The Future of Active vs Index Investing

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Riley15
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The Future of Active vs Index Investing

Post by Riley15 » Mon Oct 02, 2017 9:55 am

Nearly everyone has determined that Active management doesn’t work with their outrageous fees (>1%) compared to minimal fees with Indexing. That’s why basically active funds mostly always underperform in the long run and are quickly becoming out of favor with huge outflows every year. I believe this will serve as a wakeup call to the overpaid fund manager and financial advisor industry and will lead to a big overhaul.

Fees have already started coming down across mutual funds on average. In a few years it’s possible that the difference in fees between active and passive funds will be nearly equal. This could be due to a few factors, one is smart beta using various criteria with “robo” fund-managers. The other is that fund managers will become more like bankers without outrageous salaries and bonuses bringing overall costs down.

My question is therefore, without any difference in Cost between Active or Passive Funds how would your Investing strategy change? Would you still index based on market cap?

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Re: The Future of Active vs Index Investing

Post by Jack FFR1846 » Mon Oct 02, 2017 10:02 am

Nope. Why would I change a winning strategy. Since it's proven that active funds (on average) underperform index funds, why would I invest in a loser?

Others WILL continue to invest in active funds with high cost active managers. Why? Because they see the nice EJ commercials with salespeople giving them coffee and saying "this is what we've saved for" and hiring medium successful musical talent to sing their Nationwide songs. My wife has to put up with me saying "THIEF" whenever these commercials come on the TV. People are scared and think investing is rocket science. Active funds will tout the magical gifts their managers possess and explain how during a down market, they get out to reduce losses......because, of course we know that magical unicorn managers know when the market is going down.

For me.....if active managed funds became $0 cost, I still wouldn't invest in them.
Bogle: Smart Beta is stupid

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Re: The Future of Active vs Index Investing

Post by nisiprius » Mon Oct 02, 2017 10:22 am

It would depend.

It would take more than comparable costs, a convincing story, and five, ten, fifteen, or even twenty years of past outperformance. I think the big divide is not so much "active versus index" as it is "staying the course" versus "semiannual portfolio review, revision, and updating."
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Re: The Future of Active vs Index Investing

Post by oldcomputerguy » Mon Oct 02, 2017 10:27 am

The fees are not the only difference between active and passive funds. There are also trading costs and the general failure of fund managers in trying to guess which assets will outperform. Even if ERs were identical, I think I'd still stay with passive funds.
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Re: The Future of Active vs Index Investing

Post by mickeyd » Mon Oct 02, 2017 11:41 am

In a few years it’s possible that the difference in fees between active and passive funds will be nearly equal
I don't buy this. Indexing will always be a cheaper way to go. I will STC.
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David Jay
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Re: The Future of Active vs Index Investing

Post by David Jay » Mon Oct 02, 2017 11:46 am

The problem with active management is that there is a huge diversity of manager performance (whether skill or luck). How do I pick the manager who will outperform the average active fund rather than under-perform the average active fund?

As Nisi said, show me 20 years of over-performance and I will be ready to mix-and-match my investments. Although by that time (age 80) I intend to have a portfolio consisting of a single LifeStrategy fund inside a Roth.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: The Future of Active vs Index Investing

Post by deltaneutral83 » Mon Oct 02, 2017 1:35 pm

There will always be active investing. It's taken for granted around here that everyone in this country has the emotional ability to submit those 5 and six figure buy orders and not panic during 20%+ drops. People will rely on advisers. I don't see the emotional aspect of it changing anytime soon. I do see astronomical AUM fees coming down to around 40-50 Bps. I have no idea what the average is these days, 120 Bps?

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Re: The Future of Active vs Index Investing

Post by patrick013 » Mon Oct 02, 2017 1:41 pm

I've seen some active managers succeed in the short term. Say
you took a mid-cap index and further qualified it. Reducing the
total number of stocks chosen by 50% based on further qualifications.
That's active management. Even those don't beat the general
indexes when they sell gainers and replace them with the next
high quality unchosen index stock currently at a low valuation.

