This is due to his "bigger and bigger crowds, same exits" analogy: individuals easily move through doors at will; but if a crowd rushes out through the same door, injuries happen.
His premise is that many stocks that index funds invest in have low liquidity (small door): half of stocks in SP500 trades less than $150M a day. This is tiny (he quotes total market cap of indices of $150 trillion). What happens if there is a small, but synchronized outflow for any reason? If customers ask for 1% of index funds to be sold, index funds have to sell 1% of their holdings in the exact ratios defined by the index, including stocks with low trading volumes. Which is a problem, as there may be no one to sell them to, so prices of those stocks may crash and create a big panic causing additional sales of index funds bringing down bigger chunks of the market.
That is the gist of it I think.
His point is that the index funds don't own the stocks at all; they trade derivatives like futures and CDO's that mimic the movement of the stocks in leveraged fashion, and the more people who dump their money into index funds without doing their own research, the more leveraged the funds become.
He's warning that in the next serious downturn, over-leverage may cause cascading collapse of index funds and the economy with them, like it did in the mortgage finance crisis.
This is misleading, I think. Depends on the fund. Some seek to match the benchmark through a certain exposure to derivatives and synthetic things. Others hold the stocks in proportion.
The vanguard funds I'm invested in don't have much synthetics - they own the stocks
What? Where did you see that? Not only do the index ETF issuers own the stock but I believe they are legally obligated to do so.
But, granting that Burry is right and you're interpreting him correctly, what is the average person with a couple bucks to invest supposed to do instead of passive investments?
Surely we can't recommend actively managed funds, funds that don't even earn back their fees. And, if not passive investing, and not actively managed funds, then…what, exactly?
As to institutionalizing this stability, it would be nice if index funds offered fund choices that prohibited selling or trading for one, two, three decades. Since you as the investor would be adding information to the market ("I'm not an index fund band-wagoner, I understand buy-and-hold and I will practice what I preach") you would be rewarded with better returns in exchange for signaling your intentions and acting as a cushion when everyone else is panicking.
In 2008, the crash happened because suddenly Wyle E. Coyote realized there was gravity when he ran off the cliff. Mortgages were actually defaulting on a very high rate, but people put blindfolds on and didn't want to see. It wasn't just a "psychological overreaction" but real fear and panic as those same investors were trying to squeeze through the same exit door as everyone else.
There is still some reasonable fear in 2019 that large financial institutions will choose to make money at the expense of the economy.
Panic is quite literally a psychological overreaction.
No strategy/advice last forever
There is no such thing as passive investing per se.
So instead of recommending fund, it's better to recommend them to learn of the fundamentals of investing instead.
Every study has shown that people do not get rewarded appropriately for the risk they take on when they move away from diversification.
Unfortunately it's not clear how to tell which fund managers would actually be able to succeed at this.
That's pretty interesting.
In 2019, the average daily trading volume of Berkshire Hathaway (class A) was 0.04% of the total shares outstanding. If all people that held this stock were forced to sell 1% of the total shares outstanding, look out!
On the other hand, Roku has averaged 15.6% this year, with a standard deviation of 10. 1% of total shares isn't even going to be noticed.
The SP500 has a long tail 150M on a 20B dollar company, which is the median, is 0.75% per day that’s quite a bit of motion normally but you expect volatility to go up on a major sell off.
Anyway, if 1% of all money is removed from index funds on the same day whatever caused that is also going to cause the market is going to crash and crash hard. It would take something like an outbreak of Ebola in NYC to get that kind of a reaction.
In the example you give, this should result in Berkshire Hathaway Class A to have a very small weight in an index fund weighted this way.
Looking at the holdings of VOO, as of July 31, 2019, It holds 806 shares of Berkshire Hathaway (Class A) (worth ~$249 million), but about 37 million shares of Class B, worth ~$7.6 billion.
Or maybe he's counting on their low volume? :-)
I'd like to point out that while this may be the case for traditional mutual funds, it is not for ETFs. ETFs don't redeem shares for cash they redeem them for equities in the underlying index. So ETFs don't actually buy or sell any securities unless they rebalance.
A) the standard lock-up period of a fund, or
B) an ETF under strong selling pressure can be halted by the exchange. Some contracts presumably allow an ETF manager to halt sales if high outflows and low liquidity? Certainly can occur with funds.
Day 1: (before crash) price : 200$ S&P 500 weight : 2%
Day 2 :next day market crashes. Acme is very low volume so price crashes to 1$ .
what happens next ? do all the EFT that follow S&P have to sell all ACME for 1$ because it is
not in the S&P 500 anymore.
Day 5 : ACME jump back to 200 $ and is back in the S&P 500.
So my question is what would have happen to a passive investor. if he bought 1000$ worth of ETF right before the crash. Will he still have a 1000$ dollars at the end of it .
Please show me a one day 99% drop on a stock. Trading would be halted well before that to prevent manipulation or errors.
LULD is the one that applies to single stocks. It only results in a five minute halt, as I said.
The market-wide circuit breaker can halt the entire market for a full day, but only in response to a 20% move in S&P500, not a single stock.
More info on the 10% trading halt rule: https://www.nasdaqtrader.com/Trader.aspx?id=TradeHalts
Index funds generally aren't super rigidly defined in terms of 1% Company A to 1 % Company B to 3% Company C, etc. which grants them leeway to precisely not have to sell off their assets in precise ratios to maintain a certain portfolio composition.
Index funds do not seek to perfectly replicate whatever sector/market they're seeking to index, but rather they are trying to approximately track the overall change. You can ignore portions of the market while still tracking it to a very close degree (i.e. sampling a distribution).
Indexes typically don't have a fixed set of underlying securities. CDOs do. Your index fund typically won't tank because one of it's holdings become unprofitable, the fund will adjust reducing shares of said fund and thus reducing risk.
That doesn't happen with a CDO. If you're AAA mortgage holder starts having financial troubles, you can't readjust the CDO to reduce exposure.
Take an S&P 500 index as an example. If company 500 starts having a crappy quarter and falls out, what happens to your index? You dump the old 500 for the new one.
This isn't too say they aren't without risk. Just that it is a completely different financial vehicle than a CDO. So different that trying to make comparisons isn't really prudent.
I share your understanding of the article, it’s not about “index bad active good”, it’s about, “is there a problem when a lot of investors have to move quickly”. I wonder if there is some analysis of this during the last crash.
Flash crash gets resolved quickly and is transparent to non-participants because there is a lot of money willing to buy on dips. But fast trading money only buys and sells what they perceive to be highly liquid assets -- there are few things that scare them more than being stuck with an open trade.
The scenario Burry describes is akin to CDO crash. Naively, most CDO assets were not problematic and many/most of the problem ones had an underlying asset of some value guaranteeing the debt. What caused the crash was lack of liquidity that started a vicious circle.
