What if the market is 100% passive?

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IcedTea
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What if the market is 100% passive?

Post by IcedTea »

Hi,

I was reflecting on my portfolio and I suppose it matches most of the users of this forum (passive etfs + cash or cash equivalents).

What would happen to the value of stocks if the market was 100% passive?
How would the etf know what stocks to buy/sell?
What % of the market needs to be passive for it to "stop working"?

Thanks everyone!
tibbitts
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Re: What if the market is 100% passive?

Post by tibbitts »

jcarlostsousa wrote: Mon May 04, 2020 11:14 am Hi,

I was reflecting on my portfolio and I suppose it matches most of the users of this forum (passive etfs + cash or cash equivalents).

What would happen to the value of stocks if the market was 100% passive?
How would the etf know what stocks to buy/sell?
What % of the market needs to be passive for it to "stop working"?

Thanks everyone!
This question has been asked here many times. The consensus reply seems to be that it's not something to worry about.
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Schlabba
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Re: What if the market is 100% passive?

Post by Schlabba »

tibbitts wrote: Mon May 04, 2020 11:20 am
jcarlostsousa wrote: Mon May 04, 2020 11:14 am Hi,

I was reflecting on my portfolio and I suppose it matches most of the users of this forum (passive etfs + cash or cash equivalents).

What would happen to the value of stocks if the market was 100% passive?
How would the etf know what stocks to buy/sell?
What % of the market needs to be passive for it to "stop working"?

Thanks everyone!
This question has been asked here many times. The consensus reply seems to be that it's not something to worry about.
I fully agree its not something to worry about.

Lets pretend the market is 100% passive. Now the news comes out that Volkswagen's profits will skyrocket because they invented cars that run on atmospheric CO2. You can now beat the market by selling some of your index fund and buying some more Volkswagen.
By doing that the market is no longer passive.
fwellimort
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Re: What if the market is 100% passive?

Post by fwellimort »

If market is 100% passive, then you will never see a price change in any stocks regardless of the news.

In other words... it isn't going to happen. There's just too much money to be made in this industry by the top active traders.
andrew99999
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Re: What if the market is 100% passive?

Post by andrew99999 »

tibbitts wrote: Mon May 04, 2020 11:20 am This question has been asked here many times. The consensus reply seems to be that it's not something to worry about.
It's not so much that it's the consensus, but that the idea itself is ridiculous.

As a higher and higher proportion of people move to index funds, there is less analysis of companies, so the indexing bubble idea is essentially that the market then becomes inefficient. For example, if Microsoft is overvalued and the whole world used index funds based on market cap weighted indices, then Microsoft would grow to be disproportionately higher than its fundamental value because nobody would actively underweight Microsoft shares relative to the market and drive down the share price.

Interestingly, this scenario would actually make it easier for active managers to outperform due to having more inefficiencies for them to exploit and make money from, so your first red flag should be to ask why on earth they are the ones complaining about the idea of an indexing bubble.

In reality, as the market becomes less efficient, more active managers would come in to exploit these inefficiencies which in turn makes the market more efficient again. There will always be this back and forth maintaining an equilibrium.

To believe the index bubble idea, you would have to believe that active funds would just see these opportunities in an inefficient market and not make money out of them, which is absurd.
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Re: What if the market is 100% passive?

Post by David Jay »

jcarlostsousa wrote: Mon May 04, 2020 11:14 amWhat % of the market needs to be passive for it to "stop working"?
Virtually all of it.

Market prices are not set by “holdings”, they are set by “trading”. As long as there are at least two traders in every stock, setting prices, the system continues to function. So 90+ percent could be index and the 5% or 10% being traded could set the prices.
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Re: What if the market is 100% passive?

Post by tetractys »

To have a market is to have trading. If all companies only have private stockholders, then there would be no public trading or market.
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David Jay
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Re: What if the market is 100% passive?

Post by David Jay »

andrew99999 wrote: Mon May 04, 2020 11:39 am Interestingly, this scenario would actually make it easier for active managers to outperform due to having more inefficiencies for them to exploit and make money from, so your first red flag should be to ask why on earth they are the ones complaining about the idea of an indexing bubble.

