Hedge Fund Billionaires: where does this money come from?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Hedge Fund Billionaires: where does this money come from?

Post by LH »

http://www.nytimes.com/2007/04/24/busin ... wanted=all

So three hedge fund managers made over a billion dollars in a year? I am assuming this is just them individually, and that others who helped run the fund made millions more right?

In terms of hedge funds, is this activity a zero sum game? If they made a billion each, then some entity or entities lost a billion?

If so, where did the money come from? Did they extract it from other hedge funds that did poorly, did they extract it from passive index funds? Does some of it actually come from them creating wealth in some fashion (if so, how?).

To me, they are at the opposite end of bogleheads, and are making a killing. They not only have yachts, but could buy entire countries? Kinda of an entirely different scale, than the customers not having yachts, and only the brokers having yachts, that process I understand I think : )

I guess to sum up my question: If one took ALL hedge funds(HF), and add them together, are they making net profit, or is it:

HF winners winnings-HF losers losings-all HFs summed cost = Negative number?

This is kinda simplistically what I would expect reading all the diehard stuff.

If its not a negative number:

1) who is footing the bill?
0r
2) are they somehow creating wealth? If so how.
or
3)a combination of 1+2, if so, whats the relative combination?

thanks for your help,

LH
Last edited by LH on Mon May 14, 2007 8:47 pm, edited 1 time in total.
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Post by larryswedroe »

Not exactly
The zero sum game is relative not absolute.

They could make a bilion and no one lost a billion, someone just made made one billion LESS. Now they might have lost money also.

Outperforming market is zero sum game--for every dollar of outperformance there must be dollar of underperformance
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Post by LH »

larryswedroe wrote:Not exactly
The zero sum game is relative not absolute.

They could make a bilion and no one lost a billion, someone just made made one billion LESS. Now they might have lost money also.

Outperforming market is zero sum game--for every dollar of outperformance there must be dollar of underperformance
Well, sorry for not being clearer, but my intent was, if someone made a billion less than they would have, they "lost" that billion. Thats why you are a published author : ) Thanks for clarifying, I am reading your book at the moment in fact.

Really, to be hopefully more explicit/clear about it, is the "someone" who would have made a billion but didnt, the passive index industry and its customers, aka me?

Did I participate in losing/not getting that billion?

Its always seemed to me, that if everyone followed passive index investing, except say .01 percent, and that .01 percent where smart insiders, that they could just extremely exploit the markets (the market= near 100 percent indexors) inefficiencies.

Because really the market being efficient, depends on people trying to exploit/find opportunities to make costs.

Now when everyone is doing that..... The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.

But if a low percent, or certainly if no one is doing that (100 percent blind indexing), then the market would seem to become inefficient by definition. Extreme, but at some point on the gradient, mayeb starting now?, the blind indexers just putting money in some company simply because its on a friggin market cap list without looking at anything ben graham would talk about, would start to get exploited.

I was just wondering, if with all this blind indexing going on, if this is the start of a few people exploiting indexers?


PS I know we are no where near 100 percent indexors currently.
User avatar
drjdpowell
Posts: 882
Joined: Thu Mar 01, 2007 8:56 pm

Post by drjdpowell »

LH wrote:The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.
Market efficiency means that being "smart money" that profits from finding pricing "errors" is a very competitive business. Indexers, and anyone else who trades without "smart money" insight, is effectively a "customer" of the "smart money industry". Competition keeps our costs very low, but we indexers are getting no "free ride". Every time we trade, we pay. Nor is the "smart money" that keeps the market efficient losing money (wouldn't be very smart). They make money. However, there are far too many people claiming to be "smart money" for more than a small fraction to actually BE what they claim/believe.

-- James
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Post by larryswedroe »

LH
Since passive investors earn market returns less low costs, it is other ACTIVE investors that the hedge funds are exploiting--like other hedge fund investors and other active investors----not the passive guys.
Also they make lots of money buying different type of securities (highly risky/illiquid instruments) than you would be buying---So again you are not among the ones being exploited.
And passive investing, the zero sum game (see Chapter one of The Successful Investor today) is simple math and holds whatever the percentage of active/passive investors. The sum of the parts (active and passive investors) must equal the whole. And since passive investors earn the market return (regardless of what % of market they own) then so must active investors collectively earn that same return.But that is BEFORE expenses. And active investors have higher expenses, thus COLLECTIVELY they must have lower returns, even if they have only 1% of market. Remember they are only trading among themselves.