Index fund scenario could be similar: less liquid stocks that are big components of major indices would crash with unknown systematic consequences. Even if only 10% of passive index investors heads for the exits we could see broad, long term damage. And they could: pension funds have been investing huge sums into indices and a targeted PR / a few headlines of the type "look what those financiers doing with worker's money" may nudge a lot of money out of stocks.
On the other side, it is easy to make conspiracy theories on any subject.
And of course, that company can, subject only to it's own chosen limitations, "print" SPY shares and sell them. So there's never any shortage of those.
When people transact in SPY, the trades are satisfied from those buckets. The cash bucket for investors selling SPY, the reserve shares bucket for investors buying. Those buckets are then refilled by the firm behind SPY buying and selling shares so that their share reserve and cash reserve remain at useful levels.
But let's now say there's heavy selling, for whatever reason. Sells really exceed buys and ... the cash bucket runs dry. Well, now sales stop, potentially indefinitely. The company will try to refill that bucket quickly, but there's absolutely no guarantee they will succeed, and there's no timeframe. Because the price for redemptions is only determined when they refill the bucket, you have no control over when this price is determined. It could be days after your order went through. Most index funds also technically have the right to just suspend redemptions entirely, indefinitely. Because of the amount of money in index funds, this will exhaust liquidity on actual shares relatively quickly and the whole market will freeze (because: no buyers)
Burry's claim is that if this ever happens, and investors find themselves stuck in index funds with no way out, there is nothing that will resolve that situation. Buyers won't want in, because once in, no way out. Sellers will panic and REALLY want out. This situation will self-reinforce until the market is driven into the ground.
0. some random situation causes that sellers exceed buyers for an index fund enough to initially exhaust the liquidity buffer of that fund
1. liquidity buffer in an index fund is empty
2. because of this transactions in the index fund stop
3. this causes panic, meaning less buyers, more sellers
4. goto 1, with situation getting worse every iteration
It won't be a "flash" crash, you'll just be locked in your index funds until the crash is complete.
It's hard to argue that this situation is impossible, that it cannot develop. It also seems to me that his conclusion that if this ever happens, it'll self-reinforce is correct. That said, we are pretty far from this happening.
Even if one of the underlying stocks becomes illiquid, a big enough price divergence on all of the other liquid stocks would make it profitable to eat the loss or hold the illiquid ones (risky, but remember, there are many authorized participants competing with each other so if there is some way to make an easy arbitrage profit, they will find a way). You'd basically need the entire market to become illiquid.
Or, for that matter, a bank run?
SP500 is a market cap weighted index. That would alleviate some of this hypothetical problem, no?
It just won't happen, because there's a negative feedback loop against it, leading to a kind of homeostasis.
> At some point, no one is left to figure out which cookies are tasty vs meh, so the price of all cookies converge to a single price.
Five minutes later someone says: "Holy shit, I can make a ton of money by buying loads of cookies, sorting them, and re-selling them -- except with the definitely-tasty ones at a higher price."
I'm thinking specifically of attempts to artificially inflate crypto coin valuations for members, then quickly sell off before anyone catches on. Should be, I would think, impossible to do that across a large area of the market, but if everyone is investing in index funds, it might be, I would guess.
Nonetheless, for my situation, index funds are the best rational solution. That or hiding all my money under my mattress.
Except that there’s a lot of money to be made by figuring out which cookies are winners, and buying them cheaply to sell to the passive investors.
All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced. No matter what, they have an average distribution of cookie-quality in their holdings.
The passive investors are not buying cookies at any price other than the market price. Whatever the clever-cookie-buyer is paying for cookies, they're paying the same. If a clever-cookie-buyer buys low, takes out an ad in Cookie Magazine, and sells high to a bunch of tasty-cookie aficionados, the passive investors win, too. If a too-clever-cookie buyer buys low and discovers that the apparently-tasty cookies have spoiled, the passive investors lose a little, too.
It is hard to bilk a passive investor. The first people to really figure out how will accumulate a lot of money (and ire).
> All the passive investors want is for their cookies (and new-cookie acquisitions) to be properly priced.
No, they want the cookies they purchase to be under-priced, and consumed once their price has gone up. The cookie analogy fails here, but passive investors are exclusively seeking return, not an efficient market.
> No matter what, they have an average distribution of cookie-quality in their holdings.
That's not how passive investing works. The classic model is investment in an index -- say the FTSE 100 -- which attempts instead to maximize the quality of holdings, not the most accurately priced.
> It is hard to bilk a passive investor
Yes, but that doesn't mean it's hard to make money off one.
Jack Bogle's view was that if the market is 50%+ passive indexed that would be bad news.
Some folks argue that the number is even more extreme, that passive indexing generally increases efficiency, and that as long as there are even a handful of active investors, the market will still be efficient: http://www.philosophicaleconomics.com/2016/05/passive/
The same author had another thought-provoking argument that the popularity of indexing has probably driven up stock valuations: http://www.philosophicaleconomics.com/2017/04/diversificatio...
According to this source, it already is . HN discussion at the time .
In both cases the actual buyer is an intermediary, who is managing many people's money. Those people don't even know or care what is being invested in. If for some reason many of them decide to disinvest around the same time (say a recession) they may be hurting themselves due to the asymmetrical nature of the action.
At that point, an active investor can say that any losses by holding the stock an additional month would be eclipsed by selling immediately. A passive investment does not have that ability.
The evidence shows that most of us suck at investing. Further, I think Burry's critique is more limited:
> One reason he likes small-cap value stocks: they tend to be under-represented in passive funds.
IMHO, the problem he's stating is that people are focusing on large-cap companies. Basically the S&P500. And the S&P500 index funds probably do hold most of the passively invested money. But to solve this (small- vs large-cap focus), the solution is not to throw away passive investing, but to change the focus.
For example, instead of buying Vanguard's S&P500 fund (VOO), to buy their Total Market fund (VTI) which uses the CRSP U.S. Total Market Index:
Or perhaps a fund that uses the the Russell 3000 or Wilshire 5000.
It's just that the S&P (and DOW) have more name recognition.
But generally speaking, these decisions are micro-optimizations. Just put away a little every month and re-invest and dividends, and over the long-term you'll do well.
By this reasoning indexes focussing on small caps would be even worse than the more popular funds.
Bottom line - they look low risk until they’re absolutely not low risk because of these properties.
As an average investor I’d say diversify is still a good strategy. Don’t just do US Market index funds. Global stocks, bonds, and other small-cap stock collections might help hedge risk of large-caps going bust. Most passive-style funds also have these options. Not an active investor. Just a dude playing a dude disguised as another dude. This is not investment advice.