My other thought is what if the trillion dollar bail-out didn't occur
starting in 2009 ? A ghost town of an economy probably with
deflation. Indexing would look bad. Active fund losses probably
worse.
age in bonds, buy-and-hold, 10 year business cycle

Riley15
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Re: The Future of Active vs Index Investing

Post by Riley15 » Mon Oct 02, 2017 5:12 pm

Lots of interesting opinions.
I would really be curious to see some long term performance comparisons of Active vs Passive funds Before Fees. I am sure the information is out there. Basically what percentage of active funds beat their passive indexes assuming no fees. Are the fees the biggest drag on active funds or it is their very nature through manager risk?

I understand many of the comments about staying the course but it's hard to comprehend that every single company in the S&P500 has the same potential of growth in the long run. It can be really difficult to pick the few winners out of many average companies but obviously there are declining industries/companies that won't be in the S&P500 in the future. Ex. Coal companies

I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.

It's a pretty obvious decision when the ER ratio's are 1% for active compared to 0.05% for passive. But when the difference is between 0.10% and 0.05% how confident can we really be in following the market cap approach?

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Re: The Future of Active vs Index Investing

Post by egionesco » Mon Oct 02, 2017 5:17 pm

If your general point is we should always be on our toes and willing to adjust when variables change and other options might be better than indexing, sure.

I think most of those responding just think this is very unlikely.

avalpert
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Re: The Future of Active vs Index Investing

Post by avalpert » Mon Oct 02, 2017 6:04 pm

Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I understand many of the comments about staying the course but it's hard to comprehend that every single company in the S&P500 has the same potential of growth in the long run.
That isn't at all what is suggested. The question isn't whether every company has the same potential growth, it is whether the market prices each company for the same potential returns given the assumptions about company-specific growth (and in modern finance we would control price for some other factors as well beside just 'market risk'). For a given active fund to outperform they would have to identify when the 'market' is wrong about a company and by what magnitude before all the other players in the market do. I don't why you think there are all these companies with 'obviously bleak futures' that aren't priced accordingly - Equifax announced the breach after the market close and the next morning the stock opened 15% lower there wasn't some opportunity to take advantage of the news before everyone else.

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Re: The Future of Active vs Index Investing

Post by Levett » Mon Oct 02, 2017 6:28 pm

What has Vanguard said?

https://vanguardadvisorsblog.com/2017/0 ... ng-debate/

Costs, costs, and costs

Despite a seismic shift out of actively managed investments and into index funds, the whole active versus passive debate misses the point. The simple fact is, investors can succeed using both actively and passively managed funds.

At the end of the day, your clients’ long-term investment success will rise or fall largely as a result of one piece of your investment strategy: costs. In an era in which returns are expected to fall short of their historical averages, costs have never been more important. Our research has shown that what investors pay for the investments they own, whether they be active or passive, can affect their net returns more than anything else.2

A low-cost actively managed fund can be an effective element of a well-balanced, diversified portfolio. As an advisor, you understand this better than anyone as you seek to make your clients’ portfolios more cost-efficient.

Our own balance sheet proves this point. In 2016, investors added $20.4 billion to our low-cost actively managed funds, according to Morningstar data. That’s in stark contrast to the rest of the industry, which had $340.1 billion in outflows from actively managed funds.

At Vanguard, we work with some incredibly talented active managers, but their real performance advantage is they aren’t handicapped by high expense ratios. In 2016, our average asset-weighted expense ratio for all actively managed funds was 0.20%, compared with the industry average of 0.71%.1


Lev

Riley15
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Re: The Future of Active vs Index Investing

Post by Riley15 » Mon Oct 02, 2017 8:26 pm

Levett wrote:
Mon Oct 02, 2017 6:28 pm
What has Vanguard said?

https://vanguardadvisorsblog.com/2017/0 ... ng-debate/

Costs, costs, and costs

Despite a seismic shift out of actively managed investments and into index funds, the whole active versus passive debate misses the point. The simple fact is, investors can succeed using both actively and passively managed funds.

At the end of the day, your clients’ long-term investment success will rise or fall largely as a result of one piece of your investment strategy: costs. In an era in which returns are expected to fall short of their historical averages, costs have never been more important. Our research has shown that what investors pay for the investments they own, whether they be active or passive, can affect their net returns more than anything else.2

A low-cost actively managed fund can be an effective element of a well-balanced, diversified portfolio. As an advisor, you understand this better than anyone as you seek to make your clients’ portfolios more cost-efficient.

