors getting a free ride

Post by DaftInvestor » Fri Feb 03, 2017 9:58 am

If avoidance of exorbitant fees to brokers is a considered a free ride so be it.
There will be no market collapse if the majority decide to not to pay high fees or do heavy trading. Underlying companies will continue to grow and prosper resulting in increased share values. The analogy doesn't work and can be easily invalidated in so many ways.

What a silly article....

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Re: Index Investors getting a free ride

Post by jhfenton » Fri Feb 03, 2017 10:04 am

nisiprius wrote:
Aptenodytes wrote:...This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum. Wrapping the argument in free-riding terms only makes it sillier...
Conspiratorial thinking alert, warning, warning!

I think it's a little worse than that. I think that there is a serious effort on the part of some in the non-passive investing community to try to get regulations passed to rein in passive investing, on the grounds of it being unfair, or "free-riding," or making the market unstable.

Last year, a paper with the title “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism" was circulated by one Inigo Fraser Jones of Sanford C. Bernstein & Co., LLC. That's not trivial; them's fighting words. (The Silent Road to Serfdom is a famous 1944 book by... um... the Hayekian economist Friedrich von Hayek).

(In my 3 a.m. nightmares, I imagine funds being required to demonstrate a certain percentage of "active share" or be forced to contribute 1% of assets per year to a pool that would be used to reimburse active funds for their good work in price discovery... thus boosting the ER of passive funds to create a level playing field.)
It's not a completely crazy fear. The other argument being made now is that as index funds grow too large they become an anti-trust problem, with too much common ownership of competing firms. There is a lot of money at stake in the world of active investment that is threatened by the increasing market share of passive investing.

But back to the original article's thesis on free-riding…. Sure. There is some theoretical point at which passive ownership has such a high market share that price discovery is weakened. I don't know whether that's 100%, 99%, 90%, or 80%. But we're far, far from that now. And it would be a self-correcting problem. If indexing grows so large that securities are systematically mispriced, the ever elusive alpha will reappear, and active management will make a comeback. The result should be an equilibrium at which the ebb and flow of assets keep passive ownership at or below the point where they "break" price discovery.

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Re: Index Investors getting a free ride

Post by Gropes & Ray » Fri Feb 03, 2017 10:14 am

I don't believe that indexing can ever make the markets inefficient for a period of any material length. There are too many smart people with money making sure that inefficiencies (at least the most obvious ones) are quickly exploited and therefore eliminated.

The anti-trust argument unsettles me. I know that my initial (and emotional) reaction is to declare it to be nonsense... but the very small part of me that is rational can see the logic in it.

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Re: Index Investors getting a free ride

Post by avalpert » Fri Feb 03, 2017 10:16 am

jhfenton wrote:
But back to the original article's thesis on free-riding…. Sure. There is some theoretical point at which passive ownership has such a high market share that price discovery is weakened. I don't know whether that's 100%, 99%, 90%, or 80%. But we're far, far from that now. And it would be a self-correcting problem.
Yes, and that is exactly why there is no 'free-riding' problem here at all - there is no limited asset to be freely ridden. Market price discovery is not a limited asset.

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Re: Index Investors getting a free ride

Post by triceratop » Fri Feb 03, 2017 10:20 am

I'm grateful for the paywall on the 2nd page; it prevented me from spending further time reading his opinions.

I'm fine with free-riding; U.S. federal government employees are free riders through the TSP program, which tells me that free riding is ok (just don't try this in a brokerage account 8-) ). What's more, TSP G fund owners free ride off the U.S. treasury with no-interest-rate risk exposure to the term premium. Clearly free riding is well-encouraged.

Active managers are free to become passive managers, and would do so if they didn't think they would lose. The free market applies to fund flows as well. I wonder why much of the mutual fund industry was unhappy with the now-extinct fiduciary rule if their funds could compete so competitively on the market and were in the best interests of clients? :idea:
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Re: Index Investors getting a free ride

Post by Dyloot » Fri Feb 03, 2017 10:29 am

I am a huge amateur in this area, but I always assumed that people like me, pouring thousands of dollars into index funds every year, would be advantageous to managed funds.