In reality, as the market becomes less efficient, more active managers would come in to exploit these inefficiencies which in turn makes the market more efficient again. There will always be this back and forth maintaining an equilibrium.

To believe the index bubble idea, you would have to believe that active funds would just see these opportunities in an inefficient market and not make money out of them, which is absurd.
While I agree with your argument, even your reply implies that assets are under the control of managers, but there will always be those who trade for their own accounts.

I was a stock-picker before I ran the numbers and saw that I was under-performing the SP500. On this topic I like to say that I will take a serious look at going back to stock picking when the SPIVA scorecard shows more than 50% of active managers are outperforming their respective indexes. That will indicate to me that there is “alpha” out there, waiting to be harvested.
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: What if the market is 100% passive?

Post by theorist »

David Jay wrote: Mon May 04, 2020 11:49 am
andrew99999 wrote: Mon May 04, 2020 11:39 am Interestingly, this scenario would actually make it easier for active managers to outperform due to having more inefficiencies for them to exploit and make money from, so your first red flag should be to ask why on earth they are the ones complaining about the idea of an indexing bubble.

In reality, as the market becomes less efficient, more active managers would come in to exploit these inefficiencies which in turn makes the market more efficient again. There will always be this back and forth maintaining an equilibrium.

To believe the index bubble idea, you would have to believe that active funds would just see these opportunities in an inefficient market and not make money out of them, which is absurd.
While I agree with your argument, even your reply implies that assets are under the control of managers, but there will always be those who trade for their own accounts.

I was a stock-picker before I ran the numbers and saw that I was under-performing the SP500. On this topic I like to say that I will take a serious look at going back to stock picking when the SPIVA scorecard shows more than 50% of active managers are outperforming their respective indexes. That will indicate to me that there is “alpha” out there, waiting to be harvested.
Given that index funds hold the market, the sum total of active managers also hold stocks at proportional to market cap. So there could be a time when more than 50% outperform, but only if the others underperform by even more so the net (before fees) is index-like. The active managers and other players always match the market, since the index funds don’t distort market weights in what they “take out.”
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Re: What if the market is 100% passive?

Post by nisiprius »

According to S&P, in 2019 less than 30% of actually managed large-cap mutual funds, using human judgement, valuation, fundamental analysis, price discovery, whatever, managed to outperform the S&P 500 index.

Image

Over the last five years, less than 20%. Less than 20%.

It sounds plausible to say that not all active managers can perform as well as the best, but that surely any good professional worth their salt can do better than average. But it hasn't been so. My personal belief is that they can perhaps eke out 0.50%/year in extra alpha through skill--but they take all of it and more out in fees.

My answer to your question is that we will know that indexing has grown too large when we begin to see five-year SPIVA numbers showing that at least half of actively managed funds are outperforming the index. That is, at least half of them are able to pay themselves (cover their costs) and also give the investor half a chance of doing as well as an index fund.

I don't think this will happen any time soon, and as soon as it does, people are going to quit buying index funds and the trend will end.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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IcedTea
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Re: What if the market is 100% passive?

Post by IcedTea »

Hi,

Thanks for all your replies.

If all funds are distributed equally by all managers and only 20% of active funds are able to beat the market, doesn't that mean that 80% of all money in the market is in allocated to non-optimal stocks and passive funds reproduce that non-optimal allocation?
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David Jay
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Re: What if the market is 100% passive?

Post by David Jay »

jcarlostsousa wrote: Mon May 04, 2020 3:47 pmIf all funds are distributed equally by all managers and only 20% of active funds are able to beat the market, doesn't that mean that 80% of all money in the market is in allocated to non-optimal stocks and passive funds reproduce that non-optimal allocation?
Passive funds and active funds, in aggregate, perform in a similar manner before expenses because they are both participating in the same market. Index funds have much lower expenses so they outperform active funds (again, in aggregate). This is a part of Nobel Laureate Bill Sharpe's point, at the link:
http://web.stanford.edu/~wfsharpe/art/t ... esting.htm
Last edited by David Jay on Mon May 04, 2020 3:53 pm, edited 1 time in total.
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arcticpineapplecorp.
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Re: What if the market is 100% passive?