Our own balance sheet proves this point. In 2016, investors added $20.4 billion to our low-cost actively managed funds, according to Morningstar data. That’s in stark contrast to the rest of the industry, which had $340.1 billion in outflows from actively managed funds.

At Vanguard, we work with some incredibly talented active managers, but their real performance advantage is they aren’t handicapped by high expense ratios. In 2016, our average asset-weighted expense ratio for all actively managed funds was 0.20%, compared with the industry average of 0.71%.1


Lev
Thanks for the link Lev, I had not read Vanguard's point of view. So Vanguard definitely considers cost to be the biggest drag on active funds than any other active factors like manager risk, trading costs, etc.

This only reinforces my assumptions. Vanguard obviously spearheaded passive indexing and have been the leader ever since but they realized the industry waking up to low cost advantages as every major competitor has low cost index funds now. I am sure they are anticipating the future and realize the limitations of both passive and active approaches. Cost being the biggest for active funds which is why recently they have been touting their lower cost active funds. Just as Vanguard reduced cost with indexing I think they may be the first to have lowest cost active funds before others follow.

Once the cost start to blur between active and passive them, this divide may no longer matter. But I am sure we will still be able to identify as Boglheads. :happy

avalpert
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Re: The Future of Active vs Index Investing

Post by avalpert » Mon Oct 02, 2017 8:39 pm

Riley15 wrote:
Mon Oct 02, 2017 8:26 pm
Levett wrote:
Mon Oct 02, 2017 6:28 pm
What has Vanguard said?

https://vanguardadvisorsblog.com/2017/0 ... ng-debate/

Costs, costs, and costs

Despite a seismic shift out of actively managed investments and into index funds, the whole active versus passive debate misses the point. The simple fact is, investors can succeed using both actively and passively managed funds.

At the end of the day, your clients’ long-term investment success will rise or fall largely as a result of one piece of your investment strategy: costs. In an era in which returns are expected to fall short of their historical averages, costs have never been more important. Our research has shown that what investors pay for the investments they own, whether they be active or passive, can affect their net returns more than anything else.2

A low-cost actively managed fund can be an effective element of a well-balanced, diversified portfolio. As an advisor, you understand this better than anyone as you seek to make your clients’ portfolios more cost-efficient.

Our own balance sheet proves this point. In 2016, investors added $20.4 billion to our low-cost actively managed funds, according to Morningstar data. That’s in stark contrast to the rest of the industry, which had $340.1 billion in outflows from actively managed funds.

At Vanguard, we work with some incredibly talented active managers, but their real performance advantage is they aren’t handicapped by high expense ratios. In 2016, our average asset-weighted expense ratio for all actively managed funds was 0.20%, compared with the industry average of 0.71%.1


Lev
Thanks for the link Lev, I had not read Vanguard's point of view. So Vanguard definitely considers cost to be the biggest drag on active funds than any other active factors like manager risk, trading costs, etc.

This only reinforces my assumptions. Vanguard obviously spearheaded passive indexing and have been the leader ever since but they realized the industry waking up to low cost advantages as every major competitor has low cost index funds now. I am sure they are anticipating the future and realize the limitations of both passive and active approaches. Cost being the biggest for active funds which is why recently they have been touting their lower cost active funds. Just as Vanguard reduced cost with indexing I think they may be the first to have lowest cost active funds before others follow.

Once the cost start to blur between active and passive them, this divide may no longer matter. But I am sure we will still be able to identify as Boglheads. :happy
Vanguard has had active funds for (almost) as long as they have had passive funds - there is no 'anticipating the future and realize the limitations'. They have been touting their active funds for a long time and this marketing piece is just that, marketing. I know people like to forget that Vanguard is a for-profit business, but they are and you should to approach their self-serving 'research' with the skepticism you would any fund management firms'.

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Re: The Future of Active vs Index Investing

Post by AlphaLess » Mon Oct 02, 2017 8:44 pm

Riley15 wrote:
Mon Oct 02, 2017 9:55 am
My question is therefore, without any difference in Cost between Active or Passive Funds how would your Investing strategy change? Would you still index based on market cap?
In my humble opinion, active management will not be able to outperform passive management, under *ANY* fee assumption.

