Bubble in passive investment funds

If they have shares of a 1000 share company that are worth 10 each, the company market cap is 10000. If the share drops to 5, the cap is 5000. If the ETF is cap based, they should sell it because the market cap is now half.
I think that its weight should change, maybe they should sell half of the stocks? This is only in case everything else stay the same…

correct me if i’m wrong

Market cap indexes are self-rebalancing. Let’s imagine a very simple ETF of:

  • stock A priced at $100 with 1’000 outstanding shares = market cap of $100’000
  • stock B priced at $100 with 1’000 outstanding shares = market cap of $100’000

The ETF share is market cap based, so it needs to have 50% A and 50% B. Let’s say that 1 ETF share consist of 1 A and 1 B, so currently it has a price of $200.

Now the following happens:

  • stock A price drops to $90, market cap = $90’000
  • stock B price drops to $10, market cap = $10’000

Our ETF share has now a value of $100 and the market cap proportions are still valid, no need to rebalance.

There would only be rebalancing needed if the number of outstanding shares changed.

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I don’t understand.
On phase 2, the market is worth 100’000. Stock a is 90% of the market so the proportions should change.

Video from Morningstar on “what happens if everyone indexes?” Start 9:48 min

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The market cap proportions change, yes. It was 50%/50%, now it’s 90%/10%. But the proportions of the stocks in the ETF have also changed so there is no need to rebalance. The ETF does not need to make any transactions when the price of an underlying stock changes.

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Thank you for this great link. I read every word of that post by MMM, it’s very soothing. It matches my intuition, but he put it into words much better than I did.

The most important takeaway is this: we should not worry about passive investors taking over the market, because the more passive investors there are, the easier it is for active investors to beat the market. So we can bet that there will always be some people who keep the prices real.

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This has been recently discussed. Probably should merge this thread…

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7000 stocks? (VT, VTI, VXUS etc…) I’d like to see how much you’d pay in fees…

I don’t understand why you created a new thread for this one. As @chca already did, there’s another thread on the same topic regarding Michael Burry.

Yes, there are risks with ETFs, and yes, there might be a problem if there’s a panic.
BUT: if you have made an asset allocation and want to stick with the passive strategy for the long run, you don’t sell when the market goes down! Instead, you’ll be happy that you get more shares for your fresh money.

What you are trying to do is market timing (selling when stocks go down, then buying again when the bottom has been reached). Just that, as all of us, you don’t own a crystal ball predicting the future…

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What would be the benefit? Liquidity and mis-pricing would apply the same as with the ETF.

Maybe this might be interesting as well…

It’s just wrong statistics. Passive investing calculated correctly accounts for ~5% according to Gerd Kommer.

How so? That goes against other sources linked here.
And what about the “closet indexers”?

5% seems too low, even according to “conventional wisdom”.

Care to share a link?

2%, 5%, wrong statistics… what gives?

Which number is most important, for the determination of the price of a share or for providing liquidity? The percentage of the shares held by ETF or the percentage of shares traded daily?
For most of the shares the daily traded volume is about 0.1% of the total number of shares. The buy and hold strategy seems to be applied not only by passive ETF. This means that finally if you invest in passive ETF or actively trade shares the whole stock market is a big theater with small exit doors. As soon as more than few percents of investors decide to sell on the same day you get a crash.

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Couldn’t remember the exact number, but it’s way lower than assumed.

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Thank you for this precious remark!

The passive/active fund ratio is an interesting statistic, but not relevant for the discussed topic. It’s more important, how big percentage of the whole equity market is managed passively, not just of the funds.

I looked for some charts.

This chart applies only to US market and at least we can see some absolute numbers (passive around $3.5T):

And this chart shows ownership of US equity market:

So 30% for MF & ETF, and of this, half is passive. That would mean around 15% passive.

This chart comes from this article, which I strongly recommend to read:

Here a quote from the article:

Passive management provides value to investors because stock markets are highly efficient. However, it is the competition between active investors, to be the first to acquire and act on new information, that sustains market efficiency.

As passive management expands, the returns to active management will increase (lower market efficiency) and the cost of active management will decline (competitive response to loss of market share) until an equilibrium is reached

At what level of passive management that equilibrium will be reached is unknown. Passively managed funds own about 18% of all publicly traded equities, across the globe.

I don’t know where he got his 18%, but it fits the previous calculation.

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I may not have completely understood what the difference is between holding an ETF that cannot destroy shares fast enough because the underlying security is not liquid enough VS. holding a security that cannot be sold fast enough.
But: is an index fund a solution for this problem? The fund manager calculates the daily price of the share from the value of the fund divided by the number of shares I guess. Alhough it may not always be easy to guess a price for illiquid assets, at least the fund share price can not drop faster than the value in the fund?

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so here’s another naive question (please shoot it down), in a fast moving market going down is there a risk that Vanguard cannot sell shares at the same speed (and price) as holders of VT try to sell VT?
What happens then?
. VT spread becomes huge?
. no market for VT?
. Vanguard stops redemptions?
. Could it be that people that are left holding VT will actually have a bigger loss than the actual market drawdown?

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