Passive investing tends to distort the prices of individual stocks, because we buy everything in a fixed ratio without considering the value of each company .
The “exit door” is small – there is a lot of money invested in fairly small companies whose shares are not frequently traded. So if we all tried to sell at once, we’d have way too many sellers and very few buyers. This would cause a massive price crash in the stock prices of these small companies.
There are some complex bits under the hood of index funds – things like options and derivatives that can break under stress and cause money losses or more volatility.
(…)
But instead of picking a fight, let’s just address these points one by one:
Yeah, but active traders have been making this argument against passive investing forever. The theory is correct, but in practice it would only be a problem if too many of us became passive and there were no active traders left. Thus the real question is: Are we close to this tipping point? And the easy answer is “Not even close”. Index funds own about 18 percent of global shares, and 45 percent here in the US. And active trading still outweighs index fund trades by 22-to-1.
A small exit door only matters if everyone is running for the exits at once. And even then, as index fund investors (as opposed to active stock traders ), we don’t do that. And even in the event of liquidity problems in a big sell-off, the only downside would be some bigger temporary price swings. We don’t care about those either.
To better answer this question, I interviewed some of the people deep inside the machine – Betterment’s investing team and their director Dan Egan. A summary of their thoughts – This is actually more of a problem for “Synthetic” or leveraged index funds, not the true funds we invest in. For the most part, in the index funds you and I use, our money simply purchases real shares of businesses.
I don’t really get this “passive investors don’t sell”…
If you retire early you do have to sell at regular intervals to be able to pay for your living expenses.
Also, sequence of return risk matters a lot, buying large quantities of securities before draw-downs is very unfortunate…the more it goes down the longer you have to wait before making it back to zero.
To be sure, I’m not talking about trying to time the market, I’m talking about (1) having to sell and (2) the risk of when you come onboard
I would describe it that the active investors goal is to be smarter than the market. They know that crashes/dips are normal but want to make profit of it (sell high/buy low). And the passive investor understand that crashes/dips are part of the long-term game and even sees them as a chance to build and invest more.
Normally FIRE date is not set in stone and people are flexible with it. If you’re facing a crash just after you’re FIRE, then too bad - you need to work one more year to sustain your portfolio. How is that a problem?
Well, I still haven’t understood the mechanics of how ETF holders are in danger. If there is a market crash, you’re screwed regardless if you hold your stock in an ETF or directly. Then you just withdraw as much as you need, provided that you’re retired, and wait for better times.
What are they actually talking about? That our ETF provider would go under somehow, or what? Because if the only worry is that the ETF might become illiquid for a couple of hours (small exit door) then I don’t see how should that be a problem for anyone else than day traders.
I agree thats not a problem. But we’re perhaps deviating a bit from the topic. The main concern about (eventual) index investing dominance in my view is that it could create opportunities for active strategies that ultimately would reduce your gains. But as that would make active more attractive it would reduce the index dominance risk again. Just a question if thats not something you could profit from too.
No worries, I don’t get most of them either. You just posted a link which has been posted a few posts above (repost), so you probably started reading the thread from the middle.
I’m pretty sure that the passive/active ratio will reach an equilibrium at some point. For years the active funds had it easy because they could have been trailing the market and still pocket the 2% fee. Now they will have to do a better job and possibly lower their fees. The funny thing is, active traders can only get an edge over indexers by beating other active traders, as passive stock holders do not participate
Well let´s say for the sake of an argument there is an ETF with bonds. In case of a crisis, some investors will try to get out and sell that ETF, so that the issuer has to rebalance that portfolio. In case of bonds (which are usually not that liquid) those prices will fall, because nobody want to buy in that negative phase, but the ETF issuer (probably a bot) must sell. So that this will turn rapidly south and the prices will even drop more.
So maybe if we see that situation but in a more extreme form with ETF shares. Maybe with a market share in the future of >30% or more, this also might become a potential risk. At the end they are managed by bots, who are programmed and react all in a similar way with similar trigger points.
yeah, but it gets its own shares in exchange, which it destroys
I fail to understand how does an ETF make it worse. I guess this could only become a problem if the ETF was cheating and creating its units without the underlying shares to cover for it. I wonder what checks are there to make sure this doesn’t happen.
So if only passive investors panic and sell their ETF shares, at first just the ETF shares’ price falls. This gives the APs a source of cheap ETF shares to exchange for the underlying set of “real” shares (that still have the original high price). Then they can do whatever they wan’t with them. If all the APs automatically sell the shares they get from the ETF, then it would cause a drop in the real market… But they don’t have to sell. There’s still a second layer of protection there, that could slow down the panic.
sequence risk sometimes means waaaaay more than 1 year to get back to zero…Big ERN’s blog has a bunch of analysis about this.
I agree being pessimistic just means you never participate, but being super optimistic and thinking that if something goes wrong everything would be fine one year later is how many people got fleeced out of their retirement savings last time around.
Ok, in worst case, one needs to work a bit longer. If you’re scared of that possibility, then you should lower your market exposure - but in that case, surprise, surprise, you will also have to work longer due to lower expected returns in case there’s no crisis in the near future. I don’t think there’s a sure way around this - most likely you just need to be flexible and stay invested.
Big ERN has an awesome blog, but as a former FED analyst he’s too focused on economy fundamentals - for example, in 2008 all major economic indicators were positive and most economists, including FED economists, were positive about the state of economy. Crash was unexpected. It usually is unexpected.
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