Two arguments:
- active management CAN NOT charge lower fees, as compared to passive management, simply because active management is more labor, technology, IP, and human-resource intensive,
- active management, AS A WHOLE, will not be able to outperform its benchmarks.

Active management can do one of two things:
- factor betting (factors are things like market, beta, volatility, momentum, etc),
- or residual betting (stock-picking, so to speak).

Of course, each of these can be further decomposed into sub-categories. The most important is the following decomposition of factor-betting:
- buy-and-hold of factor bets,
- market timing of factors.

IMO, smart betas are in the first sub-category, more or less.

As far as market timing of factors, or stock-picking: they are both very IP-intensive, and both are capacity constrained. Furthermore, most active managed strategies that STILL work will not be available to mere mortals (like you and I).

Thus, mere mortals like you and I will simply end up subsidizing some fallen-star managers lifestyle.

Just my 3.5 kopeks.

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Re: The Future of Active vs Index Investing

Post by McGilicutty » Mon Oct 02, 2017 9:28 pm

Don't index funds also have tax advantages over actively managed funds? I've never owned an actively managed fund, but my understanding is that they sometimes (most of the time?) have annual 'distributions' which are taxed even if you don't have any capital gains. With my index ETFs, I get quarterly dividends that are taxed, but I don't recall ever getting a distribution.

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Re: The Future of Active vs Index Investing

Post by swguy » Mon Oct 02, 2017 9:30 pm

It IS possible for active management to be both low cost and to perform well. Both Wellington and Wellesley have shown this to be true. These may well be outliers, but they remain examples of approaches that have worked long term.

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Re: The Future of Active vs Index Investing

Post by TD2626 » Mon Oct 02, 2017 9:41 pm

One issue for taxable investors is tax drag. Funds with high turnover (like most active funds) distribute larger capital gains distributions, and some of these gains can be short-term gains. Even if fee drag is reduced, can the tax drag issue be solved?

If it helps, we're already pretty much at the point where the rock-bottom lowest cost active funds are not very much more expensive than index funds. For example:
Vanguard Wellington Admiral, 0.16% ER
Vanguard Wellesley Admiral, 0.15% ER
(These are among the lowest I have seen. Many funds from other firms sadly still charge 1%+)

Also, alpha expectations would need to be considered with active. The average active dollar in the market should in theory receive the index return before fees. However, if one could identify market inefficiencies that cause one class of active investors (those generating the inefficiencies) to have lower-than-average returns, and if then one could join the class of active investors exploiting the inefficiencies, then one may have slight excess returns. I feel markets are relatively efficient, so doing this would be very difficult.

Also, say one finds that average active alpha for one class of active investors is 50 basis points. If fees are 30 basis points, then the investor is only making 20 basis points. The standard deviation of alpha is pretty large for a 20 basis point return. At least this standard deviation would be uncorrelated with market risk/beta.

On an unrelated note, it could be possible to envision an "active", non-index fund that specifically tries to be cheaper than, and have less turnover than, an index fund. For example, such a fund would try to have less turnover than an index fund (to lower tax drag) and it would not have to pay licencing fees to the index. If it did very little research (which the efficient market hypothesis suggests is not needed to merely keep up with the market) and bought and held a sampling of stocks for decades, maybe it could be cheaper and have less tax drag than the index fund.

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Re: The Future of Active vs Index Investing

Post by venkman » Mon Oct 02, 2017 9:55 pm

Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.
For every active manager who sold those companies on the way down, there was another active manager who bought them.

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Re: The Future of Active vs Index Investing

Post by avalpert » Mon Oct 02, 2017 10:00 pm

TD2626 wrote:
Mon Oct 02, 2017 9:41 pm
On an unrelated note, it could be possible to envision an "active", non-index fund that specifically tries to be cheaper than, and have less turnover than, an index fund. For example, such a fund would try to have less turnover than an index fund (to lower tax drag) and it would not have to pay licencing fees to the index. If it did very little research (which the efficient market hypothesis suggests is not needed to merely keep up with the market) and bought and held a sampling of stocks for decades, maybe it could be cheaper and have less tax drag than the index fund.
Isn't that essentially what Vanguard's tax-managed funds are doing?