Post by arcticpineapplecorp. »

David Jay wrote: Mon May 04, 2020 3:50 pm
jcarlostsousa wrote: Mon May 04, 2020 3:47 pm Hi,

Thanks for all your replies.

If all funds are distributed equally by all managers and only 20% of active funds are able to beat the market, doesn't that mean that 80% of all money in the market is in allocated to non-optimal stocks and passive funds reproduce that non-optimal allocation?
Passive funds and active funds, in aggregate, perform in a similar manner before expenses because they are both participating in the same market. Index funds have much lower expenses so they outperform active funds (again, in aggregate). This is Bill Sharpe's point.
and to the OP, you can read more about that here:
https://web.stanford.edu/~wfsharpe/art/ ... active.htm
It's "Stay" the course, not Stray the Course. Buy and Hold works. You should really try it sometime. Get a plan: www.bogleheads.org/wiki/Investment_policy_statement
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arcticpineapplecorp.
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Re: What if the market is 100% passive?

Post by arcticpineapplecorp. »

tibbitts wrote: Mon May 04, 2020 11:20 am
jcarlostsousa wrote: Mon May 04, 2020 11:14 am Hi,

I was reflecting on my portfolio and I suppose it matches most of the users of this forum (passive etfs + cash or cash equivalents).

What would happen to the value of stocks if the market was 100% passive?
How would the etf know what stocks to buy/sell?
What % of the market needs to be passive for it to "stop working"?

Thanks everyone!
This question has been asked here many times. The consensus reply seems to be that it's not something to worry about.
to the OP, it's been asked so many times you can read them all typing in your question in the search bar:

https://www.google.com/search?sitesearc ... ne+indexed

let google be your friend. (there are bogleheads posts on this subject on google that seem to run 14 pages of google links). happy reading!
It's "Stay" the course, not Stray the Course. Buy and Hold works. You should really try it sometime. Get a plan: www.bogleheads.org/wiki/Investment_policy_statement
whereskyle
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Re: What if the market is 100% passive?

Post by whereskyle »

jcarlostsousa wrote: Mon May 04, 2020 11:14 am Hi,

I was reflecting on my portfolio and I suppose it matches most of the users of this forum (passive etfs + cash or cash equivalents).

What would happen to the value of stocks if the market was 100% passive?
How would the etf know what stocks to buy/sell?
What % of the market needs to be passive for it to "stop working"?

Thanks everyone!
Also, assuming you fear everyone seeing the light and eventually embracing indexing, I think you might overestimate people's ability to properly judge their own abilities. Many young people are aware of indexing but think it's just for conservative old people. They'd rather bet on USO or inhalable vitamins or flying cars than embrace a long-term mindset. Seriously, one co-worker texted me in the last month to say his portfolio returned something like 4% on a single day. I told him the market returned 7% that day. Oh well. He still won't buy an index fund.

Bogleheads I think reasonably question why anyone would ever buy an individual stock. People generally tend to think of themselves as better than average, while Bogleheads embrace that this cannot be true. That's why so many refuse to settle for the market return, while Bogleheads see no better alternative.
"I am better off than he is – for he knows nothing and thinks that he knows. I neither know nor think that I know." - Socrates. "Nobody knows nothing." - Jack Bogle
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Re: What if the market is 100% passive?

Post by MarkBarb »

If passive investing gets so popular that it reduces the market's ability to price things efficiently, returns to active management should improve. So I wouldn't worry about it until you see active managers regularly outperforming passive managers. Of course, if that starts to happen, money will flow out of passive investments, making the market more efficient, and leading back to passive managers outperforming active managers after costs are considered.
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Re: What if the market is 100% passive?

Post by 272 Sheep »

Aren't Institutions and individual investors already actively trading passive ETFs?
Some at very high rates? I think many people are always trying to figure out ways
to beat the market and will use passive to do it, if they have to. I don't think you
have to worry about the lack of people to do the price discovery.
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Re: What if the market is 100% passive?