Do we, the index fund owners, not create a stable inflow of stock purchases every two weeks? I could be wrong here, but I'd assume a market that has tons of buyers who show up regularly and say "I'll take one of everything" is good for everyone's business.

I assume we minimize market drops, and support market surges. You're buying Apple this month? So are we! And the gains increase.

Most of us don't participate in sell-offs. By definition, I'd assume we decrease volatility, making the market a safer place.

I would think that we're a predictable bunch. Sure, we decrease the amount of bargains by buying them all the time without really knowing we're doing so. But our spending should be easy to forecast... no?

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Re: Index Investors getting a free ride

Post by Da5id » Fri Feb 03, 2017 10:38 am

I can't picture how indexing will ever damage the market. The problem, if one exists, is inherently self correcting. If indexing becomes so dominant that it is resulting in "incorrect" valuation of a companies shares and that can actually be profitably exploited by an active investor, go to it! Appears to be FUD to protect the ability of mutual fund companies to keeping milking their victims investors like cows.

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Re: Index Investors getting a free ride

Post by Jack FFR1846 » Fri Feb 03, 2017 10:42 am

The analogy is incorrect.

My neighbor rides the bus for free. The bus is the market and the cost to ride the bus is zero for everyone.
I pay when I get on the bus for an annoying clown to tell me stories, show me how his calculator works and generally add nothing of value to me or to my life. I voluntarily pay him because I am scared that if I don't pay him, I'll be thrown off the bus. In reality, the bus has nothing to do with this annoying man or my payments to him. They are independent and the bus company has no interest in the annoying man one way or another, but welcomes Annoying Man to ride the bus for free just like everyone else.
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Re: Index Investors getting a free ride

Post by Wakefield1 » Fri Feb 03, 2017 10:48 am

It probably doesn't require the existence of actively managed funds to keep some efficiency in the markets as long as there are individual stockholders buying and holding stocks independent of mutual funds.
Beware of those who would try to regulate low cost indexing out of existence. Motive? Also the tax lawsuit against Vanguard--does the bringer of the lawsuit have something to gain personally?
And I still have a little something in T. Rowe Price (457/401 account)

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Re: Index Investors getting a free ride

Post by Bogel0048 » Fri Feb 03, 2017 10:52 am

It seems the market ought to self-adjust. If passive investors tip the market too far toward inefficiency opportunities for active investors to find profitable investments should rise. At that point a more than random number of actively-managed funds will begin to beat the index funds and money will start shifting back to the successful managed funds.

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Re: Index Investors getting a free ride

Post by High Income Parent » Fri Feb 03, 2017 11:12 am

Does anyone have any evidence that active investors could really demonstrate some talent in stock picking say back in the 20s-30s when a million shares traded a day instead of per second like they do today?
There are so many motives for buying or selling a company it seems impossible to reliably predict the direction. It seems to me as long as the population is growing and consumers demand product and services we should have an upward trend in the overall market so that seems the surest bet. Other than that the relationship between each company and the industry they serve is very difficult to predict and leads itself to the data we have all seen that less than 2% of active managers beat the market over a 20 year period.
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Re: Index Investors getting a free ride

Post by sreynard » Fri Feb 03, 2017 11:19 am

If markets became inefficient wouldn't that make it really easy for a stock picker to beat the market? Wouldn't any odd investor be able to pick obvious winners and leave out obvious losers? Wouldn't this "easy money" attract a large number of "entrepreneurs" to this easy career? Wouldn't money leave the loser index funds for the new bonanza active funds? People wouldn't be able to wait to throw there money at the latest "new thing". :greedy

Ceteris paribus. . . Well, they don't, so we can stop right there. Trends don't continue into absurdity. When, and if, investing in index funds becomes less efficient than some other choice, that's were people will start heading. Until then, we have the best game in town.

How about another characterization. Your neighbor orders a limousine to take them to work everyday. He spends about 2% of his annual income on transportation for his 15 mile commute each morning and evening. You, on the other hand take the city bus for about 0.05%. Since your bus can use the HOV lanes, you get to work faster. Granted, the bus driver doesn't make you a cappuccino in the morning or provide chilled champagne on the ride home, but then you don't have to pay for them either. At the end of 20 or 30 years, the difference is you have saved enough to buy a dozen limousines. If you convince all your neighbors to your way of thinking, after a while, "the number of people supporting [limousine] service with their dollars becomes so small that [limousines] go out of business or fall into a state of disrepair." "The corollary sub-plot," is that with all the new bus ridership, services improve, the per rider costs decrease, and the bus company buys more efficient and more comfortable buses. Who knows, buses even may someday offer cappuccino with your fare. . . .

