
Index Investing Makes Markets and Economies More Efficient (2016) - songeater
http://www.philosophicaleconomics.com/2016/05/passive/
======
cft
I always thought that the role of the stock market is the collective
intelligence of a large pool of investors, that allocates resources to the
most effective or highest performing businesses. Index investing is a blunt
instrument that does not allow investors to resource-allocate on the fine-
grained individual business level. In the best case, it's more like the Soviet
central planning, where a handful of people selecting which stocks comprise an
index do most of the financial planning. In the worst case, it causes bubbles-
the only decision power there is buy/sell , the detailed microeconomic
information about individual businesses is almost irrelevant to the investors.

~~~
olau
I've been thinking the same. Are there any consumer-oriented products that
lets you pick your own index?

As in: you select the stocks and their proportion and supply the money/demand
money out, and stocks are then bought/sold automatically?

Say I want to follow index X, but I don't want stocks in oil or coal companies
because I believe they're going to die before I need the money out. There
doesn't seem to me to be an easy way to build that customized index.

I guess you need a low-fee stock broker and an algorithm that's aware of the
fees for this to not end up drowning in fees.

~~~
jopsen
Robinhood let's you trade for free, and quantopian.com provides a python based
platform for automated trading with support for robinhood.

Have fun,

~~~
digikata
How are they sustaining that free trading? If it's on VC money, then I worry
what exactly happens to shares if the firm shuts down. Who is actually holding
the shares becomes a critical question in that circumstance.

Edit: I see a $110M Series C in April '17 reported for Robinhood.

~~~
mi100hael
You can pay like $10 a month for their "Gold" offering. Gets you margin (which
also nets them some money) & after-hours trading.

~~~
paulpauper
Except for margin trading, robinhood is a great deal. Many of these regular
discount brokers are committing high way robbery in terms of the fees. TC
Ameritrade is the worst in this regard. I hope robbinhood puts them out of
business or at least takes away a large chunk of their market share.

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lend000
This could not be more wrong and it's discouraging to see it on the front page
of HN -- index investing exerts a normalizing pressure on the prices of
assets, which is rarely supported by the underlying values of the companies.

This is unlikely to be a popular opinion amongst passive investors, but day
traders and market makers are responsible for making economies for efficient
and providing price discovery (if they make profits) by reducing the spread
and reducing volatility. Traders who lose money have the opposite effect --
they make assets more volatile by pushing up tops and pushing down bottoms.

Active long term value investors also contribute to positive price discovery
and reduce volatility (if they make money) for the same reasons, but on a
different time scale.

~~~
pishpash
Passive investors were not going to make the market more efficient anyway
since they are not informative. They carry only one piece of information which
is that they have some money to invest into the economy and would be okay to
take some risk, and they express that well enough through a passive financial
product reproducing what the financial industry itself calls the "market
returns." They of course do care to make some money; nobody is in it to lose
money, so how are they making the market less efficient? It's not that
different from saving the money in a bank for the bank to allocate.

Now, if the passive investment flow comes to dominate volume on any given day,
then the "marginal" trade becomes a passive, uninformative one; then we have a
problem.

~~~
lend000
They aren't making the market less efficient, because index funds create value
for many people for the reasons you described. The market inefficiency is
easily corrected by day traders and market makers.

I'm just saying that index funds do not make markets and economies more
efficient, as the article claims, so if we had a 99% ownership tied up in
index funds scenario, markets would indeed be far less liquid and more
volatile.

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fallingfrog
This guy is making all kinds of assumptions to get his results that can't
possibly be true. On a first read it looks like he's assuming:

Stocks in the passive investment category stay that way forever- they are
_never_ sold at any price.

Money never enters or leaves the stock market

Companies never issue or buy back stock.

I mean with bat __ __crazy assumptions like these, you can come up with any
conclusions you want!

~~~
fallingfrog
For one thing: as soon as the price of an asset drops far enough in the
_active_ market, all those people in the passive market holding the stock are
going transition from "passive" to "active" in a _hurry_. So that breaks the
assumption set right there: passive stocks are never truly passive.

~~~
kgwgk
What do you mean? An ETF tracking the S&P 500, for example, is not going to
sell a stock no matter how much does it drop (until it gets excluded from the
index, of course).

~~~
fallingfrog
People can sell their shares of the ETF, and as you say, stocks can get
excluded from an index.

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cs702
The OP defines an "efficient" market as one in which active investors cannot
consistently outperform the average by selectively picking individual
securities. In this regard, the OP is absolutely right that index investing is
making markets "efficient," because active and passive managers, when
considered as two distinct aggregate groups, must necessarily earn the same
average return before fees, expenses, and frictional costs.

HOWEVER, that doesn't necessarily mean the growth of index investing makes
markets more _accurate_ at pricing securities.

There's NO evidence of that.

Maybe the growth of index investing is doing the opposite: making markets LESS
ACCURATE at pricing securities.