But when all the financial gurus are recommending investing in traditional securities (stocks and bonds), and millions of people wishing to get a leg up in life obey their advice, doesn't that turn the securities market in general into an "overhyped bubble"?
The market behavior and health of any investment, no matter how theoretically sound it is, will be strongly affected by investors' behavior around it. So the fact that index funds are popular (and thus perhaps inflated/overpriced) isn't a knock on the fundamental idea. It's merely an indication of a particular market situation at present.
Are there other factors like in the housing market of a decade+ ago? Is there a lot of risk for Joe Six-Pack? Are there people out there borrowing money from banks with poor underwriting practices getting into index funds when they should not be doing so?
I'd think if this is most peoples' 401k and surplus income at risk that there may be a huge market correction but it won't devastate the economy. If people take the long term view and if investors sit tight and wait for the cycle to move into recovery again they'll be OK. If however they need to live off returns on their investments in the present (like homeowners needed a place to live during the crash) then they're in trouble.
Most "age-based" or "target-date" Active Funds that 401k providers sell are built precisely around managing this gradual multi-decade progression from mixtures high in stocks to those higher in bonds.
(You probably don't want to divest from the account before you retire because you'll pay heavy taxes on it. You simply want to manage the asset mix inside it. You generally want to avoid divesting as much as possible [and want to try to keep it as slow as possible] after you retire simply because passive income is more sustainable than asset liquidation in the long term.)
The reality though is that 401ks are individual accounts for better and (mostly, much) worse. Even when people follow the best advice, they rarely hit the right passive income numbers for a living wage. 401ks also wind up with more people gambling with such savings without thinking about the long term. Then there's simply the fact in the horribly messy transition between group pensions and individual 401ks that there are a lot of "short timer" 401k accounts out there among "Baby Boomers" and "GenX", that people will just cash out when the right retirement age happens to avoid tax penalties, or when the need is greatest (or anything in between), because there's no chance they'll ever make enough passive income and the account itself at that points for most purposes is merely a tax shelf.
Reality is full of a lot a 401k accounts that are managed only so well as the account owner and maybe the interests of the bank involved in holding the account. Which is also why the world is full of a lot of bad 401k advice and advice managers, because we've distributed that cognitive load across almost the entire populace. (As opposed to classic group pensions that could afford full time managers with CPA degrees.)
A lot of the possible "mismanagement" advice lately is a Boomers in particular were sent a lot of advertising / clickbait / thoughtpieces on how much Index ETFs are generally better than Active Funds for the simple reason of Fees. An Active Fund, especially one such as the age-based or target-date funds, charges higher fees than a passive fund like an Index ETF. In the same magic that creates passive income, compound interest, whatever you save on fees multiplies greatly over time. Unfortunately for the Boomers, while this is potentially great early career advice  when the age-based/target-date active funds are most active (higher stock mixes), passive funds are still a higher risk late career than the usual bonds and similar securities such funds push to late career.
(Which returns to the topic of the article at hand, this is why Burry, as at least one investor, is worried about this over-sale of Index ETFs. Index funds in the last few years have generally done better than both traditional securities [not really a surprise] and active funds [possibly a surprise; Burry describes it as an unstable bubble, but may be hyperbolic], so there's been a lot of short term investors in that game. There probably are enough Boomer 401ks alone that are in "short time" mode ticking time bombs full of Index ETFs that should they all start coming due and trying to liquidate/divest, we might see if passive Index ETFs can handle the trade volume the hard way, which is what Burry is worried about.)
 Depending on your investment management time, of course. The majority of people with 401ks already have at least one full time job and likely don't have time to also become their own personal pension fund manager.
I don't get this at all. So why aren't active fund managers investing in the same stocks the index funds are buying in order to take advantage of the price increase for their investors? Isn't that their job? And what do you mean by "better liquidity?"
My analogy would be if we are all buying tickets to the big game and sit in the stands until it's over, there's no one to yell and shout and drive the energy of the crown or possibly no one to even compete on the field therefore why are we even showing up?
It's definitely the extreme - active trading isn't going away any time soon but fears of a only a limited group playing the market and managing or controlling stock prices for their gain isn't 100% unrealistic.
For the top 500 stocks there are enough people (and algos) going over every bit released by the corresponding companies.
And the active market is very sensitive. Especially if someone is so confident that they are willing to use drastically leveraged positions.
The consequence would be near total avoidance of the S&P 500 as a good strategy for the long run. There would be exceptions for those stocks that are quite undervalued, or so overvalued that they are worth shorting (despite the tailwind of index funds).
Don’t worry, strategies like these have predicted 12 out of the last 5 asset bubbles.
And if they're not overvalued, are index funds really a bubble?
That's not how that works... Sell-side analysts have a systematic bullish bias, that's what they are paid for.
Currently, I would argue that some large caps are clearly overvalued but others are also clearly undervalued, based on my own valuation model. The indexes are almost always a mixed bag but I buy individual large caps so that doesn't concern me much. It is rare for the entire market to become overvalued, in which case the smart move is not to buy in.
If you can come up with a clever valuation mechanism that can reliably outperform the well-understood mechanisms, then enjoy pocketing the profits!
Not saying I agree but, if he's right it makes complete sense that passive would outperform active right now, just that in the next downturn it would dramatically underperform.
You want to help? Pull some, not all but some assets out of index funds and put them into individual companies you understand and believe have long term profitability. Sell those assets when you think they're overvalued by the market.
Trading less often is correlated with better performance (you are not an HFT)
There is some responsibility you have. Your money isn't going to just magically work for you, you have some obligation to research and understand what you are investing in. When nobody does it, the market is in trouble.
If anyone was able to do this, they'd be a successful money manager themselves. Yet few professionals actually manage to do this at all, let alone sufficiently to justify their fees, which is why index-fund investing is so popular in the first place.
The only real way to reduce the reliance on index funds is for professional investment services to become sufficiently competent that it makes sense to use their services. Asking the average person to "take one for the team" and throw their dart at the same dartboard the pros can't even hit isn't a great solution.
Gathering this kind of information may be too labor-intensive to justify doing it as a profession but rewarding enough for an interested amateur.
The problem with bubbles is that everyone’s a winner and every indicator is confirming the everlasting increase.. on the way up.
The CNBC article I linked claims that actively managed funds have been beaten by the S&P 500 for _nine straight years_. How long do the investors in actively managed funds have to wait for their big celebration?
Post by ltlurker » Thu Aug 29, 2019 1:24 pm
I'm an index investor, like most Bogleheads, and I subscribe to Bloomberg digital so I can read articles such as this and did see this one at lunch (EDT). I'm open to various perspectives especially if there appears to be a rationale behind them. And of course this individual was behind the "big short" so that intrigued me.
