Larry Swedroe: New Passive Criticism Fails

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incognito_man
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Re: Larry Swedroe: New Passive Criticism Fails

Post by incognito_man » Wed Sep 13, 2017 8:30 pm

In this theoretical exchange, count me in the group that doesn't think the 'passive' market (everyone but Buffet and Soros) would/could trade directly with Buffett or Soros with one caveat: they (B & S) must have somewhat recently made the trade among themselves to set the price. i.e. B sells S Stock X for $1, 3 days later B sells Stock X to passive fund Joe for $1.01

Otherwise, passive fund Joe would only trade with passive fund Hank using prices recently set by trades between B & S. Without some recent benchmark price (set between an active buyer AND an active seller), passive funds wouldn't be able to know what price to trade at.

In other words, any trades that are made between any two parties that aren't both B & S must be made at the last traded price between B & S. The (efficient) market price necessitates both an active (read: educated) buyer and seller.

Or maybe I am just rambling to entertain myself now.

JBTX
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Re: Larry Swedroe: New Passive Criricism Fails

Post by JBTX » Wed Sep 13, 2017 8:39 pm

avalpert wrote:
Wed Sep 13, 2017 8:28 pm

It is true that the passive funds are (trying to at least) mirror the total performance of the index they are covering, and that does mean they will (should) have the same before-fee returns as all actively traded dollars. That isn't the same thing though as saying they are mirroring active trades - which is what your mistaken hypothetical had them doing.

I'm not saying they mirror all active trades. I am saying the mirror the net impact of all the collective trades. In any given day there may be a gazillion trades on stock x by active funds. The net of all that activity leads to the market weights of all the stocks, which is what the index tracks. The index is not tracking trades, they are tracking the net result of the trades.


No, what is getting me up in a wad is that you keep msicharacterizing the mechanics of passive index funds. The market price adjusts automatically when a trade is made (at least for valuation purposes in mark-to-market securities, which is what we are dealing with here) - no passive fund needs to take any action just because an active trader reduces their shares by selling, the market price adjusts and there proportional ownership of the security stays the same - this is true even if all active investors sell all their shares, passive funds still do not need to take any action to maintain their proportional ownership of the market cap.
I totally understand and agree with all of that, and have never said otherwise. My one problem with what I bolded - if all active investors wanted to sell their shares, ultimately they have to have another active investor to sell them to. On a net basis, active investors can't completely dump all their holdings of stock X to passive investors, because passive investors will ultimately by definition hold the sum total of what the total market>>active investors do, and passive investors can't hold X if no active investors do.

I am hoping we are converging here.....

avalpert
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Re: Larry Swedroe: New Passive Criticism Fails

Post by avalpert » Wed Sep 13, 2017 8:45 pm

incognito_man wrote:
Wed Sep 13, 2017 8:30 pm
In this theoretical exchange, count me in the group that doesn't think the 'passive' market (everyone but Buffet and Soros) would/could trade directly with Buffett or Soros with one caveat: they (B & S) must have somewhat recently made the trade among themselves to set the price. i.e. B sells S Stock X for $1, 3 days later B sells Stock X to passive fund Joe for $1.01

Otherwise, passive fund Joe would only trade with passive fund Hank using prices recently set by trades between B & S. Without some recent benchmark price (set between an active buyer AND an active seller), passive funds wouldn't be able to know what price to trade at.

In other words, any trades that are made between any two parties that aren't both B & S must be made at the last traded price between B & S. The (efficient) market price necessitates both an active (read: educated) buyer and seller.

Or maybe I am just rambling to entertain myself now.
I think what you are getting at is a different theoretical problem - what price do market orders execute at in a market without current bids/asks, the answer may not be the last trade price.

But even that isn't necessarily relevant to the question of what happens in a world of nearly only passive investors. Index funds need not limit themselves to market orders - and even today they don't. There goal is to best rack the index performance, various trading strategies may help them do that including using limit orders - they would not set bids/asks based on a view on fundamental value but based on a projection of what price will help them best track the market (and in a market where only passive funds are trading with each other they may very well conclude that is the last trade price and each set limit orders at that price).
Last edited by avalpert on Wed Sep 13, 2017 8:47 pm, edited 1 time in total.

JBTX
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Re: Larry Swedroe: New Passive Criticism Fails

Post by JBTX » Wed Sep 13, 2017 8:46 pm

incognito_man wrote:
Wed Sep 13, 2017 8:30 pm
In this theoretical exchange, count me in the group that doesn't think the 'passive' market (everyone but Buffet and Soros) would/could trade directly with Buffett or Soros with one caveat: they (B & S) must have somewhat recently made the trade among themselves to set the price. i.e. B sells S Stock X for $1, 3 days later B sells Stock X to passive fund Joe for $1.01

Otherwise, passive fund Joe would only trade with passive fund Hank using prices recently set by trades between B & S. Without some recent benchmark price (set between an active buyer AND an active seller), passive funds wouldn't be able to know what price to trade at.

