
Dear Hedge Funds: Index Funds Didn’t Eat Your Returns - wslh
http://www.pragcap.com/dear-hedge-funds-index-funds-didnt-eat-your-returns/
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entee
Index funds are by all evidence the better choice for the average individual,
but they present something of a chicken and egg problem.

To set the price of the index, you need people buying and selling individual
stocks. If everyone owned index funds, there would be no index. What is the
percentage of the market owned/run by index funds where the premise of
following an index starts to break down?

The article says we haven't reached it, and that at that point active
management approaches will regain an upper hand. Still, I wonder if it's true
and the broader question remains.

~~~
shoo
this is a somewhat obvious comment, but the notion of "an average individual"
and "everyone" is very different.

some people can specialise in price discovery as their occupation, and some
people can specialise in growing sweet potato, or teaching kids, or nursing,
or what have you. the former person can spend their time and energy learning
how to pick stocks by hand, and influence the market, and the latter people
can spend their time and energy learning and doing other useful things, and
they can invest in index funds.

Here's a completely different angle of attack:

suppose I believe that the market doesn't price things correctly, and that
some countries/sectors/companies are over valued, and some are under valued.
in general, for some arbitrary set of of unpopular beliefs, there isn't an
index fund I can buy into that is a good approximation of my beliefs. Even
worse, it probably isn't possible for me to build a portfolio by linearly
combining different index funds to approximate my desired portfolio
allocation.

For example, suppose I want to invest in countries A,B,C,D,E and sectors
U,V,W,X,Y,Z subject to ethical constraints K and L.

It may be the case that for each of the countries I can buy an A-country-ETF,
and a B-country-ETF, and a global-sector-U-ETF, and a global-ethical-K-ETF,
and for large countries I may even be able to buy a country-C-sector-X-ETF,
but I can't make a good approximation of my desired portfolio by adding linear
combinations of these things together.

I don't really want to buy an canned portfolio in the form of an ETF, I want
to buy a custom portfolio, or a custom portfolio factory, say.

But perhaps part of the success of ETFs for non-expert folk like me is that
they'd prevent me from expressing my strange individual beliefs about the
market (which will probably result in worse investment outcomes for me than if
I just did something mainstream).

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Ntrails
Assume that average individual represents people who have jobs unrelated to
analysing companies/markets and therefore are managing their money in spare
time only.

To me stock picking on the basis that you know better than the market is
largely hubris. Most of the people I know who do it don't do any meaningful
benchmarking so it's impossible to properly assess success. When the market
goes up they made money (yaaay - I picked well) but when they lost money it's
because the market went down (nothing I can do in the face of that).

There are a decent number of people manually investing their pension and I
genuinely think some proper requirements on reporting would be valuable for
them.

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paulpauper
The rise of indexing parallels the cutthroat, winner-take -all nature of the
post-2008 stock market and economy where winners like Google, Amazon, Visa,
and Facebook, for example, are bid higher and higher to no end and companies
that show slightest weakness are culled quickly. Even blue chips are not
immune to this. Walmart stock crashed 30% in 2015 in an otherwise flat market
due to some minor weakness in store sales. In the 80's and the 90's, large
funds were more willing to put money in sub-par stocks & sectors, investing
indiscriminately, but post-2008 capitalism has gotten much smarter and
discriminating. That means lots of losing stocks and few winners, leaving
investors with one of three choices: be lucky or skilled enough choose the
handful of winning stocks, choose index funds, or choose active management,
the latter which tries to beat the first two but almost always fails and has
really high fees. The second choice is the most viable.

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randomname2
Hedge fund Nevsky Capital called it quits about a month ago (and this is a
fund with historically stellar performance). Their "goodbye letter" [1] does
an excellent job at spelling out some of the reasons hedge funds are a less
attractive proposition lately.

[1] [https://www.scribd.com/mobile/doc/294654490/Nevsky-
Newslette...](https://www.scribd.com/mobile/doc/294654490/Nevsky-
Newsletter-151231)

~~~
vonklaus
Interesting. Markets are totally broken but I hadn't seen any legitimate
players acknowledge that yet, good find. While the main argument in favor of
HFT is providing liquidity, there really isn't a situation where a 'real'
investor needs liquidity at the microsecond level.