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Re: Index Investors getting a free ride

Post by oldcomputerguy » Fri Feb 03, 2017 11:22 am

Basing the premise of the article on the idea of people riding a bus for free is nothing short of intentionally misleading. Buses aren't operated for free. They have their costs. Someone is paying for the fuel, maintenance, and drivers' paychecks, whether it's through taxes or through fare-paying passengers.

For that matter, index funds aren't operated for free either. They have their ER's just like actively-managed funds. They're just lower.
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Re: Index Investors getting a free ride

Post by David Jay » Fri Feb 03, 2017 11:24 am

gaspony wrote:Does anyone have any evidence that active investors could really demonstrate some talent in stock picking say back in the 20s-30s when a million shares traded a day instead of per second like they do today?
There are so many motives for buying or selling a company it seems impossible to reliably predict the direction. It seems to me as long as the population is growing and consumers demand product and services we should have an upward trend in the overall market so that seems the surest bet. Other than that the relationship between each company and the industry they serve is very difficult to predict and leads itself to the data we have all seen that less than 2% of active managers beat the market over a 20 year period.
Sure there are successful stock pickers. There are also successful left-handed golfers. The problem is not that they don't exist, the problem is that I am not Phil Mickelson.

The upside is that I get a "par" on every hole by indexing.
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Re: Index Investors getting a free ride

Post by Jack FFR1846 » Fri Feb 03, 2017 11:35 am

Isn't the FOD thrown by the active market that a 100% index market would freeze prices where they are? I don't buy that for one second. That assumes nobody rebalances, nobody adds funds and buys more, nobody sells funds to pay retirement expenses, nobody's home thinking "I really like this apple....it's juicy and tastes good, so I think I'll buy some Apple stock". As long as people are buying and selling for any reason, the market continues as it does today.
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Re: Index Investors getting a free ride

Post by CyclingDuo » Fri Feb 03, 2017 11:42 am

Aptenodytes wrote:This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum.
Yup. Some knuckleheads on CNBC jawboned on for 5-10 minutes straight that 2017 was the year there would be an exodus from index funds to actively managed funds as the active managers were going to beat the market this year. Everyone on the panel (of course they are all in the BIZ) agreed like sheep as if it was fact and a sure thing. :annoyed
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Re: Index Investors getting a free ride

Post by livesoft » Fri Feb 03, 2017 11:42 am

I wonder when active managers will write articles about the free ride they are getting with their clients money. :twisted:
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Re: Index Investors getting a free ride

Post by Epsilon Delta » Fri Feb 03, 2017 11:44 am

Bogel0048 wrote:It seems the market ought to self-adjust. If passive investors tip the market too far toward inefficiency opportunities for active investors to find profitable investments should rise. At that point a more than random number of actively-managed funds will begin to beat the index funds and money will start shifting back to the successful managed funds.
This is not correct. Even if the market is inefficient actively-managed funds can't collectively take advantage of the inefficiency by trading in the market.* The people who can capture the inefficiency and push the market back to efficient trade outside the market. Investment bankers doing things like IPOs and LBOs.

* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.

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Re: Index Investors getting a free ride

Post by bertilak » Fri Feb 03, 2017 12:51 pm

CyclingDuo wrote:
Aptenodytes wrote:This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum.
Yup. Some knuckleheads on CNBC jawboned on for 5-10 minutes straight that 2017 was the year there would be an exodus from index funds to actively managed funds as the active managers were going to beat the market this year. Everyone on the panel (of course they are all in the BIZ) agreed like sheep as if it was fact and a sure thing. :annoyed
Send that to Larry Swedroe for his annual "sure things" project.
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Re: Index Investors getting a free ride

Post by MrKnight » Fri Feb 03, 2017 1:09 pm

Epsilon Delta wrote:
Bogel0048 wrote:It seems the market ought to self-adjust. If passive investors tip the market too far toward inefficiency opportunities for active investors to find profitable investments should rise. At that point a more than random number of actively-managed funds will begin to beat the index funds and money will start shifting back to the successful managed funds.
This is not correct. Even if the market is inefficient actively-managed funds can't collectively take advantage of the inefficiency by trading in the market.* The people who can capture the inefficiency and push the market back to efficient trade outside the market. Investment bankers doing things like IPOs and LBOs.

* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.

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Re: Index Investors getting a free ride

Post by Gropes & Ray » Fri Feb 03, 2017 1:19 pm

CyclingDuo wrote:
Aptenodytes wrote:This article is merely an attempt to dress up the tired old argument that passive investing will stop working when too many people do it. Been discussed and debunked many times, including on this forum.
Yup. Some knuckleheads on CNBC jawboned on for 5-10 minutes straight that 2017 was the year there would be an exodus from index funds to actively managed funds as the active managers were going to beat the market this year. Everyone on the panel (of course they are all in the BIZ) agreed like sheep as if it was fact and a sure thing. :annoyed
Active will not beat passive until there is a huge reduction in fees. I think active managers do beat the index before fees more than 50% of the time (because individual traders do poorly), but they trail the index after fees. Unless the fees for active management come in under alpha, there will not be a year that active beats passive. I don't know by how much the average active fund beats the index, though. It could be too small a margin.

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Re: Index Investors getting a free ride

Post by Epsilon Delta » Fri Feb 03, 2017 1:28 pm

MrKnight wrote:
Epsilon Delta wrote:
* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).

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Re: Index Investors getting a free ride

Post by misterno » Fri Feb 03, 2017 1:50 pm

1) Market will be more and more expensive because of the money flow from Active to Index funds. Because index funds invest in whatever in their category regardless of PE ratios. Hence XOM's PE is 39 and CVX is 81. Crazy? Yes. Even Bill Ackermann acknowledges this in an interview

2) Traders market makers or hedge funds can short these stocks but they will lose in the long run. They can make money in the short term because there will be fluctuations but in the long run, if the pace continues, the market has nowhere but to go up.

Remember only 13% of the mutual funds return higher than SP500 index. The more investors get educated, the more the flow to the index funds. Why expose to huge volatility to be in 13% of the funds? That is an unnecessary risk if you ask me.

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Re: Index Investors getting a free ride

Post by Da5id » Fri Feb 03, 2017 2:08 pm

misterno wrote:1) Market will be more and more expensive because of the money flow from Active to Index funds. Because index funds invest in whatever in their category regardless of PE ratios. Hence XOM's PE is 39 and CVX is 81. Crazy? Yes. Even Bill Ackermann acknowledges this in an interview
Proof?

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Re: Index Investors getting a free ride

Post by MrKnight » Fri Feb 03, 2017 2:23 pm

Epsilon Delta wrote:
MrKnight wrote:
Epsilon Delta wrote:
* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).
I'm still not getting it.

In my mind this is how it would work:

There is a continuous stream of new money flowing in and out of the secondary market from passive investors as they contribute, withdraw, and rebalance their portfolios.

Active investors can collectively deem company x is under priced, and purchase and hoard all the shares that passive investors sell whenever they withdraw or rebalance their portfolios, driving the price up.

The next time the company wishes to raise capital, it will be based on the market value that active investors drove the price up to.

Is my understanding flawed?

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Re: Index Investors getting a free ride

Post by avalpert » Fri Feb 03, 2017 2:28 pm

MrKnight wrote:
Epsilon Delta wrote:
MrKnight wrote:
Epsilon Delta wrote:
* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).
I'm still not getting it.

In my mind this is how it would work:

There is a continuous stream of new money flowing in and out of the secondary market from passive investors as they contribute, withdraw, and rebalance their portfolios.

Active investors can collectively deem company x is under priced, and purchase and hoard all the shares that passive investors sell whenever they withdraw or rebalance their portfolios, driving the price up.

The next time the company wishes to raise capital, it will be based on the market value that active investors drove the price up to.