If I recall correctly, I believe his position is that Index funds tend to favor the largest companies - naturally - as they're mostly market cap weighted. The S&P 500 as we've noted is widely invested in, but the Total Stock Market also has an average weighting that makes it a Large Cap Fund - by Vanguard's standards. Relatively few people directly invest in the Russell 2000 Index or even have those options in their employers' retirement plans. (I have the opportunity to invest in the Completion Index in my retirement plan so that's partway there).
I think Burry sees this as an opportunity to look at small cap value, which has been out of favor and not had a good run for some time. I think he must be thinking that a reversion is going to start at some point. None of us can know when, of course. And of course others are looking at the ratio of stock valuations to GDP (apparently one of Warren Buffet's key measures) and believe that there's significance to that, as well.
>In 2015, for example, the top 200 companies by earnings accounted for all of the profits in the stock market, according to calculations by Kathleen Kahle, a professor of finance at the University of Arizona, and Professor Stulz. In aggregate, the remaining 3,281 publicly listed companies lost money.
I'd love to see 2016 to 2019 stats on that, but I think there are structural advantages (proliferation of databases, price transparency) that large corps are enjoying right now with which small companies just can't compete. Technology is obviating many people (and therefore businesses), and allowing the big to get bigger with no marginal cost.
Would you bet against the top ten holdings in VTI, which take 1/5th of all investments?
And also, we know the government will bail out all large entities, especially if many voters are invested in them (which they are due to 401k/pension funds being invested in the very same companies).
Who is going to outcompete the few big airlines, telecom providers, FAANG, hotel brands, car rental brands, banks, pharma companies, etc that have national and worldwide reach? I'm sure a few companies here and there might, but by and large, I bet the big players are here to stay (until the whole system breaks down, but then you have bigger problems).
Right or wrong, that must be one boring place.
[Re: downvotes, The post was just intended to convey that the thesis of "put your money in the lowest cost index funds using an allocation formulatically dictated by modern portfolio theory, and don't touch it for the next 35 years" would be unlikely to provide much fresh content.]
The fact that this explains a majority of self-selecting communities is purely coincidental, of course.
The second concern is not really a concern for long-term investors. Really, neither is the first. Maybe equity is inflated, but where else are we going to put our money?
I think that this article is mostly about risk. If you are not too concerned with risk in your investments (which you should not be if you are more than 10 years before retirement, probably), I think this article doesn't say much about what you should do with your money.
This is really the main concern. The indexes these funds are based on include names that don't have any liquidity. This means 1) the price of the security is less likely to reflect its intrinsic value; 2) attempting to unwind any position may cause substantial issues.
Let's expand on 2) by examining an ETF (say SPY). This ETF is a fund that is meant to track the value of the S&P 500 (a weighted basket of securities). The value doesn't drift too far from the value of the underlying securities thanks to the creation and redemption mechanism, which allows for arbitraging the ETF against the underlying basket of securities. If constituents are illiquid, it becomes more difficult to perform this arbitrage, and the NAV of the ETF diverges from the market cap of the ETF.
This is a bigger issue with instruments like HYG or JNK, which track high yield (AKA junk) bonds. Many of these bonds are highly illiquid, and trading them directly could significantly impact their prices. Instead, many funds trade the ETFs, relying on the basket of high yield bonds as a proxy. These ETFs may then have greater liquidity than the entire underlying basket. This situation clearly undermines price discovery of the underlyings, as the implication is that investors don't particularly care about which names they have exposure to within the basket.
These concerns aren't merely theoretical. In August, 2015 there was a flash crash in which the values of a number of ETFs significantly diverged from their NAVs.
Liquidity premium isn't relevant here. The concept of the liquidity premium explains the differences in prices of otherwise identical securities as a function of their liquidity. What you're thinking of is called slippage, the difference between your target price and realized price for a trade.
When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.
> ETFs that trade illiquid assets should simply trade at a discount relative to their "last traded price" NAV
Many closed ended funds do in fact trade at a discount to their NAV.
Those are the same thing. An illiquid asset cannot be liquidated without slippage - that's why there's a liquidity premium.
> When running an ETF arbitrage strategy, your concern is not explaining the price of the relevant securities. However, you do care whether you can enter and exit positions profitably. Slippage models are highly nontrivial.
Again...slippage is the thing caused by a lack of liquidity.
We agree here.
> Those are the same thing.
We disagree here.
"In economics, a liquidity premium is the explanation for a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity." 
"With regard to futures contracts as well as other financial instruments, slippage is the difference between where the computer signaled the entry and exit for a trade and where actual clients, with actual money, entered and exited the market using the computer’s signals."
The concepts are related, but not identical.
If you could make an analogous case today that the majority of the companies that make up the S&P 500 are over-valued then you could presage the popping of the ETF bubble. In this case, however, the population size of the S&P 500 is much easier to monitor than the population of houses in the US Housing Market, which in 2003 were being built far from Wall Street in pockets of Arizona, Nevada, and Florida. In addition, companies can be subbed in and out of the index with ease in a way that houses cannot pop in and out of the market.
That is why I think the housing bubble pop in 06/07 is not analogous to the current era with ETFs
What I got from this interview was just a reminder that it makes sense not to get caught up in enthusiasm for a certain asset. And investors (including me) are certainly enthusiastic about the S&P 500 index fund.
A lot of the grousing about passively managed funds come from people who are running actively managed funds that charge huge fees to under perform passive management. By lowering fees, actively managed funds should be able to do a better net and to be able to attract more investors.
Any sort of government solution to index funds getting large would basically be protection for these actively managed funds. There are actively managed funds that can beat passive funds, but it's incredibly difficult to do so when you charge a 2% fee.
I'm willing to agree that it should cost an order of magnitude more for an actively managed fee, but most are beyond that.
A lot of this seems like plain greed to me, combined with grift and graft. A lot of workplace plans try to funnel people into actively managed funds that often charge really high fees.
There are all of these complaints from people who run actively managed funds, never once mentioning that the fees might be why so much capital is going to passively managed funds.
People like myself who invest exclusively in index funds do so because the fees charged by actively managed funds are not supported by performance.
Most active management is probably not appropriate for most individual investors because their investment needs and timelines are much different than high net worth individuals/pensions/foundations, etc.
What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe like 48% now)
I wonder if the endgame is that index funds won't be allowed to trade on the the stock exchanges? I can't imagine how that would be enforced.
"Mr/Mrs/Ms Fund manager, you've been trading too close to the index, we'll be forced to terminate your access to the markets"?
The bigger problem is that most passive investments are not really passive - for example, choosing to invest in a "passive" S&P 500 ETF over a "passive" Russell 2000 ETF is an "active" investment choice (preferring large cap over small cap) so valuation errors and bubbles could develop in segments of the market, even if constituents with an index are all fairly valued relative to one another. These valuation errors could sustain for a long period of time, because it takes much more money to correct a valuation error in a huge market segment than it takes to correct a valuation error in an individual stock.