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Re: The Future of Active vs Index Investing

Post by 9-5 Suited » Mon Oct 02, 2017 10:06 pm

Riley15 wrote:
Mon Oct 02, 2017 9:55 am
Nearly everyone has determined ...
The future you are describing reminds me of the oft-held Vanguard vs. DFA discussions on this board. That's the kind of cost spread I envision - never quite equal, but close enough that you couldn't really fault someone for choosing either option. I would continue to index since I can eliminate manager risk and attendant trading costs even if the gap were zero though. Nothing changes about the zero-sum nature of active management.

One other thing that we should pay attention to related to this topic: index funds will face growing pressure from a powerful, influential industry being backed into a corner. It's not too difficult to imagine legislation that raises the costs of indexing firms, limits their reach, or otherwise narrows the gap to active to keep the financial industry as profitable as ever. We should be always vigilant and attuned to that very real possibility.

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Re: The Future of Active vs Index Investing

Post by TD2626 » Mon Oct 02, 2017 10:33 pm

avalpert wrote:
Mon Oct 02, 2017 10:00 pm
TD2626 wrote:
Mon Oct 02, 2017 9:41 pm
On an unrelated note, it could be possible to envision an "active", non-index fund that specifically tries to be cheaper than, and have less turnover than, an index fund. For example, such a fund would try to have less turnover than an index fund (to lower tax drag) and it would not have to pay licencing fees to the index. If it did very little research (which the efficient market hypothesis suggests is not needed to merely keep up with the market) and bought and held a sampling of stocks for decades, maybe it could be cheaper and have less tax drag than the index fund.
Isn't that essentially what Vanguard's tax-managed funds are doing?
Good point.

They are more expensive (by a few basis points) than Total Stock or S&P 500, though. Yes, the reduction in dividend income through tax-management is also something important for this kind of fund. Essentially, these are "active" funds that don't try to "beat the market" before taxes, but may beat the market after taxes for those in high tax brackets. Note that while these are sort-of active funds, Vanguard describes them as "index-oriented".

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Re: The Future of Active vs Index Investing

Post by avalpert » Mon Oct 02, 2017 10:42 pm

9-5 Suited wrote:
Mon Oct 02, 2017 10:06 pm
It's not too difficult to imagine legislation that raises the costs of indexing firms, limits their reach, or otherwise narrows the gap to active to keep the financial industry as profitable as ever. We should be always vigilant and attuned to that very real possibility.
Actually, I find it very, very hard to imagine. There is no functional difference between a passive and active fund other than how they market themselves. I can't envision any legislation that could prohibit or increase cost for 'passive' funds without also doing so for 'active' funds.

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Re: The Future of Active vs Index Investing

Post by 9-5 Suited » Tue Oct 03, 2017 7:48 am

avalpert wrote:
Mon Oct 02, 2017 10:42 pm
9-5 Suited wrote:
Mon Oct 02, 2017 10:06 pm
It's not too difficult to imagine legislation that raises the costs of indexing firms, limits their reach, or otherwise narrows the gap to active to keep the financial industry as profitable as ever. We should be always vigilant and attuned to that very real possibility.
Actually, I find it very, very hard to imagine. There is no functional difference between a passive and active fund other than how they market themselves. I can't envision any legislation that could prohibit or increase cost for 'passive' funds without also doing so for 'active' funds.
I don't think it's likely, so in a sense I agree with your comment. But all things can be legislated away - even your most basic rights - so it's incredibly important to always be vigilant and always an advocate for the things one cares about. "STAMP OUT INDEX FUNDS. INDEX FUNDS ARE UN-AMERICAN." Do you think that concept has no conceivable way of taking hold? A lot of seemingly core institutions have faced such criticism in the past.

Once an attitude is adopted, creating the actual rules isn't all that difficult. "Any fund with more than 500 holdings that tracks the US Stock Market within x% for a 5 year period shall pay the Index Tax, equal to 0.50% of all assets under management." You could come up with a great many tactics.

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Re: The Future of Active vs Index Investing

Post by greg24 » Tue Oct 03, 2017 9:06 am

If active costs were to get close to passive costs, it will be 100 years from now.

