The Rise of Passive Investing - Are we missing something?

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diligentinvestor1994
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The Rise of Passive Investing - Are we missing something?

Post by diligentinvestor1994 »

The world is going passive when it comes to investing. The percentage of assets in a passive index trackers vs active funds is growing every year. The reason I mention this. Does anyone see any dangers with this?

One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital. As most trackers are Cap-weighted.

Another things I can think of might be volatility. 20 years ago, we indexers, could rise above any down trends knowing we’ll outlive the downs (those silly people selling all their assets, we would think). But if the majority of assets are under the “passive” investment umbrella and if we assume a proportion of those investors will always sell when the market drops, are we in danger of rising volatility levels.
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22twain
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Re: The Rise of Passive Investing - Are we missing something?

Post by 22twain »

This has been discussed here many times. To see some examples, enter "what if everybody indexed" in the search box at the top of this page.

Executive summary: if the proportion of active traders in the total market were to decrease enough that the market became inefficient, new active traders would appear, hoping to take advantage of those inefficiencies.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Boglegrappler »

One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital.
The level of capital available to companies today is unprecedented. And I'm talking about smaller companies that are not public yet, and might never be. There may be things to worry about concerning passive investing, but smaller companies being shut out of the funding process isn't one of them. I think a more concerning phenomenon is that the availability of private capital results in the high growth returns going to private capital. In decades past, companies had to go public to access large amounts of equity. Today that's not the case.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Valuethinker »

diligentinvestor1994 wrote: Mon Nov 19, 2018 8:44 am The world is going passive when it comes to investing. The percentage of assets in a passive index trackers vs active funds is growing every year. The reason I mention this. Does anyone see any dangers with this?

One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital. As most trackers are Cap-weighted.
That does not follow. If a company is in the index and it raises new equity, the index fund has to buy that equity.

A greater danger is simply the IPO problem - IPOs tend to underperform post first day premium. Investing in IPOs is a right tail investment strategy - on average it's a loser but every so often you get a Microsoft or a Google. But the IPO problem is now widely known. In simple terms of how investment banking works, it's hard to see a world where IPOs are not underpriced, an underpricing which accrues to the bookrunner and its clients, mostly (the whole syndicated, but the lead/ bookrunner typically gets 60% of the revenues of the IPO). At least no one, to my knowledge, has successfully created an IPO process which would still incentivize investment banks to do the heavy lifting bringing it to market (but which is still a very profitable business) and the institutions to underwrite the issue. Google tried, and it didn't work. Conversely you had the debacle that was the Facebook IPO due to the interaction of the cosy club of IPOs with SEC blackout rules.
Another things I can think of might be volatility. 20 years ago, we indexers, could rise above any down trends knowing we’ll outlive the downs (those silly people selling all their assets, we would think). But if the majority of assets are under the “passive” investment umbrella and if we assume a proportion of those investors will always sell when the market drops, are we in danger of rising volatility levels.
It's a huge assumption. That behaviour of investors is somehow changed, adversely, by increased use of index funds.

Index investing has been around for 50 years in institutional investing, and has been very significant since the 1980s. I don't think that has shown a lot of evidence that it has caused worse problems with destabilized markets. Almost by definition, index investing is not a crowded trade.

The risk is much more present than that. Momentum has become A FACTOR. And a lot of "smart beta" is being run based on momentum. That risks some serious distortions in capital markets. Thinking "bonfire of the Quants" in August 2007 distortions (that was the small cap value effect leading to a crowded trade).
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Re: The Rise of Passive Investing - Are we missing something?

Post by Valuethinker »

Boglegrappler wrote: Mon Nov 19, 2018 9:10 am
One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital.
The level of capital available to companies today is unprecedented. And I'm talking about smaller companies that are not public yet, and might never be. There may be things to worry about concerning passive investing, but smaller companies being shut out of the funding process isn't one of them. I think a more concerning phenomenon is that the availability of private capital results in the high growth returns going to private capital. In decades past, companies had to go public to access large amounts of equity. Today that's not the case.
I tend to agree.

However I have seen some pretty disturbing numbers on the number of early stage companies getting funded.

So late stage VC is awash with money (I am thinking Uber has raised upwards of $10bn so far?).

But early stage, which is the seedcorn of the whole industry, is struggling. The economics of managing VC money (more money per exec = higher profits for the VC firm, but there's a fundamental limit to the number of deals and portfolio cos a VC partner can manage) are driving the industry into ever larger deals.