One last thought, efficient markets work this way--by setting prices so they are the best estimate of the correct price, they prevent active investors from buying "undervalued securtieis". But they also protect dumb investors from buying "overvalued" securities. The price is the right price for both sets.
Larry
PS if you have any questions feel free to post or email, always happen to respond to readers

Larry
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Post by LH »

drjdpowell wrote:
LH wrote:The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.
Market efficiency means that being "smart money" that profits from finding pricing "errors" is a very competitive business. Indexers, and anyone else who trades without "smart money" insight, is effectively a "customer" of the "smart money industry". Competition keeps our costs very low, but we indexers are getting no "free ride". Every time we trade, we pay. Nor is the "smart money" that keeps the market efficient losing money (wouldn't be very smart). They make money. However, there are far too many people claiming to be "smart money" for more than a small fraction to actually BE what they claim/believe.

-- James
I do not think we actually disagree. Yes, we do pay fees. Perhaps if I used "free lunch" it would help? Either concept though, free ride or free lunch, I do not think anyone ever maintains thats its entirely free, just that one is recieving a benefit with someone else paying some of the cost, a misnomer perhaps, but a standard/accepted one?

"In economics, collective bargaining, psychology and political science, free riders are actors who consume more than their fair share of a resource"

I think right now, passive indexors benefit from all the active mutual funds, and active traders, trading in and out of things and losing money relative to passive indexing approach.

I would posit, that if indexors constituted near 100 percent, we would relatively suffer in our returns.

I think we in fact do get some free return from the efforts and trading and fees paid by others who in trying to beat the market(and failing on averge) keep the market efficient for us.

Neither I, nor my vanguard funds are engaged in maintaining market efficiency, rather, they are engaged in transactional efficiency, and responding to changes on the index they follow, and reducing tracking error, and doing a marvelous job of mimicing TSM by sampling and such, great stuff. I just do not see that in itself being sufficient to maintain an efficient market.

I am not saying, that we do not bear ANY cost of maintaing an efficient market, clearly, when more and more price movement of companies becomes due to blind indexing, there is going to be more and more opportunity for not only smart money, but for an average schmoe like me to read ben graham, look at fundamentals, and go, geesh, these indexors reaching 90 percent of the money in the stock market have created some truly moronic situations valuation wise.

This is happening to some extent now, I am sure traders exploit passive investors to some extent, but the "exploitation" much like ETF arbitrage, actually helps us on average, and helps them.

The free ride I am refering to, is the schmoes like me, who trade and such, or who invest in managed funds, provide liquidity at minimum, perhaps market efficiency at best, BUT LOSE MONEY relative to passive investors who do nothing directly or by proxy via the funds we choose to look at balance sheets and value individual companies and MAKE the market efficient.

We free ride off of them. Thier existance benefits passive investors monetarily I believe.
Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb »

LH Said:
Now when everyone is doing that..... The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.
You don't "get screwed" or "lose" by buying individual stocks long term. You get screwed or lose by actively trading individual stocks. You and your low-cost passive fund are doing the same thing - buying individual stocks long term.

I think we agree that high-cost strategies are losing propositions.

Best wishes.
Andy
christianryther
Posts: 12
Joined: Sat May 12, 2007 1:27 am

The HFs

Post by christianryther »

>Really, to be hopefully more explicit/clear about it, is the "someone" who would have made a billion but didnt, the passive index industry and its customers, aka me?

HFs earn performance fees based on how much their returns beat 0%. So there are several ways to make money:
1) earn the market return (>0): you get what your investors lose.
2) earn less than the market return but >0: you get what your investors lose.
3) beat the market through good stock picking: you benefit from other market participants' underperformance.
4) beat the market through leverage: you benefit from the use of a lower cost supply of capital (for example, debt). I don't know who loses here
5) you beat the market by investing in another asset class (for example, oil futures): I don't know who loses here
6) you beat the market by positively influencing the companies the you invest in: you have created value and deserve your fees.

