The growth in passive funds has caused markets to become more correlated?

This article brings up a point I used to worry about - if people are just automatically pumping money into a list of stocks, how does the price remain connected to reality?. But apparently the answer is that mis-priced stocks present an arbitrage opportunity (<a href="https:&#x2F;&#x2F;www.investopedia.com&#x2F;terms&#x2F;i&#x2F;indexarbitrage.asp" rel="nofollow">https:&#x2F;&#x2F;www.investopedia.com&#x2F;terms&#x2F;i&#x2F;indexarbitrage.asp</a>), so as long as a few people are paying attention, the price remains rational, and the remaining people paying attention are rewarded for doing so. The Economist had an article about this issue recently and they concluded that the main effect of Index Funds was to drive low-performance fund managers out of business.

Theoretically, I think the concern is reasonable. The &quot;concern&quot; here being if everyone switches to passive funds, then the behavior of markets will change. However, when you look at the numbers, it doesn&#x27;t seem like this concern is actually a reality.<p>&gt; The market capitalization of the S&amp;P 500 is roughly $22 trillion as I write this. The entire ETF market in the U.S. is $3 trillion. That’s 14%. Even the whole industry—about $4 trillion, would only be 18%.<p><a href="https:&#x2F;&#x2F;www.etf.com&#x2F;sections&#x2F;blog&#x2F;no-etfs-dont-own-37-sp-500" rel="nofollow">https:&#x2F;&#x2F;www.etf.com&#x2F;sections&#x2F;blog&#x2F;no-etfs-dont-own-37-sp-500</a><p>This statistic was actually a big wake up call for me about 6 months ago. For a long time I had been investing based on theoretical ideas, like the one mentioned in this Bloomberg article that we&#x27;re discussing. After I saw this statistic, I realized that I needed to look closer at the numerical reality when making investing decisions. This is probably obvious to many of you. I&#x27;m just sharing the moment when this insight really hit home for me.

There&#x27;s a phrase we use in investment banking: &quot;talking his own book.&quot; A trader is talking their own book when the superficially neutral view they give of the market is designed to promote the value of their own positions. The active managers that Levine quotes are talking their own books when they decry passive funds. As ever, one should follow the money, and ask who stands to benefit if a view of recommendation is implemented. &quot;Where are the customers yachts?&quot;

A pet theory of mine: if everybody starts investing in passive funds replicating indexes, then the creativity will go into increasingly more sophisticated indexes.<p>You might for instance want to make the bet that the market at large is systematically underestimating the risks related to global warming in particular, and the environment in general. Said differently, it is entirely possible that governments will start to tax the hell out of various externalities, like CO2 emissions, or plastic garbage generation. Or maybe courts will ask companies to pay to clean up after their own mess.<p>If you believe that this is true, then indexes (existing or being created) weighting in those risks will over-perform the S&amp;P 500 in the medium term, until a couple of companies are wiped out and analysts start to correctly price in these risks...<p>That&#x27;s just one example of the kind of creative index that could be created.

&gt; The function of the capital markets is to allocate capital.<p>I never fully grasped this idea. I have no problem understanding that venture capitalists, angel investors or investors that buy shares at IPO do allocate capital. However, why is trading existing shares considered &quot;allocating capital&quot;?

The article is interesting. We replaced the baity title with representative language from the text. Hopefully that will spare us all yet another boring flamewar about the c-word.<p>If anyone can suggest a more accurate and neutral title, we can change it again.<p>Edit: ok, you guys didn&#x27;t like &quot;When analysts are replaced with index funds, the market stops allocating capital&quot;, so I dug up another representative sentence from the article.<p>The best way to complain about a title is to offer a better one, so if you don&#x27;t like this one either, maybe take a crack at it?

This is equivalent to worrying that <i>all</i> the animals in the entire world might eventually become helpless herbivores.<p>Relevant past topic: <a href="https:&#x2F;&#x2F;news.ycombinator.com&#x2F;item?id=12368136" rel="nofollow">https:&#x2F;&#x2F;news.ycombinator.com&#x2F;item?id=12368136</a>

I have thought for a while that most of the financial advisers are just middlemen on the stock market, getting a small amount of my money by trading for me. If I just buy index funds I&#x27;ll do fine. My financial adviser who charges me at 0.75% management fee didn&#x27;t protect me from huge losses in 2008 and 2009. I don&#x27;t necessarily blame her, but she was not really different than buying an index fund or a managed year retirement fund.

If you went to a financial advisor 30 years ago, they would have said &quot;give me your money and I&#x27;ll make you a portfolio&quot;. He&#x2F;she would then have bought most of the S&amp;P 500 or some other exchange in a diversified manner buying equities and bonds. They would have shifted around your allocations ever so slightly every quarter, buying some stocks and selling others. But really, the strategy was to buy and hold. Bonds were similar.<p>Is that not indexing under another name?