A related problem is that the people who run the big tech cos have all been to business school, have all studied Clay Christensen and Disruptive Innovation.

Thus Google Facebook (Amazon, Apple?) acquire early stage companies privately, thus potentially strangling their innovations. WhatsAp went to FB for a price which at the time seemed unimaginable (but became imaginable as user takeup kept growing). Instagram. Lots of private deals which are never announced.

These corporate leaders know what happened to previous generations' monopolistic providers, and they are determined to prevent it. They are the John D Rockefellers of their generation. And that could stifle innovation.

Tim Wu has written a new book on this. Tim Wu's books are all amazing, but serious reads, this one looks to be more condensed.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Tamalak »

It's a good question and one worth revisiting. History is full of examples of the dangers of bandwagoning and like it or not, index investing is a bandwagon right now, big time.

Others have already mentioned that there's no problem with the loss of active investors. We always had way more active investors than was needed for price discovery, and the financial rewards for successful price discovery are so good that there's no danger of a shortage.

What does concern me as possible issues:

1) The buy and hold philosophy takes hold enough that stocks 'feel' safer to people, leading to higher prices/PE ratios than are rational.

2) The prices of stocks and (safe, short term) bonds get inflated since they're the typical components of a boglehead-y asset allocation, while other sources of income - long-term bonds, junk bonds, REITs, private equity as examples - get undervalued.

3) The world changes quickly these days. It may be that the way value is created will change as well. Will index investors be flexible enough to change?

The old joke about passive investors is that a passive investor and his buddy are walking down the street, and see a $100 on the ground. "Wow! Let's get it!" says the buddy. "No, it's a fake bill", replies the passive investor, "if it were real, someone would have picked it up already."
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Re: The Rise of Passive Investing - Are we missing something?

Post by arcticpineapplecorp. »

diligentinvestor1994 wrote: Mon Nov 19, 2018 8:44 am Another things I can think of might be volatility. 20 years ago, we indexers, could rise above any down trends knowing we’ll outlive the downs (those silly people selling all their assets, we would think). But if the majority of assets are under the “passive” investment umbrella and if we assume a proportion of those investors will always sell when the market drops, are we in danger of rising volatility levels.
the market has always been volatile. people just forgot that because volatility was "lower" the past couple of years than "average".

I don't see how passive indexing makes this any different than if people owned the stocks in the index individually. For instance, if people want to jump like lemmings (I know, it's a myth) they can and will just as easily do that owning individual stocks as indexes. Indexing doesn't change that or make it worse.

If you're concerned about volatility, then you'd make sure to have other assets that are not as volatile...i.e., bonds.

Volatility can help you as an investor because you want more opportunities to buy the market when it becomes cheaper. But it obviously can hurt you as a retiree...that's the reason you would want a less volatile, i.e. a more conservative, rather than aggressive portfolio...one which holds more bonds.

Nothing about any of this has to do with passive vs. active though. It's more about what level of volatility are you willing to accept at different stages of your life or based on your time horizon for when you plan to spend the money.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Random Musings »

Human nature and the want to "win" will continue the active investing game. In the end, a few active investors will beat passive and that is what is touted. The strong majority that lose to passive investing is really the story.

Even during bear markets, active investing doesn't always pan out. And a lot of those funds have cash as part of their asset base which you would think would act as a buffer. Here is a study by Vanguard (that was before the 2008 bear market). 50/50 for active vs passive.

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Re: The Rise of Passive Investing - Are we missing something?

Post by nisiprius »

diligentinvestor1994 wrote: Mon Nov 19, 2018 8:44 am The world is going passive when it comes to investing. The percentage of assets in a passive index trackers vs active funds is growing every year. The reason I mention this. Does anyone see any dangers with this?
Yes, it gets mentioned all the time. It's a standard talking point against index funds. It's also bogus.
One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital. As most trackers are Cap-weighted.
No, think, think. A small company doesn't need as much capital as a big one, so it's not a problem that an index allocates less to it.

The big mistake people make is in missing the seemingly obvious point: an index investor, when buying stocks and temporarily removing them from the market, doesn't change the mixture of stock left behind. A small-cap value investor removes small-cap value stocks and leave the market with relatively fewer small-caps in it, creating a scarcity small-cap value stocks. If taken sufficiently far, theoretically this would drive up the price of small-cap value stocks and make them good investments than before; in any case, it affects the market.

An index investor leaves the composition of the market unchanged. Indexing is the only investing strategy that does this. Therefore, index investing is the only investing strategy that cannot result in "overgrazing" or a "crowded trade."