I think that 6) is the only case in which the HF manager does not "earn" their fees from someone else's loss. However, I don't see where passive investors lose except in the opposite of 6). The real losses come to those who invest in HFs that don't beat the market.

ps. I'm sure that there are more than 6 ways for HFs to make $
Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb »

Christian said:
However, I don't see where passive investors lose except in the opposite of 6).
Depends on what you mean by "passive". Gus Sauter of Vanguard has publicly stated that he believes traders (hedge funds and others) take advantage of index funds through front-running the index changes. He estimates the S&P500 index fund loses 0.25% annually to front-running. I don't know about the other indices.

In this sense, the hedge funds gain at the expense of index investors. A more passive fund - like DFA funds - may suffer little or no front running loss.

Best wishes.
Andy
DaveHanson
Posts: 19
Joined: Tue May 01, 2007 5:26 pm

Post by DaveHanson »

Wagnerjb wrote: A more passive fund - like DFA funds - may suffer little or no front running loss.
Or, to look at funds available directly to individual purchasers without middlemen, a fund like VG Total Stock Market as it doesn't peg one index.
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Post by LH »

Wagnerjb wrote:LH Said:
Now when everyone is doing that..... The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.
You don't "get screwed" or "lose" by buying individual stocks long term. You get screwed or lose by actively trading individual stocks. You and your low-cost passive fund are doing the same thing - buying individual stocks long term.

I think we agree that high-cost strategies are losing propositions.

Best wishes.
Well, perhaps the wording is unfortunate : )

I would state that the expected outcome, of owning individual stocks long term, versus a passive index portfolio, is below market returns achievable by passive indexing. Unless you can hold enough to achieve the diversification and risk limitation of an index, while keeping low fees like and index, which is impossible to do right? One fee for an ETF of 500 shares, versus 500 fees, or 100 fees, or 15 fees or whatever to try to achieve the same result.

ergo screwed : )

The expected outcome, of choosing individual stocks, and holding long term, is to NOT beat the passive indexers, and that to me is a losing proposition.
Last edited by LH on Mon May 14, 2007 10:43 pm, edited 1 time in total.
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Post by LH »

Wagnerjb wrote:Christian said:
However, I don't see where passive investors lose except in the opposite of 6).
Depends on what you mean by "passive". Gus Sauter of Vanguard has publicly stated that he believes traders (hedge funds and others) take advantage of index funds through front-running the index changes. He estimates the S&P500 index fund loses 0.25% annually to front-running. I don't know about the other indices.

In this sense, the hedge funds gain at the expense of index investors. A more passive fund - like DFA funds - may suffer little or no front running loss.

Best wishes.
Yeah, thats exactly what I am thinking of. I think some funds, have started to buy some stock they think will go in into the index right? To mititgate that problem?

Also, I think I think I have read as well that in some small cap companies, someone has posited that 20-40 percent of price movement is due to index funds, not someone trying to gauge the companies worth, just indexors blindly buying selling it according to a list..... Thats not efficient, and will be exploited.
rockH
Posts: 11
Joined: Thu Apr 19, 2007 2:17 pm

hedge fund investor pay the billions

Post by rockH »

The article is about the fees being earned by the fund managers. They generally charge a 2% management fee plus a 20% carry (20% of realized capital gains). As noted in the article, some charge as high as 5% management fee plus 44% carry.

So if the manager has raised a $1 billion fund and charges 2+20, he earns $20mm in one year on the management fee even if the fund loses money for the year. A $10 billion fund would generate $200 million a year in management fees before capital gains.

These fees are paid by the fund investors, all those pension funds and university endowments and high net worth individuals that invest some portion of their portfolios in hedge funds. The investors are the "losers" in the context of the enormous earnings of the fund managers. Its analagous to the high management fees of many managed equity mutual funds - the investors pay these fees and are the "losers".

"Hedge funds are not investment vehicles, they are compensation vehicles."

rockH
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Re: hedge fund investor pay the billions

Post by LH »

rockH wrote:The article is about the fees being earned by the fund managers. They generally charge a 2% management fee plus a 20% carry (20% of realized capital gains). As noted in the article, some charge as high as 5% management fee plus 44% carry.

So if the manager has raised a $1 billion fund and charges 2+20, he earns $20mm in one year on the management fee even if the fund loses money for the year. A $10 billion fund would generate $200 million a year in management fees before capital gains.