In other words, any trades that are made between any two parties that aren't both B & S must be made at the last traded price between B & S. The (efficient) market price necessitates both an active (read: educated) buyer and seller.

Or maybe I am just rambling to entertain myself now.
:sharebeer

I think what you are articulating, like me (not so successfully in my case) is an exaggerated example of the theoretical inefficiency caused by a shrinking number of active traders vs passive traders.

incognito_man
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Re: Larry Swedroe: New Passive Criticism Fails

Post by incognito_man » Wed Sep 13, 2017 9:07 pm

avalpert wrote:
Wed Sep 13, 2017 8:45 pm
I think what you are getting at is a different theoretical problem - what price do market orders execute at in a market without current bids/asks, the answer may not be the last trade price.

But even that isn't necessarily relevant to the question of what happens in a world of nearly only passive investors. Index funds need not limit themselves to market orders - and even today they don't. There goal is to best rack the index performance, various trading strategies may help them do that including using limit orders - they would not set bids/asks based on a view on fundamental value but based on a projection of what price will help them best track the market (and in a market where only passive funds are trading with each other they may very well conclude that is the last trade price and each set limit orders at that price).
What is the "index performance"? Is it not the educated delta of valuation of the companies made by 'active' traders? If that delta doesn't exist (no trades between B & S on some stock or collection of stocks) what is the 'performance'?

Also, if the last trade price is the benchmark, without an active investor figuring something out to change that price/value, isn't the expected market return necessarily 0?

incognito_man
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Re: Larry Swedroe: New Passive Criticism Fails

Post by incognito_man » Wed Sep 13, 2017 9:09 pm

JBTX wrote:
Wed Sep 13, 2017 8:46 pm

:sharebeer

I think what you are articulating, like me (not so successfully in my case) is an exaggerated example of the theoretical inefficiency caused by a shrinking number of active traders vs passive traders.
I'm also in the group that thinks this is a purely fantastical journey as arbitrage opportunities will exist, be discovered, and be executed before we even come close to realizing a critical mass of indexers. :D

avalpert
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Re: Larry Swedroe: New Passive Criticism Fails

Post by avalpert » Wed Sep 13, 2017 9:17 pm

incognito_man wrote:
Wed Sep 13, 2017 9:07 pm
avalpert wrote:
Wed Sep 13, 2017 8:45 pm
I think what you are getting at is a different theoretical problem - what price do market orders execute at in a market without current bids/asks, the answer may not be the last trade price.

But even that isn't necessarily relevant to the question of what happens in a world of nearly only passive investors. Index funds need not limit themselves to market orders - and even today they don't. There goal is to best rack the index performance, various trading strategies may help them do that including using limit orders - they would not set bids/asks based on a view on fundamental value but based on a projection of what price will help them best track the market (and in a market where only passive funds are trading with each other they may very well conclude that is the last trade price and each set limit orders at that price).
What is the "index performance"?
The index performance is the gain/loss of the index holdings at their determined weights. Those gains/losses may or may not be driven by valuation considerations of active traders.
Also, if the last trade price is the benchmark, without an active investor figuring something out to change that price/value, isn't the expected market return necessarily 0?
Benchmarks are valued based on the 'closing price' of the holdings. If the only traders in the market are two passive funds that need to exchange holding to meet net inflows/outflows their price will set the index value for that day. No active investors needed. Just because active investors aren't arguing over the valuation doesn't mean it doesn't have expected growth.

JBTX
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Re: Larry Swedroe: New Passive Criticism Fails

Post by JBTX » Wed Sep 13, 2017 9:24 pm

incognito_man wrote:
Wed Sep 13, 2017 9:09 pm
JBTX wrote:
Wed Sep 13, 2017 8:46 pm

:sharebeer

I think what you are articulating, like me (not so successfully in my case) is an exaggerated example of the theoretical inefficiency caused by a shrinking number of active traders vs passive traders.
I'm also in the group that thinks this is a purely fantastical journey as arbitrage opportunities will exist, be discovered, and be executed before we even come close to realizing a critical mass of indexers. :D
Agree. I am not too worried about it. It is an interesting thing to ponder, but the market and investors will adapt one way or other.

All of these technological - trading changes just keep making indexing the best play for average investors. The whole controversy about front-running program trading, to the extent it is material is one more reason not to actively and frequently trade and just instead follow the market as a whole.