Indeed, by many measures, US stock prices are looking positively FROTHY these
days.[1][2][3]

[1] [https://www.nytimes.com/2017/09/15/business/stock-market-
mas...](https://www.nytimes.com/2017/09/15/business/stock-market-mass-
psychology.html)

[2] [https://www.nytimes.com/2017/06/29/business/stock-market-
val...](https://www.nytimes.com/2017/06/29/business/stock-market-value-
trump.html?mcubz=1)

[3] [http://time.com/money/4943479/wall-street-prediction-
stock-m...](http://time.com/money/4943479/wall-street-prediction-stock-market-
downturn/)

~~~
bandrami
What is the "accurate" price of a security, particularly if it does not pay a
dividend? And what good is achieved by that price being found?

~~~
cs702
Pricing is more accurate when it's closer to the net present value of the
profits that could be taken out of the business by a person "who buys it for
keeps," to paraphrase J. M. Keynes.

The more accurate a market is at pricing securities, the less severe the
magnitude of bubbles and subsequent crashes. Bubbles are extreme examples of
overoptimistic pricing.

To be clear, I do NOT know if index funds are causing pricing to be less, or
more, accurate. I don't think anyone else knows either.

That said, it seems to me that (1) the ongoing mass-scale removal of
intelligence from the investment process is unlikely to make pricing more
accurate, and (2) these days, stock prices are looking frothy by many measures
(e.g., Shiller CAPE).

~~~
bandrami
I'm still missing something here. A stock is an instrument of potential income
and control, but I've never seen a price that was anywhere close to correlated
with that. In fact, if anything there seems to be a discount given to high-
dividend stocks (for which I, as an income investor, am grateful to all you
baseball card traders that I don't understand).

To put it another way: the actual _value_ of a no-dividend no-vote stock is
precisely zero. The _price_ is whatever the buyer and seller agree on, right?
So how can one price be more "accurate" than another?

~~~
kshitijl
In the event of liquidation, shareholders are on the list of those owed a
portion of the proceeds. In fact they are last on the list, after creditors
(those who have loaned the company money directly), bondholders (bonds are a
form of debt), and holders of preferred stock.

That right is the ultimate determinant of the value of a no-dividend no-vote
stock: fractional ownership of the right to proceeds in the event of
liquidation, after those above have had theirs.

As a higher-risk asset, it produces greater returns, since otherwise there is
an arbitrage: buy bonds issued by the same company instead. This arbitrage
lasts until the bond becomes "expensive", and therefore produces worse returns
(since its payout is independent of its price).

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kolbe
Economists are always right within their own narrowly-defined models! Yes, if
you pre-define a set of securities that you will forever be limited to
exclusively trading, and divide two groups into passive (never makes another
trade again) and active (makes trades), the two groups will perform equally
(excluding fees).