But even in this case the fund only holds stocks (no bonds or real estate) and only US stocks at that (no international or emerging market exposure).
There's maybe some room for redeeming index value and "caching" that demand from within Vanguard, etc, but I tend to doubt this action wouldn't hit the market at all.
That may be true at the point in time where it's already at 99%, but consider the impact on prices as funds were poured into it over time on the way to 99%..
If there is an equilibrium, it may take a significant price shock to discover where it is. I.e. that equilibrium could be years behind us, and if there is a crash we might never recover the value that our current market assumes is there.
That's not true. They'll still function just fine.
What will likely change is that they will begin to underperform other strategies, including different types of indexing and active investing.
At that point the market will self-correct and simple indexing will fall out of favor.
As more of the market moved to indec funds, a smaller amount will be controlled by active investors, which will make the entite market dumber (I would say less efficient, but that would include the cost of managing the fund). As the market gets dumber, an active investor can make more profit without needing to be any better then he currently is.
At some point (in theory), the marginal profit one can make with an active fund will equal the added cost.
If you mean "current market values", then those are being set by the aggragate opinions of active traders. If there are less active traders, there is less brainpower being devoted to finding this consensus, so it would be suprising if the consensus did not get less accurate.
I don't really consider it possible for pricing to be "accurate". It is what it is, but accurate implies there's a correct valuation, which I don't think there is.
There is arguably an objectivly true answer for exactly what payments a given stock will make, and so there is an objectivly true answer for what the present value of the stock is (also dependent on other aspects of the future market). This is somewhat of a philosiphical question, largly boiling down to determinism; and is largly moot because no one claims to be able to predict the future well enough for this to work.
Instead, the working position that most take (at least implicitly) is that there is an objectivly correct probability curve of what the future payouts will be, and therefore an objectivly correct probability curve of present values. How to determine what this curve is is a matter of great debate. Further, there is a sufficient lack of objective methodology, that many of the factors that people use in this calculation would be refered to as "opinion", but there is still an objective reality out there.
However, this only gets us an (unknowable) objective probability curve of present values. In general, there is no objective way to turn this into a price. That is to say it is a matter of opinion how much a 50% chance of making $100 is .
In an ideal market, you would be able to sell a stock for its objective value at any time. However, "the market can stay irrational longer then you can stay solvent", so you may pay a premium for stocks that you expect to not be undervalued when want to sell them.
Conversly, you may by a stock not because you think it is worth what you are paying, but instead because you expect to find a greater fool to pay you even more then you paid.
There are also cases where people value stocks not just because of their future payments, but because they actually care about the company (or, in the case of divestment, people dont buy them becausr of personal preferences).
In short, there is some matters of opinion in determining a correct price; but most of the disagreement comes from a factual disagreement about what the future looks like.
 this calculus changes when you have many such gambles with varying degrees of corralation (and many a financial problem have stemmed from underestimating this corralation)
IOW, is there any practical difference between "there is no objectively correct price" and "we'll never know what it is"? The price at any given time reflects the current consensus of the objective price, distorted through the current average psychological lens of the market?
If something is unknowable before it occurs, we will never know what the objectively true measure is until it's occurred. At which point it changes, since the market is dynamic. How could we ever know which point is the correct price?
In theory, we can take a now worthless stock and look back in time to determine the actual present value at a given point in the past.
In theory, we can imagine an outside observer running an arbitrarily large copies of our universe from a given point in time to determine the probability curve at said point in time (under whatever model of randomness you want to use). More plausibly, we can take a set of predicted probability curves and look back to see how accurate they were (did events predicted with uncorralated 50% probability happen half the time?).
Economics is hard, because it is very difficult to determine these facts, even in retrospect, but they still exist.
If we can't know the truth, how do we know it exists (in this situation)? I'm not convinced there's an objective true value of a stock -- it seems like stock prices are the general consensus of a huge number of subjective inputs. And that will always be the case.
(Definitely appreciate the time and thought you've put into your responses, btw! Thank you.)
Once a company dissolves, we have enough information to do this calculation over the entire lifetime of the stock issue. At that point, we can determine what real value that stock had at any point in the past for the bearer.
This explains how value investors interpret stock value, but most traders are speculators that expect to make their profit by selling the shares on to someone else. They will only buy a share of stock if they believe that a future investor will buy it off of them at a higher price. This future investor will either be a value investor that expects to get the dividend returns or another speculator that is making the same calculation. Thus, even if a share of stock will pass through many hands before it lands in the portfolio of a value investor, that value investor is the only real price anchor, and the entire chain of speculators are ultimately trying to sell to him/her.
It may be possible that although they can't beat other active investors enough to justify their fees, they can beat a big dumb index fund enough to make their services worthwhile. That remains to be seen however.
So instead if active fund managers "knowing the market better", we'll get active fund managers, "knowing the passive investor crowd better".
This is madness.
Obviously we're not in either state, but presumably the closer we get to the latter state, the game gets a little easier for the active traders, not that that necessarily means they'll get a free "win"
Indexes holding shares have no influence on the price. The price only changes when traders trade.
When there is a majority buying/selling all the shares in block without any consideration to the differences in liquidity and fundamentals between stocks it may be easier to find opportunities than when everyone buys and sells individual stocks. (But one could also say that the average stock-picker is so bad that having more active investors actually increases the gain for the talented ones rather than pressuring profits due to competition).
For example, if you bought near the top in 2000, you were still underwater a decade later.
> Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. But past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place.
But it strikes me that index funds are parasitical in a way and depend on price signals from active investors.
Some people say that it’s ok, the situation is self-correcting.
But what if the smart active money is active in places we can’t see in the public markets? Again, I’m a dummy, but I believe a lot of investment is happening privately these days.
I'll just point out there's the argument about market makers and underwriting and blah blah blah. If that's such an issue just price that into the underwriter fees to begin with. No reason the public markets should lose out on a 30% gain to people that didn't actually take a risk and invest early in the company, and only intend to hold the stock for 8 hours at most.
You are a ”dummy” in the sense you don’t have perfect information awareness on every possibly tailwind or headwind that could impact a particular stock. But everyone is a dummy in that sense.
And even honest people well versed in economics will tell you that they are too.
I'd wager at least 90 percent. Passive investing is generally designed to track active investor activity without effort, so it shouldn't add much inertia to the system. If Dave thinks IBM is overvalued and Under Armor is overvalued, the act of buying and selling will shift those numbers, and the index investors, instead of taking the opposite trade and undoing that flow of information, hold their portfolio.
IMO, the real challenge is active investors competing for access to that 10 percent of active invested money. There's no shortage of people happy to manage money under the 'heads I win, tails you lose' fee structure, and one hopes that the same people fighting over a smaller pool of cash would (more strongly than status quo) favor people who can actually produce results.