Is my understanding flawed?
The (collective) active investors can't outrun the passive investors - as they drive the price up they are driving up returns for the passive investors as well

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Re: Index Investors getting a free ride

Post by MrKnight » Fri Feb 03, 2017 3:44 pm

avalpert wrote:
MrKnight wrote:
Epsilon Delta wrote:
MrKnight wrote:
Epsilon Delta wrote:
* Mr. Bogle's argument that collectively active market traders and total market indexers must have the same return before costs still holds.
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).
I'm still not getting it.

In my mind this is how it would work:

There is a continuous stream of new money flowing in and out of the secondary market from passive investors as they contribute, withdraw, and rebalance their portfolios.

Active investors can collectively deem company x is under priced, and purchase and hoard all the shares that passive investors sell whenever they withdraw or rebalance their portfolios, driving the price up.

The next time the company wishes to raise capital, it will be based on the market value that active investors drove the price up to.

Is my understanding flawed?
The (collective) active investors can't outrun the passive investors - as they drive the price up they are driving up returns for the passive investors as well
At which point the market reaches efficiency, which was my point, that active investors would squirrel away any market inefficiencies that may develop, hence the concern of 'too many passive investors', in terms of market efficiency, is unfounded.

What I am trying to wrap my head around is that claim that market efficiency would have no effect on the secondary market if it did exist.

avalpert
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Re: Index Investors getting a free ride

Post by avalpert » Fri Feb 03, 2017 3:48 pm

MrKnight wrote:
avalpert wrote:
MrKnight wrote:
Epsilon Delta wrote:
MrKnight wrote:
Why would an actively managed fund be unable to capture market inefficiencies? Inefficiencies can occur after capital was released, or missed at the initial IPO.

The secondary market influences cost of capital and effects future capital raising by the company. Active investors would trade with passive investors or active investors who are not aware of the inefficiencies.
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).
I'm still not getting it.

In my mind this is how it would work:

There is a continuous stream of new money flowing in and out of the secondary market from passive investors as they contribute, withdraw, and rebalance their portfolios.

Active investors can collectively deem company x is under priced, and purchase and hoard all the shares that passive investors sell whenever they withdraw or rebalance their portfolios, driving the price up.

The next time the company wishes to raise capital, it will be based on the market value that active investors drove the price up to.

Is my understanding flawed?
The (collective) active investors can't outrun the passive investors - as they drive the price up they are driving up returns for the passive investors as well
At which point the market reaches efficiency, which was my point, that active investors would squirrel away any market inefficiencies that may develop, hence the concern of 'too many passive investors' is unfounded.
I agree that the concern is unfounded and that active investors will step in if price discovery slows. What I thought you were also saying was that collective active investors could benefit relative to passive investors and realize higher returns due to slowing price discovery - and that can't be done for the average active investor because the average active investor (technically the average actively invested dollar) must get the average market return by definition just as the passive investor is getting.

MrKnight
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Re: Index Investors getting a free ride

Post by MrKnight » Fri Feb 03, 2017 3:59 pm

avalpert wrote:
MrKnight wrote:
avalpert wrote:
MrKnight wrote:
Epsilon Delta wrote:
The bold bit. Active managers cannot collectively beat the market by being in the market. Active investors do not trade with passive investors they trade with each other. If the active trader scalps an another active trader it does not put active traders collectively above passive investors. Active traders could capture inefficiencies by trading in and out of things that are not in the market, but the passive investors can counter by indexing everything (i.e. total financial market index instead of total stock market index).
I'm still not getting it.

In my mind this is how it would work:

There is a continuous stream of new money flowing in and out of the secondary market from passive investors as they contribute, withdraw, and rebalance their portfolios.

Active investors can collectively deem company x is under priced, and purchase and hoard all the shares that passive investors sell whenever they withdraw or rebalance their portfolios, driving the price up.

The next time the company wishes to raise capital, it will be based on the market value that active investors drove the price up to.

Is my understanding flawed?
The (collective) active investors can't outrun the passive investors - as they drive the price up they are driving up returns for the passive investors as well
At which point the market reaches efficiency, which was my point, that active investors would squirrel away any market inefficiencies that may develop, hence the concern of 'too many passive investors' is unfounded.
I agree that the concern is unfounded and that active investors will step in if price discovery slows. What I thought you were also saying was that collective active investors could benefit relative to passive investors and realize higher returns due to slowing price discovery - and that can't be done for the average active investor because the average active investor (technically the average actively invested dollar) must get the average market return by definition just as the passive investor is getting.
I updated my prior post with additional insight to what I am referring to before you quoted it.