Now, in the real world, there are several significant reasons why that model
model offers nothing but a fun little thought experiment.

~~~
mannykannot
This does look too contrived to be meaningful, but the author claims that it
is an example of a general rule identified by Fama and Sharpe:

"The aggregate performance of the active segment of a market will always equal
the aggregate performance of the passive segment." (before frictions like
trading costs and taxes are taken out.)

I hope those economists have a more sound basis for this claim than the author
gives here - assuming, of course, that the author of this article is not
misrepresenting or misinterpreting them. To take an extreme case, if all the
passive investment is in a single asset, I don't see how this could be, and an
issue with passive index investing is that it is in a limited set of assets.

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sethev
Ownership seems to get mixed up with efficient capital allocation in a lot of
discussions about this (referring to likely comments, not the article). For
index investing to work you only need a market that's "efficient enough in
aggregate". What you're actually purchasing is ownership of future economic
growth.

------
hellsten
For those interested in indexation, FRMO's Murray Stahl has published some
thought-provoking articles about indexation here:

[http://www.frmocorp.com/indexation.html](http://www.frmocorp.com/indexation.html)

 _In principle, the theory behind indexation is very much like the theory of
perfect competition. In perfect competition, the idea is that no participant
is sufficiently powerful or sufficiently large to influence the price of the
product. The product is assumed to be homogeneous, and shares are designed to
be homogeneous. In the theory of market efficiency, no one has an information
advantage over anyone else, and there is always enough liquidity. It seems
reasonable to make those assumptions. Yet, it is worth making some
observations about them._

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jyriand
I think the main reason someone chooses to invest money into index funds is
either they just want stable returns without too much hassle, or they believe
in efficient market theory that basically states that you can't beat the
market, so no point in even trying(and that's true for most of the mutual
funds). But looking at value investors, it seems you can consistently beat the
market.

Also, what bothers me about indexing, is that a lot of money is going into
same companies(S&P500). Look at any S&P500 companies Top Institutional Holders
and without a doubt Vanguard is on top(wild guess). Not sure what happens with
the price, when company is excluded from S&P500.

In conclusion, indexing is fun in the bull market, it's just you can't retire
in the recession years.

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cjlars
This assumption that passive investors have no cash inflows / outflows totally
breaks his model. As soon as passive investors start buying or selling the
index -- a real world necessity -- they are playing a zero sum game against a
counterparty. Specifically, active investors could sell overpriced stocks to
indexers and buy underpriced stocks from indexers, which in turn drives the
price discovery. This churn allows for active investors, as a group, to gain
alpha at the expense of indexers.

Piggybacking off the article's example: Suppose news breaks that Facebook has
made a catastrophic legal error which will result in them losing 50% of their
revenue over the next year. This is obvious to the active investors who
collectively decide to sell their Facebook shares, resulting in a fall in the
total value of the index equal to the drop in value for Facebook. In the time
it takes the old pre-news price to drop to the new post-news price, active
investors have, on net, sold Facebook and gone to cash and will have shared in
a relatively small portion of the crash, and passive investors will have
bought Facebook due to churn, or held Facebook as part of the index, resulting
in them absorbing a larger portion of the crash than active investors.

So how does this all fit into the "active managers don't earn their keep"
narrative? I think what we've seen is a long term drop in the alpha available
to the active share due to things like narrowing spreads, faster response to
new news, etc. So effectively active management is in a secular decline, which
allows for (1) bad results for active managers on net, and (2) failure of poor
performers and their removal from the market, and (3) continued real value
generation by the better and remaining active managers. So this idea of
conservation of alpha is also silliness because the market will always be
slightly oversaturated (net negative value for money managers) or
undersaturated (net positive value for money managers).

If you doubt this, read Ben Graham's the "Intelligent Investor" \-- In 1949 he
thought it was quite easy (EASY!) for an average Joe to earn outsized returns
with a little stock research (and I think history proved him right until at
least the late '70s).

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paulpauper
_It’s important to remember, here, that secondary market trading and investing
is a zero-sum game for the participants. For a given market participant to
outperform, some other market participant has to underperform. Obviously, for
a market participant with a given level of skill, the ease at which that
participant will outperform will be a function of the quantity of unskilled
participants that are there for the skilled participant to exploit. To the
extent that the prevalence of indexing preferentially reduces that quantity,
it makes outperformance more difficult._

That is a myth that refuses to die.

Market makers and liquidity providers enter into neutral trades so it doesn't
matter which way the market goes..they make money from the spread and churn.
Just because you made $40k from being long Google doesn't mean some schmuck
lost $40k.

 _Eventually, indexing comes around to disrupt the industry. Of the 500,000
individuals that were previously managing funds, 499,500 go out of business,
with their customers choosing the passive option instead. The remaining
500–which are the absolute cream of the crop–continue to compete with each
other for profit, setting prices for the overall market._

Indexing has been around for a long time now, but active mgmt has had a
terrible time and is actually getting worse in recent years, against the
author's thesis that passive investing is supposed to create a small pool of
'superstars'.

~~~
dforrestwilson
[http://www.investopedia.com/terms/o/opportunitycost.asp](http://www.investopedia.com/terms/o/opportunitycost.asp)

Some schmuck sort of did. The market makers and liquidity providers are not
the source of the sold stock, simply intermediaries.

"is actually getting worse in recent years, against the author's thesis that
passive investing is supposed to create a small pool of 'superstars'."

This is a huge point of contention. Capital takes a long time to flow out of
mutual and hedge funds which have been underperforming. It could be many years
yet before any "superstars" emerge.

~~~
paulpauper
I mean as in a P&L statement. If I sold a bitcoin at $1 in 2010 did I lose
$4000? no but I may regret it. If someone short sold it, then it would be a
$4000 loss.

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skdjksjdksjdk
Quick Question: Why is efficiency a desired outcome in markets? Or is it just
a natural outcome of competing players?

~~~
yellowstuff
The core social benefit of financial markets is to get capital to where it can
be used most productively. This is why Google could get funding in 1998 and
why Venezuela can't today.

~~~
bandrami
What did Google's initial funding have to do with the securities market?

~~~
tacostakohashi
The angels / VCs that funded it did so with the knowledge that they'd be able
to go public later and get their money back out. If there's no market for
selling equity in mature companies, there's less incentive for starting or
investing in small / growing companies.

~~~
bandrami
So, investors simply don't believe in the existence of income?

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jamez1
This is dumb, the point of the stock market is the return the stocks give you
in dividends etc. Here, he treats those returns as not being a factor, and as
stocks having no intrinsic value.

If they have no intrinsic value of course passive management makes sense!

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bcoates
Prices are set at the margin.

This article is concerned with the average skill of investors, an entirely
meaningless metric that determines nothing. The marginal investor determines
prices not the mean one.

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bandrami
Is efficiency a desired quality of a market?

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CoreXtreme
Investing in index is like subscribing for slavery. It only benefits people
with tons of money. Sure, it's less risky. But along with preventing massive
downside, it prevents massive upside too. I've just got 1 life, limited time
and I want to risk everything for a massive upside, not efficient market.

~~~
euyyn
I'd think investing all your money in playing the lottery opens up a much
bigger upside. Sure, it's more risky, but you've just got 1 life!

~~~
mfoy_
Wait... are you trying to tell me that scratch tickets aren't essentially the
same thing as stock certificates?

~~~
euyyn
I'm just saying, don't subscribe for slavery!