If you have one trillion dollars invested, and the entire exchange volume is based on me and my friend trading a single share back and forth, everything will still work. It doesn't matter how much you own, because my friend and I are going to want a fair price for that one share in any case. There's no practical limit to how passive things can get before a problem kicks up, as long as a few hedge funds stay in.
You are talking like such a market is extremely liquid (there are enough shares for everyone). I think when a third person enters such a market your example breaks apart. Now you have one person who constantly wants to buy a stock but is unable to do so. Because you and your friend trade at a fair price and index fund does nothing. So he have to buy at an unfair price and rises his bid until index funds kicks in the game.
How so? I can certainly see "lost opportunities" where good stocks are undervalued just because they aren't in the index funds, but I don't understand why you think index funds can't work. Can you elaborate?
First: When you buy a ETF share for the S&P 500 (iShares, Vanguard etc), the share is not backed by all 500 S&P components. Virtually all the large-number component ETFs are using a sampling of shares to match the underlying index. (They would be buried by transaction fees otherwise.) The subsampling of the index is reasonably well-understood math, but relies on an assumption: That the buying and selling each component share will not be greatly affected by the ETF purchase or sale.
[Edit: I may be out of date - Some ETFs are full samples. Nevertheless, the bigger point that the ETF purchase/sale does not much affect the price stands.]
Second: The ETF uses a very clear process to keep the price of the ETF in equilibrium with the index it represents. Large players are allowed to go to the ETF adminstrator (say iShares) and turn in a bunch of the ETF shares, and iShares will transfer back the underlying components. So if the ETF price ever gets too cheap relative to the index, the big players will redeem the ETF share, and then sell the underlying shares they received, which results in a quick, nearly guaranteed profit.
Conversely, if the ETF price goes above the index, a large player will bring a basket of the underlying component shares to iShares, and iShares will give them corresponding ETF shares. So they buy the components cheap, sell the expensive ETF, again making a quick profit.
Now to what Burry is saying: Several components of the big indices are thinly traded compared to the amount of money in the index funds. In a large index drop, there will be disproportionate downward moves in those thinly traded shares: As large players will be redeeming the ETFs for underlying shares and then sell, these thinly traded stocks will drop further than you'd predict from the index. This will cause the index to drop further, which will cause more ETF shares to be redeemed, perpetuating the cycle.
I think his point should be better known than it currently is: The current wisdom that "you can't lose money in the stock market long-term" is reminiscent of "you can't lose money buying a house."
He seems to say that if you have trillions of dollars in ETFs, you should be seeing more volume in the shares in these indexes than we actually observe.
So some of this cash is going toward synthetics -- mathematical models that are supposed to mimic the underlying securities -- and not the actual stocks in the index.
In a general rout, the synthetics won't perform like you'd expect them to. Prices might eventually clear, but it's not "as good as cash" like many investors assume.
Here's anecdata from the past: I spent a lot of time during the housing bubble working on a similar strategy. I came to the conclusion that shorting the banks (with leverage!) would be a profitable way to make money.
It turns out that was a beautiful and correct strategy, up until the moment the SEC decided to ban shorting. We got out with profit, but it was stressful and certainly nothing life-altering as a consequence of the SEC action. (bastards!) If you have seen The Big Short, they had a similar problem: Because the CDOs stopped trading, Goldman and company unilaterally declared that there was no problem. Since there was no market, there was no mark-to-market. Burry and friends were able to wait it out, but you'll notice that Burry had to exercise some extraordinary clauses in the contract; Dealing with your investors after that must have been all kinds of fun.
The moral of the story is probably something like: When you are profiting from the system melting down, the system will invent new rules to impede your profit, so be prepared.
Edit: BTW, I don't think mark-to-market accounting has ever been fully restored, but it's been a while since I checked.
You could buy a closed-end mutual fund since it won't be balancing its holdings in the same way.
You could buy a small cap fund and short a large cap fund, betting that small cap shares will get distorted in the positive direction if there's a liquidity crunch.
I guess I'm somewhat less worried about people not picking stocks because hedge funds, and really, anyone greedy, will always try to do that, bringing some amount of pricing to the market.
Put in a large enough number of years in that "long-term", and it is true. But many people don't have the time horizons of institutional investors, so what is "long-term" to an re-insurance company might be "lifetime" to an individual investor.
Now, if we could only resolve the principal-agent problem for institutional investors to the benefit of individual participants that make up the institution's backers...
If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.
A passive fund adds money into the system, but it doesn't add any intelligence - it relies on the intelligence of the current market participants.
As more and more money switches from active to passive, we have more and more money relying on less and less intelligence. This means that the market is becoming less and less efficient, and prices are deviating more and more from where they should be.
Passive investors are essentially leeching returns off the work of the active investors.
This article suggests that the effect will be ultimately catastrophic, where I suspect that it'll just result in money slowly swinging back the other way as active funds take advantage of the situation to start to make more money than before. That's pretty much what the article says he's doing.
He points to a mismatch between the daily trading volume of various of the smaller components of these indexes and the amount of money globally indexed to them. The suggestion as I understand it is that some of the indexed money is not directly holding the indexed stocks but is using financial instruments to track the indices indirectly and that in the case of another global financial crisis those instruments could break down and you'd potentially see significant divergence between the tracking funds and the actual indices.
That's just my layman's interpretation though, I'm not an expert on this stuff.
This makes sense to me - I would see returns to active investors increasing gradually, as there are fewer of them. At which point, more people take their passive investments and give them to the active investors. At some point you maybe reach some sort of equilibrium.
Why would it not be a well-functioning feedback loop like this?
> If your money is in an active fund, there's a manager exerting his intelligence in trying to make good choices with your money. This effort is beneficial, as it helps the market find the right prices for assets.
Also, worth noting that it's beneficial for the market, not necessarily (and probably not likely) for the individual investor, who will pay higher fees and may underperform the market.
Excellent point. Indeed, I believe the academic view is that due to decreasing returns to scale, funds flow in and out of active funds, with an equilibrium only when any alpha (performance above the norm) is entirely swallowed by fees.
That's assuming that the mutual fund managers who are being moved away from are all contributing their own unique information to the market, as opposed to repeating textbook business analysis techniques. If the fund managers that survive are smarter than the ones being replaced by indices, the intelligence of the market will improve.
Anyone can go all-in on red five times at the roulette table. One out of every 33 players will see 3100% returns from this investment 'strategy'!