What I described in the prior post was the mechanism that that permits the market to remain efficient despite a scenario of very few active investor participants.

The post I responded to originally however, appeared to contend that market inefficiency would not effect the secondary market at all even if it did exist... which would seemingly discard the notion of a self-correcting market efficiency cycle completely.

So there is two offered models why a scenario of very few investor participants does not matter:
1. (My contention) Any inefficiency would quickly be pounced on, the market doesn't actually need that many active invetors to remain mostly efficient.
2. (Poster that I responded to) Market inefficiency does not effect the secondary market, only the primary market.

Each model gets to the same place but I think that the reason is different... unless I misinterpreted something.

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Epsilon Delta
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Re: Index Investors getting a free ride

Post by Epsilon Delta » Fri Feb 03, 2017 4:27 pm

MrKnight wrote:
2. (Poster that I responded to) Market inefficiency does not effect the secondary market, only the primary market.
I believe the poster you responded to is me.

I'm not arguing the inefficiency does not affect the secondary market. I'm arguing that any inefficiency affects active and passive secondary investors alike, so there will never be a point where the average active fund beats the average index investor. It's only if the active fund starts doing something other than trading in the market that it could possibly be of interest.

Nate79
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Re: Index Investors getting a free ride

Post by Nate79 » Fri Feb 03, 2017 5:23 pm

I guess it was this guys turn to write the anti index fund article of the week. Whose turn is it next week?

TareNeko
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Re: Index Investors getting a free ride

Post by TareNeko » Fri Feb 03, 2017 5:49 pm

Hey, if the bus tickets were reasonably priced and the bus driver was looking for my best interest, I'd be happy to pay a fee.

jumppilot
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Re: Index Investors getting a free ride

Post by jumppilot » Sat Feb 04, 2017 3:52 am

Using riding the bus as an example, with index investing we are paying for the operating costs of the bus directly, albeit a small fare to the bus driver upon boarding the bus. With active management, we are paying a travel agent - who in turn pays the bus costs after their cut. In both example a person is paying a fare to keep the bus operating.

There is no free ride, only a more efficient means of paying your way.

To the authors example of the bus service ceasing due to no one paying their way, that would never happen because there are new riders every day who will pay regardless. There are also different bus companies who would swoop in with different fares due to a stagnant market of the original bus company.

I'll let others expound on other details and possibilities.

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JoMoney
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Re: Index Investors getting a free ride

Post by JoMoney » Sat Feb 04, 2017 4:26 am

The analogy falls apart because a bus provides transportation, a service I see value in and would be willing to pay for.
Active mutual funds managers do not provide a service I would be willing to pay for. If index funds were more expensive than they are (they're not free), I would not substitute them for an active mutual fund, I would go back to building a portfolio of individual stocks myself with an eye towards modest diversification and keeping transactions/expenses to a minimum.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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telemark
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Re: Index Investors getting a free ride

Post by telemark » Sun Feb 05, 2017 2:49 pm

The argument used to be "index funds will never catch on, they don't beat the market." Now it's "Ok, index funds work, but they must be cheating somehow." Makes me wonder what the next argument will be.

But what these people miss is that even if they somehow succeeded in getting index funds banned, it would only mean that everyone would move to inexpensive managed funds. The old days of high fees are gone, and they aren't coming back.

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Re: Index Investors getting a free ride

Post by jebmke » Sun Feb 05, 2017 2:53 pm

JoMoney wrote:The analogy falls apart because a bus provides transportation, a service I see value in and would be willing to pay for.
Just not the route from his house to his country club.
When you discover that you are riding a dead horse, the best strategy is to dismount.

likegarden
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Re: Index Investors getting a free ride

Post by likegarden » Sun Feb 05, 2017 4:17 pm

Whatever the active investing companies and active financial advisers say, investors understand nowadays not to invest in funds with high fees. High fees will not lead to high performance ever.

anil686
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Re: Index Investors getting a free ride

Post by anil686 » Sun Feb 05, 2017 5:22 pm

I believe the argument of index funds versus active management was addressed in the last annual report I read on TISM by Vanguard in which they were clearly of the opinion that active management was not dead - in fact far from it. But high cost active management is done - low cost active that exists at a handful of firms remains competitive and will probably stay that way - just my impression of the letter in the annual report....