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Re: The Future of Active vs Index Investing

Post by David Jay » Tue Oct 03, 2017 9:11 am

venkman wrote:
Mon Oct 02, 2017 9:55 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.
For every active manager who sold those companies on the way down, there was another active manager who bought them.
Not really. The majority of stock market trades are not performed by mutual funds.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: The Future of Active vs Index Investing

Post by Riley15 » Tue Oct 03, 2017 9:34 am

9-5 Suited wrote:
Tue Oct 03, 2017 7:48 am
avalpert wrote:
Mon Oct 02, 2017 10:42 pm
9-5 Suited wrote:
Mon Oct 02, 2017 10:06 pm
It's not too difficult to imagine legislation that raises the costs of indexing firms, limits their reach, or otherwise narrows the gap to active to keep the financial industry as profitable as ever. We should be always vigilant and attuned to that very real possibility.
Actually, I find it very, very hard to imagine. There is no functional difference between a passive and active fund other than how they market themselves. I can't envision any legislation that could prohibit or increase cost for 'passive' funds without also doing so for 'active' funds.
I don't think it's likely, so in a sense I agree with your comment. But all things can be legislated away - even your most basic rights - so it's incredibly important to always be vigilant and always an advocate for the things one cares about. "STAMP OUT INDEX FUNDS. INDEX FUNDS ARE UN-AMERICAN." Do you think that concept has no conceivable way of taking hold? A lot of seemingly core institutions have faced such criticism in the past.

Once an attitude is adopted, creating the actual rules isn't all that difficult. "Any fund with more than 500 holdings that tracks the US Stock Market within x% for a 5 year period shall pay the Index Tax, equal to 0.50% of all assets under management." You could come up with a great many tactics.
I tend to agree, it's very possible this could happen especially since wall street and has so much lobbying power. They could come up with a number of reasons, that indexing makes markets inefficient, hampers price discovery, reduces market competition or encourages collusion within companies since they are part of the same funds with large ownerships which. We've heard all these arguments before and they can frame it in a way that they are protecting the economy. And I don't think there would be mass outrage. I wonder how many people would even bother to care except for the few like bogleheads who get what's happening.

avalpert
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Re: The Future of Active vs Index Investing

Post by avalpert » Tue Oct 03, 2017 9:56 am

Riley15 wrote:
Tue Oct 03, 2017 9:34 am
9-5 Suited wrote:
Tue Oct 03, 2017 7:48 am
avalpert wrote:
Mon Oct 02, 2017 10:42 pm
9-5 Suited wrote:
Mon Oct 02, 2017 10:06 pm
It's not too difficult to imagine legislation that raises the costs of indexing firms, limits their reach, or otherwise narrows the gap to active to keep the financial industry as profitable as ever. We should be always vigilant and attuned to that very real possibility.
Actually, I find it very, very hard to imagine. There is no functional difference between a passive and active fund other than how they market themselves. I can't envision any legislation that could prohibit or increase cost for 'passive' funds without also doing so for 'active' funds.
I don't think it's likely, so in a sense I agree with your comment. But all things can be legislated away - even your most basic rights - so it's incredibly important to always be vigilant and always an advocate for the things one cares about. "STAMP OUT INDEX FUNDS. INDEX FUNDS ARE UN-AMERICAN." Do you think that concept has no conceivable way of taking hold? A lot of seemingly core institutions have faced such criticism in the past.

Once an attitude is adopted, creating the actual rules isn't all that difficult. "Any fund with more than 500 holdings that tracks the US Stock Market within x% for a 5 year period shall pay the Index Tax, equal to 0.50% of all assets under management." You could come up with a great many tactics.
I tend to agree, it's very possible this could happen especially since wall street and has so much lobbying power. They could come up with a number of reasons, that indexing makes markets inefficient, hampers price discovery, reduces market competition or encourages collusion within companies since they are part of the same funds with large ownerships which. We've heard all these arguments before and they can frame it in a way that they are protecting the economy. And I don't think there would be mass outrage. I wonder how many people would even bother to care except for the few like bogleheads who get what's happening.
I think what you are missing is that 'indexing' is just another trading strategy.

So sure, you could plausibly pass a law that limits the number of holdings in a fund - but then fund families will just construct funds at the limit and if that limit gets too small it starts to net the 'active' funds as well. After that they will use fund of funds to replicate larger indexes, you outlaw that and down goes target date funds that the active fund families heavily market in their 401k plans. Same thing with ownership concentration in fund families - that hits the big fund families regardless of if they are using active or passive strategies.