Each active investor gets some return and contributes some movement to the market. If there are enough active investors, the aggregate move of the market matches the actual value movement of the stock in a company. Then, on the sidelines, over some time period the market's moves are copied by the index (a balancing of the index). If, however, there are too few active investors, the index funds will be causing feedback into the system by being the only source of liquidity in a stock. If active investors then attempt to capitalize on this "failure", they will be the movements of the market. Then the index funds will copy them in the next round of balancing. In the end, there is a level where the market is not something the active investors can get a good return in because all the momentum is in the index and nowhere else. If the active investors are all doing way better than the indexes, the indexes will just copy that and suddenly be doing as well... Right?
Passive investors are copying the average of the active investors. Just as you would never have a situation where all active investors are outperforming passive investors, you would always expect there to be some active investors outperforming the average. The big question is the extent to which individual managers can keep it up over time (and as more AUM flows into their funds) and the magnitude of their out-performance.
And you're right - as active investors find new opportunities and make money out of them, they will improve the average and hence the performance of the passive investors.
You can add up the performance of all active funds and see how they are doing as a whole. My understanding is that at the moment, the sector as a whole is doing OK, but almost all of the returns are from the top performing funds, so an active fund chosen at random is likely to be destroying value. However, this could change as more mispricing opportunities arise in the market.
Index investors are basically free riders off the information and research generated by active investors. Indexing basically works pretty well because the market's efficient.
An index investor just comes in and just pays whatever the current market price is and allocates in proportion to whatever current market valuations are. He doesn't even need to know anything about the underlying companies. "Microsoft? Never heard of it. But the market says it's worth 3.8% of all major American stocks, so I'll put 3.8% of my money in it"
Astonishingly, this mostly works out fine. In fact, just indexing is very likely to beat any sort of actively managed funds after taking fees into account. That's kind of incredible when you think about it.
And the reason it does work is because the active managers compete so fiercely with each other. They end up showing all their cards to the market. And all the information they have, and the research and the analysis winds up reflected in the publicly available stock prices. In effect active investors pay their managers big fat salaries to analyze stocks, and passive investors get nearly all the benefits without any of the costs.
Well, what also works fine is picking (enough) random stocks and buying them for an equal amount of money.
That index funds base the allocation on market share is (in my understanding) not a method to increase performance, but to greatly simplify any rebalancing of the stock allocation. If the price of a stock changes, an index fund does have to do anything. The allocation will always automagically reflect the market cap of the stock - more or less by definition.
Every other allocation (e.g. equal weight) would need to rebalance every now and then to return to the initial allocation. This can be complicated and/or costly. However, it might still perform better than the market cap index: https://www.realizeyourretirement.com/comparison-sp-500-inde... (of course it might perform worse in the future).
Throwing darts is cheaper and safer for them.
Index investors are only really messing with the market if there’s more capital chasing fewer goods than there otherwise should be if they were being “active”, which isn’t proven.
ETFs aren't necessarily index funds
So there is a very closely coupled lever to the market.
I wonder if there are high speed shorts triggered by twitter already.
There are: https://www.marketplace.org/2019/08/29/meet-the-algorithms-c...
Twitter Flash Trade Platform?
If one believes this to be true, one necessarily believes that illiquid index constituents are overvalued today relative to their actual enterprise value and will, at some point in the future, be sharply undervalued as a large number of computers controlling trillions of dollars attempts to implement a for loop shoveling money at you.
What eventually happens is that there's not enough new money coming in for index fund buy orders to maintain the bottom of the underlying prices, which means that the prices start drifting lower, the popular financial press goes nuts, CNBC/FoxBusiness/WallSt Journal/etc blast it in the headlines and the same way goes the other way. People start selling their index funds, which makes the index funds sell the underlying which creates a massive wave of the sell orders creating a downward pressure, which in turn puts brings the indexes lower which makes press go screaming more which causes more people to want to "protect their test egg" by selling the index funds they had.
Actively managed funds have choices in what they invest, and how much they put into any of the companies. Index funds do not.
for an example.
The rest is chicken little - we got into that mess before because neither CDOs nor CDSs were liquid which means that as long as they were not trading banks were able to continue book them at the nominal value and since to trade them one needed to have banks that were on a hook for them to do the trade nothing was moving. That's the biggest issue with those kinds of instruments.
Nothing of sort could happen with the index funds because both the derivatives and the underlying are sufficiently liquid, so the drop won't be 100->20 but rather 100->99.9->99.8->99.7->....->20.1->20 which in turn would re-balance everything.
Retail investors are told to shovel money in and keep it there. Who's going to be selling to pop the bubble? Do investment banks have a lot of index funds and their derivatives bought? Does there have to me some major re-allocation within the fund that causes investors to sell?
If a single stock is valued incorrectly, how is that going to bring down the entire index?
CDOs are collections of mortgages with rules about how they pay out. During the last bubble they were sold (and rated by supposedly respectable third-party arbiters) as among the safer investments available. This was because the CDO had a safety feature where a certain percentage of the mortgages were expected to default, and so you didn't need all top-quality mortgages, lousy ones were okay, too. Thus the sudden availability of "NINJA" (No Income, No Job, no Assets) loans, which were completely inexplicable to basically everyone. No one would have lent their own money to poor credit risks, but the CDOs would buy that loan and stick in in their security in a heartbeat. The problem came that once the expected maximum level of default was breached, the CDO started paying out very little or nothing, and the value fell to near zero.
So his analogy is that the same thing will happen to index funds, which invest on the principle that you don't need to pick top-quality stocks, that you just buy all of them. As far as it goes, there is a significant similarity with CDOs. As an index investor, I don't try to find my own good stocks, I don't even need someone skilled in stock picking. I'm relying to an extent on financial engineering and the rest of the market to make sure that I'm not grossly overpaying for the lousy companies that are in the index. He notes that there is a huge multiple on many of the stocks, such as the 266 that have less than $150 million in daily trades, but represent trillions held by index funds. Trading is the "price discovery" mechanism of the market, and lightly traded stocks are subject to all kinds of manipulations and volatility, to be sure.
But there are several places where I think he's making a major stretch with this argument. First, the CDOs were sliced into "tranches", so when you bought a CDO you didn't get the underlying assets, just the right to a payment stream. The index fund sticks very close to the current market value of its assets; you get what you would have gotten if you just bought all 500 stocks individually, without any financial magic. For instance, on a $10K investment the Vanguard S&P fund trails its index by about $100 over 10 years. There's no daylight for shenanigans there, so I think the financial engineering argument is categorically false.
It also doesn't bother me that the stocks are thinly traded relative to the assets, because one of the big advantages of passive investing is that you're not trading all the time. Again looking at Vanguard, they turn over less than 4% of the stocks in a given year. But that's what you should do if you don't want to get killed by trading fees. Buy and hold and all that. For there to be a problem you'd have to see that those stocks were getting volatile, or that the index funds were constantly buying at a disadvantage. It is true that there is a certain amount of trying to beat the index funds to the punch; kind of hard to keep from telegraphing your investment choices when they're literally written into the name of the fund and you need to buy for a half-billion dollar fund. But these are tiny in magnitude. If anything, things are much more efficient and rapid then they were before computers took on most of the trading.