Post by dmcmahon »

David Jay wrote: Mon May 04, 2020 11:40 am
jcarlostsousa wrote: Mon May 04, 2020 11:14 amWhat % of the market needs to be passive for it to "stop working"?
Virtually all of it.

Market prices are not set by “holdings”, they are set by “trading”. As long as there are at least two traders in every stock, setting prices, the system continues to function. So 90+ percent could be index and the 5% or 10% being traded could set the prices.
I think two traders wouldn't be enough. In fact they could easily mislead the market to their advantage. There has to be a critical mass of traders and competition between them to provide an effective price-setting service.

This is why I refrain from disrespecting the traders or active managers on CNBC. Without their constant efforts, we wouldn't know a fair price for anything.
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Re: What if the market is 100% passive?

Post by IndexCore »

Treating "passive" as a monolith ignores differences in passive investing. Besides total stock market, some investors allocate small cap value index funds. Is someone buying passive index funds no longer a passive investor because they buy more small cap, more value, or both?

During a crisis, people panic and increase their cash or bond holdings - is someone who invests solely in passive index funds no longer a passive investor when they panic?

Regarding active market participants, price discovery (putting a price on each stock) doesn't require a certain percentage of assets. "The market", by assets, may be 99% passive - and those assets typically do nothing. Price discovery isn't so much about a percentage of assets, as the velocity of assets. Even 1% of the market by assets, changing hands all day long, could provide a lot of information about the value of stocks in the market.
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Re: What if the market is 100% passive?

Post by Swivelguy »

If 100% of all investors were index investors, then all shares of company stock could (as a thought experiment) be replaced by "index" shares. The price of an index share would be based on supply and demand for those shares, driven by the amount of cash flowing into the market from accumulators versus the amount flowing out to retirees. Dividends from all companies would be distributed equally among all holders of index shares. There would no longer be trades in specific companies to drive changes in the makeup of the index share, but that doesn't matter because it becomes materially irrelevant what the makeup is.
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Re: What if the market is 100% passive?

Post by SimpleGift »

jcarlostsousa wrote: Mon May 04, 2020 11:14 am What % of the market needs to be passive for it to "stop working"?
Just to clarify, it's not the percentage of passive market assets that matters for price discovery, it's the percent of active trading — and what's crucial is the difference in turnover ratios between active and passively assets.

To illustrate this point, the chart below assumes there are two categories of assets, active and passive, and the turnover ratio is 100% annually for active assets and 10% annually for passive assets (both conservative assumptions).
  • Image
    NOTE: Assumes active turnover is 100% annually and passive is 10%. Chart adapted from S&P-Dow Jones.
Under these assumptions, if half of the market is indexed (in red above), active managers will still be doing 91% of the trading. Indeed, if 90% of the market is indexed, active managers will still be doing 53% of the trading. This makes it unlikely that indexing will ever have a significant impact on market efficiency and price discovery.
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Re: What if the market is 100% passive?

Post by 272 Sheep »

SimpleGift wrote: Tue May 05, 2020 8:06 am
jcarlostsousa wrote: Mon May 04, 2020 11:14 am What % of the market needs to be passive for it to "stop working"?
Just to clarify, it's not the percentage of passive market assets that matters for price discovery, it's the percent of active trading — and what's crucial is the difference in turnover ratios between active and passively assets.

To illustrate this point, the chart below assumes there are two categories of assets, active and passive, and the turnover ratio is 100% annually for active assets and 10% annually for passive assets (both conservative assumptions).
  • Image
    NOTE: Assumes active turnover is 100% annually and passive is 10%. Chart adapted from S&P-Dow Jones.
Under these assumptions, if half of the market is indexed (in red above), active managers will still be doing 91% of the trading. Indeed, if 90% of the market is indexed, active managers will still be doing 53% of the trading. This makes it unlikely that indexing will ever have a significant impact on market efficiency and price discovery.
I hope this is right.
In the (21 years ago) past, I did much more than my individual fair share to help others get their price discovery. Despite the fact it had a practical nil effect on the market, I am now happy to be a free-rider and let other more than willing people to do it for me.
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David Jay
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Re: What if the market is 100% passive?