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TD2626
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Re: Larry Swedroe: New Passive Criticism Fails

Post by TD2626 » Thu Sep 14, 2017 12:16 am

First, it is worth noting that many on this board keep a portion of their portfolios in active funds (such as Wellington/Wellesley/Dodge & Cox/Primecap/etc) and a few even have individual stocks. Some of these folks do not intend to ever sell these positions - so if they don't, then the market won't go to 100% passive in our lifetimes. The idea that it will reach 100% is an academic exercise.

Second, analogies are helpful here (as Nisiprius mentioned earlier). Relatively few will drive miles out of their way to save a small amount on gas, but the few who do keep market prices efficient. Few will go from grocery to grocery to find the cheapest gallon of milk, but the few who do keep the market price efficient. Few will go from bank to bank looking for the best interest rate, but the few who do keep rates competitive. Only a small percentage of people need to be "active" for passive to work. It's why you don't need to check every time you go to the grocery to make sure you aren't about to pay $52 for a gallon of milk - the price will pretty much always be competitive (for the product at the same type of large supermarket). Similarly, in general even in a very passive world, no one will pay 200 times what a stock is clearly (and foreseeably) worth given all available information - because active traders set prices. Maybe things will be a bit less efficient, and maybe that will make volatility in the markets slightly higher. But even with high levels of passive in the market, there's probably no cause for alarm.

There may be reasons to invest a portion of the portfolio in active. While I feel that most investors should have most of their portfolios in passive, there are arguments to be made for being in 5-30% low cost, broadly diversified active funds. As is suggested in "The Arithmetic of Active Management" by Sharpe, it may be possible for the average professionally-managed active dollar to beat the average passively managed dollar. This would occur if the universe of actively managed dollars is divided into professionally-managed and individually-managed. The average active dollar (professionally-managed and individually-managed) must have equal performance before costs to the passive dollar. If individual investors in individual stocks underperform by a large amount, then the professional managers would by simple arithmetic outperform in order for the total weighted performance of the active dollars was equal to the passive dollar's performance. Of course, the active alpha must be larger than costs for this to pay off - and for 1% ER funds, it's nowhere close. Individual stock investors are a small portion of the market, and they probably don't cause all that many enormous inefficiencies that can be exploited. My previous calculations are here: viewtopic.php?f=10&t=218393&p=3359852#p3359852, and here: viewtopic.php?f=10&t=221271&p=3418174#p3410527). It is in general very difficult to justify an investment in a 0.5%+ ER fund, and it is virtually never justifiable to chase returns or have a short-term focus in active funds.

However, if one wanted to have a small portion (<30%) in a diversified set of active funds (which would likely need to have a <0.5% ER, and very preferably have a <0.2% ER), then this likely wouldn't have a too large of an expected impact over decades, either positive or negative, on the portfolio so long as the active funds are broadly-diversified, and bought-and-held for decades. 100% 60/40 TSM/Total International/Total Bond vs 90% three fund + 10% total split between {Wellington/STAR/Wellesley/other similar funds} would probably have similar performance (tracking error may be substantial, even on the order of several percent, and there are no guarantees. Active risk is a risk above and beyond passive risk and should only be contemplated by knowledgeable investors who have the willingness/ability/need to take the risk. Those who (inadvisably) chase returns over short periods are speculating and will likely lose to the index.

The added complexity of active may not be worth it for those who desire simplicity, also. For many, if not most, an index-based three fund or target date/target risk portfolio is reasonable and consistent with the Boglehead philosophy.

Basically, the only investors that I would see considering active, in my opinion, are those with legacy active funds with accumulated capital gains, those with poor 401k options, and those who desire an active allocation, have a high complexity tolerance, and believe that they have the knowledge, experience, and ability to identify an outperforming broadly-diversified, buy-and-hold active fund investment strategy. Other than that, few would even consider active.

I agree that the criticism of passive late is getting weaker and weaker. The SPIVA scorecards are real evidence - and active managers aren't refuting it. Many active managers are likely grasping at straws trying to protect their livelihoods. However, their livelihoods depend on doing pointless work (there is in my opinion an excess of price discovery effort in this country, so many of those doing price discovery are wasting their time) and charging investors for it.

People need to realize the power and intellectual sophistication of passive investing. It's likely the only investment strategy that can have such heavy adoption (40-70% of the markets being passive depending on market/country) with no major issues so far. Imagine if everyone wanted to put 70% of their portfolios in Small Value - or (gasp) momentum? That would likely cause serious issues. The mechanics of cap weighting, though help protect against such issues. Market cap weighted index funds are a brilliant vehicle for allowing everyone to have their fair share of the market's returns - without the costs of price discovery. Again, I feel that most investors should have most of their long-term portfolios in low-cost, buy-and-hold, broadly diversified passive index funds, in a portfolio based on the well-known https://www.bogleheads.org/wiki/Lazy_portfolios (especially the Three-fund portfolio). Risk and risk tolerance must be carefully considered and based on willingness/ability/need.

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