These fees are paid by the fund investors, all those pension funds and university endowments and high net worth individuals that invest some portion of their portfolios in hedge funds. The investors are the "losers" in the context of the enormous earnings of the fund managers. Its analagous to the high management fees of many managed equity mutual funds - the investors pay these fees and are the "losers".

"Hedge funds are not investment vehicles, they are compensation vehicles."

rockH
Yeah, I knew the 2 20 thing, I just assumed they made a lot of profit for that 1 billion, good point. I guess it is possible they just had 50 billion dollar funds and broke even?
grumel
Posts: 1629
Joined: Fri Mar 30, 2007 1:38 am
Location: Germany

Post by grumel »

Its hard to determine if they did beat the market on a risc adjusted basis. I mean how are you suposed to measure all that strange risks they take. However i am confident to say without any knowledge about hedgefonds or all the math to measure risk, that they wont outperform on after cost basis for their investors with that insane fees :(.
Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb »

I would state that the expected outcome, of owning individual stocks long term, versus a passive index portfolio, is below market returns achievable by passive indexing. Unless you can hold enough to achieve the diversification and risk limitation of an index, while keeping low fees like and index, which is impossible to do right? One fee for an ETF of 500 shares, versus 500 fees, or 100 fees, or 15 fees or whatever to try to achieve the same result.

ergo screwed : )

The expected outcome, of choosing individual stocks, and holding long term, is to NOT beat the passive indexers, and that to me is a losing proposition.
I don't want to derail this conversation, but I think it is important to clarify when individual stocks are unwise and when they aren't.

The expected outcome of holding individual stocks - for the long term - is the same as the market. It is higher than an index fund since you don't face the annual Expense Ratio. If you hold stocks passively, you have no annual costs.

Where I agree with you is that the typical individual stock portfolio is too small to achieve adequate diversification. This means your expected volatility is higher than an index. But your expected return is nonetheless higher. Whether the volatility is worth the lower ER is the issue, and for the vast majority of investors it isn't worth it.

Best wishes.
Andy
User avatar
Random Musings
Posts: 5908
Joined: Thu Feb 22, 2007 4:24 pm
Location: Pennsylvania

Post by Random Musings »

LH,

The only thing you have to know about hedge funds is not to invest in one - after the "managers" skim off the top, you are left with T-bill like returns in the aggregate.

I'm not into subsidizing scam artists for a "chance" to outperform a T-bill - but I guess there are billions of dollars chasing those dreams.

RM
Valuethinker
Posts: 42150
Joined: Fri May 11, 2007 11:07 am

Re: Hedge Fund Billionaires: where does this money come from

Post by Valuethinker »

LH wrote:http://www.nytimes.com/2007/04/24/busin ... wanted=all


If its not a negative number:

1) who is footing the bill?
0r
2) are they somehow creating wealth? If so how.
or
3)a combination of 1+2, if so, whats the relative combination?

thanks for your help,

LH

1. the client

2. 200 basis points + 20% performance fee is enough to generate a billion dollars of fee income, on a decent sized fund

The effect of this is, of course, to tilt HF managers to take bigger risks (because they get such a large chunk of the upside, and the client takes the downside).

There *are* I believe, people who can outperform, sustainably. I just don't see how the average individual investor can make money on those terms.

If I were doing hedge funds now I would be focusing on turnaround/ distressed debt investors. There is a real smashup coming in the credit markets, and good distressed investors should do well.

Investing in HFs to get exposure to ordinary equities seems like a mugg's game, but in the case of specialised asset classes it might be worth a punt.
User avatar
stratton
Posts: 11083
Joined: Sun Mar 04, 2007 5:05 pm
Location: Puget Sound

Post by stratton »

There *are* I believe, people who can outperform, sustainably. I just don't see how the average individual investor can make money on those terms.
Compared to mutual funds hedge funds apparently don't have to deal with as many SEC regulations. That alone could give them a leg up. I imagine David Swensen has similar benefits since he runs a private endowment fund.