Solid private companies refuse to go public not on boarding the typical mix of
innovators/new companies on an exchange.

Companies have much shorter lifespans.

and a massive amount of other factors, I can't do justice to on a 48hr sleep
deficit. My personal thesis, we are in a huge bubble. Tech, while certainly
overvalued, is possibly the _least_ out of whack with a true underlying value
(to the degree that even exists).

Signs of this are everywhere. It isn't a terrible thing I don't think, but an
average investor might not make much money in the market if they started
putting money in now.

~~~
kasey_junk
> Markets are totally broken but I hadn't seen any legitimate players
> acknowledge that yet

That is one way to read the letter. Another way to see it is that technical
innovation has provided much cheaper ways to capture the value the hedge fund
previously provided. Between index funds that are a cheap way to capture macro
gains and and algo funds as a cheap way to capture micro gains there just
isn't a reason to pay a hedge fund manager his 2 & 20\. I for one am _glad_
about this, because that hedge fund managers profit came largely out of _my_
(or some aggregate person much like me) pocket.

> HFT is providing liquidity, there really isn't a situation where a 'real'
> investor needs liquidity at the microsecond level

This is a common misstatement of the liquidity argument for HFT market makers.
The correct way to frame it is that HFT market makers can provide liquidity
cheaper for a variety of factors:

1) cheaper infrastructure as it is much cheaper to get a machine at an
exchange than a person in a pit.

2) more efficient quoting as a computer can quote thousands of markets while a
person can quote a half dozen.

3) less risk which is the crux of the argument for speed. To a market maker
(HFT or otherwise) the risk they are trying mitigate is the risk presented by
hedge funds and other large block orderers. Those large blocks will move the
price of the market (that is in fact how the large block orderer captures
profit, the information imbalance they have at the beginning of the order
compared to the end). Historically some of that profit came out of the market
makers pocket, so they had to price every trade higher to account for it. It
has always been a cat and mouse game between market makers and hedge funds.
Now HFT is better at recognizing and reacting to these large block orders
meaning the market maker can price less risk into all of their quotes.

> an average investor might not make much money in the market if they started
> putting money in now.

One of the very nice things about our markets is that they will actually
reward you handsomely if you take that opinion and turn it into action.

------
kgwgk
Matt Levine's take on Bill Ackman vs index funds:
[http://www.bloombergview.com/articles/2016-01-27/bill-
ackman...](http://www.bloombergview.com/articles/2016-01-27/bill-ackman-runs-
an-anti-index-fund)

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randomfool
Maybe Bill Ackman should not have invested such a high percent of his hedge
fund into a un-ethical price-gouging pharmaceutical company (Valeant).

~~~
tristanj
That's not a fair criticism. At the time they invested, Valeant posted
impressive financials with strong growth potential. Investors had no clue
about the fraud occurring within the company. It was very rational to invest
at that time. I don't think it's fair to say it's his fault for believing
someone else's fraud.

~~~
mseebach
One of the things hedge funds do to justify their high management fees, is to
research the companies they invest in very deeply, definitely deeper than
looking at financials, often meeting with management.

~~~
dsr_
A dozen or so years ago I got a call from what turned out to be Michael Dell's
wealth managers. They wanted to interview me about my recent ex-employer.

Clearly their research goes much deeper than reading over the 10Q forms and
annual reports.

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cm2187
The solution would be larger indices referenced by ETF, so that passive
investors would buy pretty much "the whole market" and not just a subset of
stocks that would end up being overpurchased.

But a smaller index has one important benefit, which as an ETF investor is key
to me. I do not believe in the ability of a randomly picked asset manager to
outperform the market (and I have no way to pick one any other way). An index
selects stocks by just one criteria: the market capitalisation. So it will be
selling stocks that are on the way down and buying stocks on the way up (as
they become big/small enough to enter/exit the index).

Very simple investment rule and good enough in my opinion. This strategy comes
with a "tax": hedge funds are watching stocks about to get in or out of an
index and front-run the expected flow of ETF buyers and sellers, which means I
leave some money on the table. That's the tax I pay for being a lazy investor.