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Re: Index Investors getting a free ride

Post by Call_Me_Op » Mon Feb 06, 2017 7:31 am

The active management community is obviously approaching the pinnacle of desperation.
Best regards, -Op | | "In the middle of difficulty lies opportunity." Einstein

IlliniDave
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Re: Index Investors getting a free ride

Post by IlliniDave » Mon Feb 06, 2017 8:33 am

Index investors contribute to the "price discovery" of the total market (and/or indexed segments), rather than individual issues. It's the same thing only on a larger/slower scale. Buy-and-hold investors get more of the "free ride", irrespective of whether the holding is an index fund. But it's really not a "free ride". Their capital is at risk same as everyone else. That others set the ongoing instantaneous prices is sort of a footnote.

I know several people (individual investors) who have an irrational, passionate, disdain for index funds. The amount of disinformation out there is both surprising and a little scary.
Don't do something. Just stand there!

IlliniDave
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Re: Index Investors getting a free ride

Post by IlliniDave » Mon Feb 06, 2017 8:38 am

anil686 wrote:I believe the argument of index funds versus active management was addressed in the last annual report I read on TISM by Vanguard in which they were clearly of the opinion that active management was not dead - in fact far from it. But high cost active management is done - low cost active that exists at a handful of firms remains competitive and will probably stay that way - just my impression of the letter in the annual report....
+1
Don't do something. Just stand there!

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1210sda
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Re: Index Investors getting a free ride

Post by 1210sda » Mon Feb 06, 2017 8:55 am

CyclingDuo wrote: I don't know by how much the average active fund beats the index, though. It could be too small a margin.
In his paper "A Case for Index Funds" (June 2103), Rick Ferri compared a portfolio of index funds to a portfolio of active funds for the 16 years from 1997 to 2013.

He found that, in this study, active funds beat index funds 17.1% of the time (i.e. failed to beat in 82.9%). The median outperformance was .52%.
Means that of the 17.1% that out performed (by any margin), only 8.55% did so by more than .52%.

1210

misterno
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Re: Index Investors getting a free ride

Post by misterno » Mon Feb 06, 2017 9:50 am

1210sda wrote:
CyclingDuo wrote: I don't know by how much the average active fund beats the index, though. It could be too small a margin.
In his paper "A Case for Index Funds" (June 2103), Rick Ferri compared a portfolio of index funds to a portfolio of active funds for the 16 years from 1997 to 2013.

He found that, in this study, active funds beat index funds 17.1% of the time (i.e. failed to beat in 82.9%). The median outperformance was .52%.
Means that of the 17.1% that out performed (by any margin), only 8.55% did so by more than .52%.

1210
Wow this is a very important figure. Glad I am in index funds for all those years.

So the next question is what happens if majority of investors start to prefer index over active. Then it will raise all boats and even the junk stocks will go up. Isn't this irrational? What is the solution here?

avalpert
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Re: Index Investors getting a free ride

Post by avalpert » Mon Feb 06, 2017 10:22 am

IlliniDave wrote:Index investors contribute to the "price discovery" of the total market (and/or indexed segments), rather than individual issues.
What does that mean? Price discovery doesn't happen at the market level (with the possible exception of etfs, but let's leave that aside for a second).

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telemark
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Re: Index Investors getting a free ride

Post by telemark » Mon Feb 06, 2017 11:32 am

misterno wrote: Wow this is a very important figure. Glad I am in index funds for all those years.

So the next question is what happens if majority of investors start to prefer index over active. Then it will raise all boats and even the junk stocks will go up. Isn't this irrational? What is the solution here?
That's perfectly normal, it happens in any reasonably efficient market. What makes a stock attractive is not whether the company is a great company but whether the stock price is high or low relative to the value of the company. If everyone bought only the best companies, it would drive the up price of their stocks to the point where they are no longer a good investment, relative to other less popular companies. More money going into the market necessarily raises the price of all stocks, good and bad.

There's an argument that too much money pouring into the market is a bad thing overall, but it's separate from the question of index funds.

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