Paul
Valuethinker
Posts: 42150
Joined: Fri May 11, 2007 11:07 am

Post by Valuethinker »

stratton wrote:
There *are* I believe, people who can outperform, sustainably. I just don't see how the average individual investor can make money on those terms.
Compared to mutual funds hedge funds apparently don't have to deal with as many SEC regulations. That alone could give them a leg up. I imagine David Swensen has similar benefits since he runs a private endowment fund.

Paul
Hedge funds can be very creative with their strategies. Low or few SEC rules means lower costs.

But for the individual contracting with a hedge fund manager, I don't see how '2 and 20' can really work for the investor (as opposed to the manager), in the long run. You really have to be betting that the HF manager can *keep* outperforming by c. 30% pa, to justify both the management cost and the performance fee.
jaybard
Posts: 48
Joined: Tue Apr 17, 2007 9:54 am
Location: Bellevue, WA

It’s all about ACCESS

Post by jaybard »

This is a good discussion thread. I will just add my 2c..

Hedge fund compensation structure and lose regulation attracts the best money manager who can consistently beating market. I envy people who have access to such manager but will I be jumping in for any hedge fund manager (or wannabe) I can have access to? No! Average guy like me have chance to access to or knowing how to evaluate manager

I like Larry’s explanation active trader make money by taking advantage from other active traders. So I guess if only 10% of all HF managers are making all the profit, than the other 90% of the HF managers (and their investor) are paying for it.
-Jay 8
User avatar
drjdpowell
Posts: 882
Joined: Thu Mar 01, 2007 8:56 pm

Post by drjdpowell »

LH wrote:
drjdpowell wrote:
LH wrote:The market is pretty efficient, and its hard/near impossible to succeed at that, thus people who index get a free ride so to speak, on the efforts of others in the market looking for inefficiences, who actually get screwed for thier efforts (me buying individual stocks long term, average managed mutual fund long term with higher costs) and LOSE money, for making the market efficient on aggregate.
Market efficiency means that being "smart money" that profits from finding pricing "errors" is a very competitive business. Indexers, and anyone else who trades without "smart money" insight, is effectively a "customer" of the "smart money industry". Competition keeps our costs very low, but we indexers are getting no "free ride". Every time we trade, we pay. Nor is the "smart money" that keeps the market efficient losing money (wouldn't be very smart). They make money. However, there are far too many people claiming to be "smart money" for more than a small fraction to actually BE what they claim/believe.

-- James
I do not think we actually disagree. Yes, we do pay fees. Perhaps if I used "free lunch" it would help? Either concept though, free ride or free lunch, I do not think anyone ever maintains thats its entirely free, just that one is recieving a benefit with someone else paying some of the cost, a misnomer perhaps, but a standard/accepted one?
No, we are disagreeing. Indexers do not receive any benefit that is being paid for by anyone else.
"In economics, collective bargaining, psychology and political science, free riders are actors who consume more than their fair share of a resource"
Indexers are not "free riding". We pay fair market value when we trade. Fair market value happens to be rather small, but it is there. Note that this has nothing to do with "fees". We don't pay the smart money through fees. We pay by "buying hi" and "selling low" to the smart money.
I think right now, passive indexors benefit from all the active mutual funds, and active traders, trading in and out of things and losing money relative to passive indexing approach.
Most active mutual funds are likely just churning. This doesn't help us.
I would posit, that if indexors constituted near 100 percent, we would relatively suffer in our returns.
True. But this statement is similar to the fact that we'd all starve if no-one was a farmer. It doesn't mean we are currently getting free lunchs from farmers.
I think we in fact do get some free return from the efforts and trading and fees paid by others who in trying to beat the market(and failing on averge) keep the market efficient for us.
I think there are two groups, those who make money as traders and those who are fooling themselves (or are making money of those who are fooling themselves). We indexers pay the first group and outperform the second because we aren't wasting money.

-- James
User avatar
BigBird
Posts: 305
Joined: Tue Feb 27, 2007 6:19 pm
Location: A Big Nest

Post by BigBird »

Wagnerjb wrote:Gus Sauter of Vanguard has publicly stated that he believes traders (hedge funds and others) take advantage of index funds through front-running the index changes. He estimates the S&P500 index fund loses 0.25% annually to front-running. I don't know about the other indices.