The only bad effect indexing has on the stock market is to remove a supply of potential patsies who might otherwise be available as prey for the predators. This is indeed bad for the predatory segment of the investing industry.
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Re: The Rise of Passive Investing - Are we missing something?

Post by alpine_boglehead »

nisiprius wrote: Mon Nov 19, 2018 12:31 pm
An index investor leaves the composition of the market unchanged. Indexing is the only investing strategy that does this. Therefore, index investing is the only investing strategy that cannot result in "overgrazing" or a "crowded trade."
That's a fascinating thought.

The only "overgrazing" which still can occur would be of stocks relative to other asset classes.
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Re: The Rise of Passive Investing - Are we missing something?

Post by 2015 »

Sure are missing something. Missing that it's been shown repeatedly--and I do mean repeatedly--that investors are markedly more likely to trip over themselves based on their own behavior than on anything happening outside of them. Investors will trip over their own shoe laces studying (and acting on!) the navel of investing long before anything like the rise of passive investing ever becomes a threat.
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Re: The Rise of Passive Investing - Are we missing something?

Post by TigerNest »

To add some numbers to this, passive management in the US went from 13% of the market in 2001 to around 38% in 2017. A majority of investing remains active.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Nate79 »

What did the other 50,000 threads on this subject miss that this thread is supposed to enlighten?
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Re: The Rise of Passive Investing - Are we missing something?

Post by AlohaJoe »

arcticpineapplecorp. wrote: Mon Nov 19, 2018 9:49 am
diligentinvestor1994 wrote: Mon Nov 19, 2018 8:44 am Another things I can think of might be volatility. 20 years ago, we indexers, could rise above any down trends knowing we’ll outlive the downs (those silly people selling all their assets, we would think). But if the majority of assets are under the “passive” investment umbrella and if we assume a proportion of those investors will always sell when the market drops, are we in danger of rising volatility levels.
the market has always been volatile. people just forgot that because volatility was "lower" the past couple of years than "average".
Ironically the simultaneous explosion in index funds AUM and the historically low volatility over that same period is somehow used to make the case that increased index fund AUM will result in higher volatility.
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Re: The Rise of Passive Investing - Are we missing something?

Post by AlohaJoe »

TigerNest wrote: Mon Nov 19, 2018 8:29 pm To add some numbers to this, passive management in the US went from 13% of the market in 2001 to around 38% in 2017. A majority of investing remains active.
Ironically, most money is almost certainly already in passive management and has been that way for probably a decade or two with no noticeable ill-effects. Something like 70% of all active funds are "closet indexers", meaning they have a low active share, invest like index funds, but charge high fees.
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Re: The Rise of Passive Investing - Are we missing something?

Post by Phineas J. Whoopee »

The only something we're missing is that the active-management salespeople who tell us we're missing something aren't sure where next month's boat payment is coming from.
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Re: The Rise of Passive Investing - Are we missing something?

Post by TVD »

diligentinvestor1994 wrote: Mon Nov 19, 2018 8:44 am The world is going passive when it comes to investing. The percentage of assets in a passive index trackers vs active funds is growing every year. The reason I mention this. Does anyone see any dangers with this?

One thing I might imagine is that if the market becomes more reliant on passive investing, smaller companies might find it hard to find capital. As most trackers are Cap-weighted.

Another things I can think of might be volatility. 20 years ago, we indexers, could rise above any down trends knowing we’ll outlive the downs (those silly people selling all their assets, we would think). But if the majority of assets are under the “passive” investment umbrella and if we assume a proportion of those investors will always sell when the market drops, are we in danger of rising volatility levels.
With 3 million stock indexes covering 40 thousand publically available companies, what could possibly go wrong?

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Re: The Rise of Passive Investing - Are we missing something?

Post by TigerNest »

AlohaJoe wrote: Mon Nov 19, 2018 9:27 pm
TigerNest wrote: Mon Nov 19, 2018 8:29 pm To add some numbers to this, passive management in the US went from 13% of the market in 2001 to around 38% in 2017. A majority of investing remains active.
Ironically, most money is almost certainly already in passive management and has been that way for probably a decade or two with no noticeable ill-effects. Something like 70% of all active funds are "closet indexers", meaning they have a low active share, invest like index funds, but charge high fees.
Yes. On the flip side, some of those passive investments are likely used in active strategies. Active managers use passive ETFs for trading strategies, getting exposure to certain sectors, hedging etc.
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