Finally you get to the thing I worry he has a point. If 100% of the money was passive, there would be huge opportunities to exploit. There's no law that says passive investing is going to be better than active. It's been true so long that maybe it's taken as gospel when it shouldn't be. Nothing is forever, and anyone who argues "it's different this time" is probably wrong, eventually. But there's still a ton of money out there in active funds, hedge funds, pensions, etc. If they saw a good opportunity, they would take it. There's too much money to be made by sharp-eyed investors to let the market as a whole get to the point where bad stocks and good stocks are treated the same.
Burry's argument is that many of the underlying stocks inside the index have a lot less liquidity than the index funds and securities themselves. E.g. if a lot of capital quickly exits the index funds, then some of the single-name stocks may be overwhelmed by the liquidity. That would result in their prices becoming severely dislocated relative to their true value.
But if you're just buying-and-holding that doesn't matter. If the stocks in your portfolio become temporarily dislocated, who cares? Dislocations by definition correct themselves over time. If some stock falls 50% because of panic selling, without anything having to do with the underlying company, it will eventually return to the correct price. And much sooner than the decades long timeline that you're saving for.
That doesn't mean that Burry's thesis is irrelevant to everyone. In particular if you're an institution that offers liquidity to your clients it may be very relevant. Or if you're a bank, hedge fund, or insurance company that's subject to mark-to-market capital ratios or margin calls.
If stocks become very dislocated, your investors may panic and redeem their money. Or your regulator may say you have insufficient capital and have to liquidate. That's very bad, because you'll be forced to sell at fire-sale prices. However, that's not relevant to individual investors, because nobody can force you to sell out just because your portfolio goes down.
But that's not true, because suppose if 99.9% of investors are buying ETFs and only 0.1% are actively managing, there won't be enough funds to bring all these panic dislocated stocks back up for many, many years.
The price change of a stock doesn't always depend on how often a stock is bought. For example, when earnings hit, a stock can easily move 10%. That's not because there was a certain amount of people buying at every price between what it was and +10%. This can happen because earnings are better, and many people base price of an earnings multiple. When new knowledge is put into the system, there's a new price.
If everyone who is trading a stock agrees on a price, that is the price. If people don't agree, it is generally the highest price someone is willing to sell it for (and find a buyer), or the lowest someone is willing to buy it for (and find a seller). If that disconnects a lot, you get a high bid/ask spread, and possibly no shares trade (lack of liquidity). It might only take a few shares or be a very short time to move a stock a lot.
You can pull your money out and pay zero capital gain taxes for seven years. Then get a 15% discount on your capital gains at that time. All returns you realize from the fund are capital gains tax free.
The benefits end this year.
The timing restrictions around OZ investments (180 days after cap gains event) make it a bit difficult and will result in lots of bad investments with non-experienced, first-time fund owners.
But maybe you have a connection to an OZ that you are familiar with and can rehab a property there. You should get help from a CPA and lawyer, but the basic process would be:
1) Sell stock and now you have cap gains
2) Setup OZ Fund XXX LLC
3) Fund the LLC with your cap gains within 180 days
4) Setup OZ Property YYY LLC
5) Purchase property inside the YYY LLC and fund purchase with XXX LLC
6) Rehab property within 31 months
7) Hold for 10 years
a) Pay original cap gains tax bill (minus 15%) in 2026 tax year (negative interest loan from gov)
b) Pay zero cap gains on the increase in property value over the 10 years
Annual investment management fee 0.75%
Annual tax and accounting fee 0.45%
Annual carried interest / promote 15% over 8% return
Maybe it's not as high when you consider that they purchase the property directly, but it still seems a bit too risky to lock myself into those high fees for 10 years.
I think the main benefit is the 7 year deferment of your capital gains, which given that your money will be compounding from that point onward, is a pretty significant break if you have a lot of gains you haven't triggered yet.
Good resources on that page.
1. Even among index funds, maintain some diversification. Don't put all in US large caps (S&P 500), but also some international and some small caps (Russel 2000).
He is saying that given how much money is invested via index funds now, there are opportunities in assets that are not (or insufficiently) represented in index funds. (This is hard, though, and the standard advice to refrain from trying and placing your bets on index funds instead remains valid, I think, particularly for mature markets in which you don't have an edge.)
The second take-away is at a tension with the first:
2. Avoid ETFs that handle illiquid assets (real estate, bonds, etc.) or create synthetic exposure using swaps and derivatives.
For big, liquid assets, the ETF or index fund can just take the investor money and go buy the assets. Then the value of the fund is approximately the value of its constituent assets, sort of by definition, and that value is relatively easy to realise (that is, if you want your money back, you get it - they'll have to sell some of the assets, but they're liquid, and that won't influence price too much).
For smaller or more exotic assets, a fund might not buy them outright, but contract with a third party (an investment bank, typically), and give the bank the money, with the bank promising that it will return the value of the asset. So, it's "like" holding the asset, except that you get the credit risk of the bank - there's a risk the bank might not be able to uphold its promise. And this is most likely to happen when everyone runs for the exit.
> The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.
> ... the impossibility of unwinding the derivatives and naked buy/sell strategies used to help so many of these funds pseudo-match flows and prices each and every day.
So, an ETF promising to deliver the value of an index can generally do it, and there was no big failure so far, but scenarios are conceivable where it cannot deliver.
There is also nothing wrong with adjusting the ratio of cash vs equities that you're accumulating (eg the share of your income going into the market vs going into cash in a span of time). It's the exact same safety vs risk lever that is commonly utilized in adjusting equities vs bonds as you get older. Some will call it market timing, it is not, as you are not attempting to time a top or bottom. With recession alarms going off in most global economic data, increasing your conservative posture is nothing more than being modestly prudent (and it doesn't have to be an extreme adjustment; if 100% of your net savings is going into the market now, changing that to 75/25 or 50/50 with cash, is entirely reasonable). Even Warren Buffett has turned hardcore conservative with this market, he's buying nothing and sitting on a $122b record pile of cash that is very much annoying him (by his own admission). The reason for his behavior, beyond the obvious blaring economic data, is that the valuations are terrible vs the growth we're seeing (both macro economy and corporate earnings); right now investors are paying a steep premium in most cases for the value they're getting. Buffett doesn't like the price he's paying for the value he's getting, so he has gone into bunker mode, as he has done prominently several times in the past. The simple, non-professional approach to that move, is to just make a reasonable adjustment to how much cash you're accumulating (which can obviously later be deployed if an opportunity presents; in the meantime you're likely to see a very modest inflation debasement to the fiat).