In this sense, the hedge funds gain at the expense of index investors. A more passive fund - like DFA funds - may suffer little or no front running loss.
Out of curiousity, what is the ballpark size (in $) of such a 0.25% loss to the S&P500 index fund? Why would the DFA funds not suffer this loss?
BB
User avatar
Topic Author
LH
Posts: 5490
Joined: Wed Mar 14, 2007 2:54 am

Post by LH »

drjdpowell wrote: No, we are disagreeing. Indexers do not receive any benefit that is being paid for by anyone else.
"In economics, collective bargaining, psychology and political science, free riders are actors who consume more than their fair share of a resource"
Indexers are not "free riding". We pay fair market value when we trade. Fair market value happens to be rather small, but it is there. Note that this has nothing to do with "fees". We don't pay the smart money through fees. We pay by "buying hi" and "selling low" to the smart money.
I would posit, that if indexors constituted near 100 percent, we would relatively suffer in our returns.
True. But this statement is similar to the fact that we'd all starve if no-one was a farmer. It doesn't mean we are currently getting free lunchs from farmers.
"Indexers do not receive any benefit that is being paid for by anyone else."

You are right, we do disagree : )

The fact that one has a cost, does not mean anything to whether one is getting a free ride, as free ride is defined. Yeah, we pay some fees. Thats irrelevant, the issue is whether we get a benefit, without covering the cost of that benefit.

Passive indexing depends on non passive indexors to maintain an efficient market. The people who do maintain the efficient market are not benefiting from doing so, they are on aggregate, losing. Passive investors on aggregate are winning/beating the active investors due to cost of active investing, ie, attempting to respond to market information.

When any company, posts information, an efficient market via its active traders, instantly adjusts. When it adjusts, the market players that adjust and keep the market efficient incur costs in excess of what passive investors do, they therefore, lose, compared to passive investors.

Passive investors, do NOTHING, and incur no costs, when an individual company posts information. The list usually remains unchanged. We do not contribute to maintaining the efficient market pricing we depend upon for passive investing to work, but we get the benefit from it nonetheless.

Thats a free ride. Thats the whole basis of passive investing, free riding off active investors who incur the cost of maintaining the nice efficient market for us, where we can be complete morons in a ben graham sense, buy a silly list of stocks based on market cap usually, brilliant stuff, completely ignore every fundamental aspect of every company long term, and have it come out in our favor.

Thats a beautiful thing.

It is about fees.

There are transaction costs to maintaining an efficient market. When IBM announces earnings, and the stock market efficient prices it in (either before, anticipating the earnings, or after if its "surprised") the price changes. That change in price has a COST in transaction fees that we do not bear.

If the market was all passive investors, it would be, IBM announces it is likely going out of business, in other news, just like the last 50 years, IBM is unchanged at 60 dollars, as it is still on the list of 500 biggest companies, or is still a member of the TSM.

I am not watching IBM, I am babbling on this board, and hold a diversified portfolio of the entire world, including some IBM. The only reason my percentage holding in IBM will change, is if by incurring transaction costs/fees etc, the active traders MAKE it change, thus making the market efficient.
Valuethinker
Posts: 42150
Joined: Fri May 11, 2007 11:07 am

Post by Valuethinker »

BigBird wrote:
Wagnerjb wrote:Gus Sauter of Vanguard has publicly stated that he believes traders (hedge funds and others) take advantage of index funds through front-running the index changes. He estimates the S&P500 index fund loses 0.25% annually to front-running. I don't know about the other indices.

In this sense, the hedge funds gain at the expense of index investors. A more passive fund - like DFA funds - may suffer little or no front running loss.
Out of curiousity, what is the ballpark size (in $) of such a 0.25% loss to the S&P500 index fund? Why would the DFA funds not suffer this loss?
On the first question I have no idea, but about 40% of institutional money follows indexed strategies. That's a lot of money which could be exposed to this.

ON the second question, I think it is the case that DFA don't directly index against the S&P500, so they don't suffer the promotion/demotion bias problem.

The problem has gotten sufficiently bad as to call into question the utility of exact replication strategies. A degree of active management, such as anticipating future promotion and demotion candidates (ie behaving like a hedge fund) seems to be necessary.