Riley15
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Re: The Future of Active vs Index Investing

Post by Riley15 » Tue Oct 03, 2017 10:01 am

avalpert wrote:
Mon Oct 02, 2017 6:04 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I understand many of the comments about staying the course but it's hard to comprehend that every single company in the S&P500 has the same potential of growth in the long run.
That isn't at all what is suggested. The question isn't whether every company has the same potential growth, it is whether the market prices each company for the same potential returns given the assumptions about company-specific growth (and in modern finance we would control price for some other factors as well beside just 'market risk'). For a given active fund to outperform they would have to identify when the 'market' is wrong about a company and by what magnitude before all the other players in the market do. I don't why you think there are all these companies with 'obviously bleak futures' that aren't priced accordingly - Equifax announced the breach after the market close and the next morning the stock opened 15% lower there wasn't some opportunity to take advantage of the news before everyone else.
I definitely agree in the short-term there are no advantages but I am thinking there may be larger long term market and industry trends that may restrict passive funds from doing things that active funds are free to do.

That also raises an interesting question, when something like this happens as with Equifax where the market cap suddenly decreases by 40-50% overnight or in a matter of few days, when is it that index funds actually "rebalance" to maintain the new cap weights. Or generally is there a percentage amount they figure they can deviate before they need to buy/sell?

avalpert
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Re: The Future of Active vs Index Investing

Post by avalpert » Tue Oct 03, 2017 12:02 pm

Riley15 wrote:
Tue Oct 03, 2017 10:01 am
avalpert wrote:
Mon Oct 02, 2017 6:04 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I understand many of the comments about staying the course but it's hard to comprehend that every single company in the S&P500 has the same potential of growth in the long run.
That isn't at all what is suggested. The question isn't whether every company has the same potential growth, it is whether the market prices each company for the same potential returns given the assumptions about company-specific growth (and in modern finance we would control price for some other factors as well beside just 'market risk'). For a given active fund to outperform they would have to identify when the 'market' is wrong about a company and by what magnitude before all the other players in the market do. I don't why you think there are all these companies with 'obviously bleak futures' that aren't priced accordingly - Equifax announced the breach after the market close and the next morning the stock opened 15% lower there wasn't some opportunity to take advantage of the news before everyone else.
I definitely agree in the short-term there are no advantages but I am thinking there may be larger long term market and industry trends that may restrict passive funds from doing things that active funds are free to do.
I think you misunderstand how markets adjust - yes, if the active fund can identify the trend before the other active players in the market (and the market ultimately adapts to the trends) then they can outperform the market and the passive strategies tracking it - which is just another way of saying if they can outsmart the market they can beat it. But if all active players can see the same trend then there is no advantage to be had on one another, the price adjusts accordingly and passive investors get the same returns as the active investors.
That also raises an interesting question, when something like this happens as with Equifax where the market cap suddenly decreases by 40-50% overnight or in a matter of few days, when is it that index funds actually "rebalance" to maintain the new cap weights. Or generally is there a percentage amount they figure they can deviate before they need to buy/sell?
Passive funds never need to buy/sell because of price changes - when the price changes the relative weighting of their holding automatically adapt accordingly.

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David Jay
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Re: The Future of Active vs Index Investing

Post by David Jay » Tue Oct 03, 2017 5:53 pm

avalpert wrote:
Tue Oct 03, 2017 12:02 pm
That also raises an interesting question, when something like this happens as with Equifax where the market cap suddenly decreases by 40-50% overnight or in a matter of few days, when is it that index funds actually "rebalance" to maintain the new cap weights. Or generally is there a percentage amount they figure they can deviate before they need to buy/sell?
Passive funds never need to buy/sell because of price changes - when the price changes the relative weighting of their holding automatically adapt accordingly.
Riley:

This is a key concept - market weighting. It is a major reason why expenses are so low. The only buying and selling in a normal day is to process purchases and redemptions. If $10 million comes into the fund in a given day and $10 million is withdrawn, nothing has to be bought or sold.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

venkman
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Re: The Future of Active vs Index Investing

Post by venkman » Tue Oct 03, 2017 9:39 pm

David Jay wrote:
Tue Oct 03, 2017 9:11 am
venkman wrote:
Mon Oct 02, 2017 9:55 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.
For every active manager who sold those companies on the way down, there was another active manager who bought them.
Not really. The majority of stock market trades are not performed by mutual funds.
But isn't most of the VALUE traded back and forth by institutional investors? (i.e. Retail investors trading 100 shares each would have to make 1,000 trades to match one mutual fund trading 100k shares.) I'm not counting high-frequency trading--just retail investors and/or managers who are buying a stock with the intent to hold it and not immediately sell it.