Post by David Jay »

dmcmahon wrote: Mon May 04, 2020 11:58 pm
David Jay wrote: Mon May 04, 2020 11:40 am
jcarlostsousa wrote: Mon May 04, 2020 11:14 amWhat % of the market needs to be passive for it to "stop working"?
Virtually all of it.

Market prices are not set by “holdings”, they are set by “trading”. As long as there are at least two traders in every stock, setting prices, the system continues to function. So 90+ percent could be index and the 5% or 10% being traded could set the prices.
I think two traders wouldn't be enough. In fact they could easily mislead the market to their advantage. There has to be a critical mass of traders and competition between them to provide an effective price-setting service.

This is why I refrain from disrespecting the traders or active managers on CNBC. Without their constant efforts, we wouldn't know a fair price for anything.
I did say “at least two” because two is the minimum number of parties to have a trade and thus a price. The system does not collapse.

(for the record, so we don’t go down any further down a rabbit hole, I am in favor of improved market efficiency)
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: What if the market is 100% passive?

Post by Independent George »

tibbitts wrote: Mon May 04, 2020 11:20 am This question has been asked here many times. The consensus reply seems to be that it's not something to worry about.
I'd amend that. I think it's something to worry about eventually, but not quite yet.

In theory, as more and more of the market becomes passive, inefficiency should increase to the point where active traders will do better. I do expect this to happen eventually, but I don't think it will follow a normal distribution, or be very transparent - I would expect a small number of traders to capture most of the gains, while also closing themselves off from new investments due to scalability issues. The rest would follow a normal distribution which roughly matches the market so that in total, active does beat passive in the aggregate, but (1) very few people will be able to access those 'winners', and (2) determining which funds will outperform in advance will remain as difficult as ever.
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IcedTea
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Re: What if the market is 100% passive?

Post by IcedTea »

Hi,

Thanks everyone for your input.

I'm 100% conviced that:
1) at present time an indexed strategy has higher probability of yielding higher returns that an active management strategy
2) active management does a significant higher number of trades (resulting in higher costs, which reduces net returns)

Most of you point seem to defend that the only reason for the market not to be 100% passive is "humans want to maximize returns" and therefore there will always be individuals will chase better returns and engage in active strategies. Not sure if that is so simple - why does the majority of people decide not to vote in elections, e.g. decide to be passive?

Personally I think that the market share of passive investment strategies will continue to increase and consequently the ability to influence pricing of whoever prefers active strategies will also increase. I see this as a risk for my portfolio which is suppose to last 60+ years (more if I consider inheritance ...).

PS: Thanks for these links
- https://web.stanford.edu/~wfsharpe/art/ ... active.htm
- http://web.stanford.edu/~wfsharpe/art/t ... esting.htm
- https://www.google.com/search?sitesearc ... ne+indexed
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Teriyaki
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Re: What if the market is 100% passive?

Post by Teriyaki »

I recommend you to check these four posts by Philosophical Economics:

http://www.philosophicaleconomics.com/2016/05/passive/
http://www.philosophicaleconomics.com/2016/05/followup/
http://www.philosophicaleconomics.com/2 ... ndexville/
http://www.philosophicaleconomics.com/2 ... iveactive/

They're quite long but I found them very interesting and his reasoning easy to follow.
Slowtraveler
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Re: What if the market is 100% passive?

Post by Slowtraveler »

The proposed situation would be amazing but impossible.

Imagine it's 100% passive. Company A is worth $100 now and has a $5 dividend with a 10% earnings yield. In 10 yesrs, let's say it has the same share price because nobody is buying more beyond the original proportion but it is now offering a $15 dividend and 30% earnings yield for a stable company. Many people would jump over and buy it since it becomes such an obvious buy.

Imagine Apple still had its share price from 20 years ago with the current earnings.

This won't happen. Trading is way too easy now.
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David Jay
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Re: What if the market is 100% passive?

Post by David Jay »

jcarlostsousa wrote: Wed May 06, 2020 8:52 amI see this as a risk for my portfolio...
I suppose everyone needs something to worry about...
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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