Another way of avoiding this is to hold as much of the index as you can. HFs find it difficult to acquire and trade very small cap stocks, so the promotion/demotion problem shouldn't be severe.
Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb »

BigBird wrote:
Wagnerjb wrote:Gus Sauter of Vanguard has publicly stated that he believes traders (hedge funds and others) take advantage of index funds through front-running the index changes. He estimates the S&P500 index fund loses 0.25% annually to front-running. I don't know about the other indices.

In this sense, the hedge funds gain at the expense of index investors. A more passive fund - like DFA funds - may suffer little or no front running loss.
Out of curiousity, what is the ballpark size (in $) of such a 0.25% loss to the S&P500 index fund? Why would the DFA funds not suffer this loss?
the Vanguard 500 fund has $125 billion in assets, so that would mean $312 million for Vanguard alone. Don't forget that all S&P500 index funds suffer from this front running.

DFA considers their funds "asset class" funds rather than index funds. They try to buy all companies in an asset class regardless of whether they are included in an index or not. The hedge funds will buy company ABC if they feel it will be added to the index soon, and they will sell it when the index adds the company. The hedge fund's short-term gain is a loss for the index investors. On the other hand, DFA owned company ABC all along.

Hope this helps.
Andy
User avatar
Karl
Posts: 1074
Joined: Sun May 13, 2007 5:52 pm
Location: Milwaukee, WI

Post by Karl »

Some folks complain that the rich have it all and the little guy gets a raw deal.

Luckily there are hedge funds to even the score. They make sure the rich get taken advantage of too! For a half million or more you can join an exclusive club where you get to pay 2% + 20% of profits. Golly, what fun. This proves that it is possible to be both rich & stupid at the same time.
User avatar
drjdpowell
Posts: 882
Joined: Thu Mar 01, 2007 8:56 pm

Post by drjdpowell »

LH wrote:"Indexers do not receive any benefit that is being paid for by anyone else."

You are right, we do disagree : )

The fact that one has a cost, does not mean anything to whether one is getting a free ride, as free ride is defined. Yeah, we pay some fees. Thats irrelevant, the issue is whether we get a benefit, without covering the cost of that benefit.
Fees are not the issue. Every time we indexers trade (and we do have to trade sometime) we have to offer a price that is attractive enough for someone, somewhere to balance our trade (supply must always equal demand). We cannot but and sell at the same price. This spread, which could be no more than the bid-ask spread but could also be larger, represents a cost to us and a profit to the smart money that makes the market efficient.
Passive indexing depends on non passive indexors to maintain an efficient market. The people who do maintain the efficient market are not benefiting from doing so, they are on aggregate, losing. Passive investors on aggregate are winning/beating the active investors due to cost of active investing, ie, attempting to respond to market information.
There is no reason to believe that those who make the market efficient aren't making considerable profits in doing so. Certainly the proprietary trading of investment banks are known to be consistantly profitable. The typical "active investor" is underperforming because the typical active investor isn't competative.
When any company, posts information, an efficient market via its active traders, instantly adjusts. When it adjusts, the market players that adjust and keep the market efficient incur costs in excess of what passive investors do, they therefore, lose, compared to passive investors.

Passive investors, do NOTHING, and incur no costs, when an individual company posts information. The list usually remains unchanged. We do not contribute to maintaining the efficient market pricing we depend upon for passive investing to work, but we get the benefit from it nonetheless.
Only the prices on your own trades matter. Only the people deciding to trade just after the new information care how fast it is encorporated. Smart money only trades to the extent that they can profit.
Thats a free ride. Thats the whole basis of passive investing, free riding off active investors who incur the cost of maintaining the nice efficient market for us, where we can be complete morons in a ben graham sense, buy a silly list of stocks based on market cap usually, brilliant stuff, completely ignore every fundamental aspect of every company long term, and have it come out in our favor.
I disagree. The basis of "passive" investing is allowing free competition in a state-of-the-art industry to provide me a good "product" at a low price. It's the same basis used for most acquiring products. Take these computers that we are communicating through, for example. I suspect you did not build your own computer from scratch. Nor do you care about the technical details of how it works. The only difference with investing is that few people believe they can profitably make computers, but many people believe that can "market time" or "stock pick" or whatever. Passive investors leave active trading to the profesionals, and benefit from the results, but don't think you aren't paying for the service.

-- James
Post Reply