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David Jay
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Re: The Future of Active vs Index Investing

Post by David Jay » Tue Oct 03, 2017 10:00 pm

venkman wrote:
Tue Oct 03, 2017 9:39 pm
David Jay wrote:
Tue Oct 03, 2017 9:11 am
venkman wrote:
Mon Oct 02, 2017 9:55 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.
For every active manager who sold those companies on the way down, there was another active manager who bought them.
Not really. The majority of stock market trades are not performed by mutual funds.
But isn't most of the VALUE traded back and forth by institutional investors? (i.e. Retail investors trading 100 shares each would have to make 1,000 trades to match one mutual fund trading 100k shares.) I'm not counting high-frequency trading--just retail investors and/or managers who are buying a stock with the intent to hold it and not immediately sell it.
Yes, but the vast majority of those institutional investors are not mutual fund managers. They are quants, program traders and HFT types trading for institutional accounts.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

AlphaLess
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Re: The Future of Active vs Index Investing

Post by AlphaLess » Tue Oct 03, 2017 11:24 pm

venkman wrote:
Mon Oct 02, 2017 9:55 pm
Riley15 wrote:
Mon Oct 02, 2017 5:12 pm
I mean there was no staying the course with Enron, Lehman, Kodak, more recently Equifax, etc.. I wonder how many passive funds were forced to hold on to these companies when it was pretty clear the future was very bleak.
For every active manager who sold those companies on the way down, there was another active manager who bought them.
Not quite. Market is not efficient automatically: certain market participants make the market efficient. This participants are not active managers: rather, they are market intermediaries.

There are market intermediaries at various frequency horizons, judged by the size of their portfolio and amount of volume they trade.

The amount of money lost by active managers is generally recouped by:
- intermediaries at operating at various frequencies,
- trading fees.

Let's compute the costs to active managers that are due just to those.

US Equities trades around $250B a day, give or take.
One of the most important fees is the SEC Stamp tax, levied at 0.231 basis points on all SELLS (https://www.sec.gov/news/press-release/2017-111). That's equivalent to $23.10 for every $1MM traded. Since there is a buyer and seller for each dollar traded, then the aggregate SEC fee paid by all traders is around $250,000 * $23.1 = $5.8MM per day, or $1.44B per year. You can verify this from

Separately, it is reported that HFT trading constitutes around 45-50% of all US Equities. Since $250B is single-sided volume (in fact, if counting $1 traded BOTH from buyers and sellers point of view, volume would be double), then HFT accounts for around $250B * 2 * 45% = $220B. HFT reportedly make around 0.5 basis point per $1 traded (after fees). Thus, HFTs make around $11M a day, or around $2.7B a year.

Furthermore, there are exchange fees. By consulting, for example, the revenues from exchange fees from NASDAQ, NYSE, and BATS (all of which are public), we can get an estimate for that. I would estimate that exchange fees are at least $1.5MM a day, or $375MM per year.

So, let's recap:
- $1.44B per year to SEC,
- $2.7B per year to HFTs,
- $0.375B per year to exchanges.

And we are just getting started.

As a comparison, there are a lot of market intermediaries that operate at higher frequency / horizon than HFTs, and they, too make money, and probably more money per unit of volume traded. For example, I would consider Renaissance Technologies as an intermediary. They make somewhere in the neighborhood of single digit Billions per year for virtually no risk.

Unfortunately, you can't invest in:
- SEC fees,
- exchange fees,
- HFT revenues,
- or Renaissance returns.

You can invest in HFT earnings (such as Virtu), but those companies make almost no money after expenses. Likewise, exchanges themselves have a lot of costs, and the fees are not directly investable. And likewise, you won't be able to invest in Renaissance returns.

So I am very skeptical of active management that you can actually invest in.
As a matter of fact: even if active managers charged ZERO fees (worked for free), you will probably will get sub-benchmark returns.

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