The issue is that in the long run, index funds or passive investors do outperform hedge funds or active investment management as shown by Warren Buffett:<p><a href="https:&#x2F;&#x2F;www.cnbc.com&#x2F;2018&#x2F;02&#x2F;16&#x2F;warren-buffett-won-2-point-2-million-on-a-bet-and-gave-it-to-girls-inc.html" rel="nofollow">https:&#x2F;&#x2F;www.cnbc.com&#x2F;2018&#x2F;02&#x2F;16&#x2F;warren-buffett-won-2-point-2...</a><p>There are a lot of factors at play but simply for your non-analyst mom-and-pop investors, they don&#x27;t have time and the know-how to investigate stocks and index funds are just much more accessible and as they say, in the long run we are all dead.

To me, the interesting question is: if the market is mostly index funds, what does that do?<p>Lots of passive money means that the market is an amplifier for the decisions of those who choose to make their own decisions. Want $AMZN to have a little more market capitalization? Buy some, and the entire market is <i>forced</i> to follow you. Sell some, and they will follow you, too.<p>It is herd behavior (which can be quite beneficial), but it affords certain advantages to those wily enough to use the herd instinct for their own designs.

The biggest danger of all this money in index funds is that the market becomes to big to fail and the government has to keep propping it up. In fact, it becomes a way to actually disburse wealth - enact policies such that they go to people in the market.

&gt; Indexing is cheaper, yes, but that&#x27;s because active management has positive externalities, and if no one will pay for it, those benefits will disappear.<p>Oh yeah? which benefits? When you know that on average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.<p>I recently read the Little Book Of Common Sense Investing, and it was brilliant.

The only driving force for the popularity of passive investing is the bull market of the past 10 years.<p>It will be significantly less popular when we hit the next recession.

This is a common refrain. Passive indexing is killing the market. ETFs are killing the market.<p>I take a very cyclical approach on everything. The rise of passive actually creates huge opportunities for active managers. We see this already in the ETF landscape: you can invest in any product today for very cheap. This creates a new challenge to manage the portfolio of the future. 60&#x2F;40 allocations are the exposures of yesterday.

It&#x27;s actually a great article with a HN title that misrepresents what it is actually about. Anyway, with that proviso, here is my take:<p>So long as the bots aren&#x27;t conscious there will be no bot-dominated stock market. Too much information is wrapped up in conscious thought that isn&#x27;t easily expressed in stock market pattern matching. The article mentions that the line between active and passive isn&#x27;t as clear as people that make it out to be say it is, and that is true, but it&#x27;s also incomplete. Certain events are conceivable to humans that are not conceivable to machines. Short of simulating humans, anyway.<p>For example, I as a human know that there is a non-zero chance that the DPRK and USA get into a nuclear war. I can know that Trump defaulting on Chinese held US debt is something that is at least on the table. The quants can try to pull in percentages from experts all they want (and they were calling my nuclear weapons arms control friends a year ago asking for percentiles) but it isn&#x27;t the same thing because the model is still fundamentally concerned with statistics and many of the events we understand as humans have implicit dependence to each other that is hard to model.<p>It&#x27;s far easier to employ a small number of smart people and have the models serve and be tuned by them than to have the models actually run everything. Plus you don&#x27;t even really need them sometimes. Take Bitcoin, for example. The gains were obvious. The incentives were completely aligned and the friction was in the buy side and it was temporary. I didn&#x27;t need to model out Bitcoin to buy it at $4 CAD. I just had to think about it from first principles, something that is currently not possible with ML.

This is fearmongering. If the market approached an allocation to index funds that enabled arbitrage, more actors would switch to arbitrage eliminating such arbitrage.<p>It is a self-balancing situation. A scenario of &quot;oh my god, everyone is just putting their money on index funds&quot; would never happen.<p>Another way to think about it is in terms of evolutionary stable strategy. Index funds and arbitrage-seeking reach a Nash equilibrium at some point (far more index-allocated than today&#x27;s market) where arbitrage-seekers will reap returns almost equal to index funds, as index allocation starts o not capture all available market information.<p>If the market deviates from that point, forces push it back into that point. If the market starts over-allocating into arbitrage-seeking (like today), returns on index funds will beat arbitrage, pushing capital back into index funds. If the market over-allocates in index funds, index funds will return below arbitrage, pushing money out of index funds.<p>Edit: Right now, the market is still far over-allocated into the arbitrage-seeking side, resulting in a natural shift to index funds.

The worst part is that many governments around the world use peoples&#x27; Superannuation&#x2F;401k accounts to invest in index funds. In Australia, employee contributions of 12% are mandatory... So basically the government is driving inequality and centralization of wealth using people&#x27;s own money.<p>This represents an unfathomable about of money

Back when hedgies were the masters of the universe and every punk and his dog was starting a hedge fund and when you could beat treasury bills with &quot;market neutral&quot; strategies people used to blame correlation on hedgies.

I&#x27;m not sure what the concern is with index funds. For now they&#x27;re a better deal than active funds but if they take over too much of the market that will leave more opportunities for active investors to succeed.

Once they&#x27;ve found the perfect capital allocation algorithm to replace markets, they can work on the perfect policy calculating algorithm to replace democracy<p>Edit: &#x2F;s

Passive funds were never meant to be used on this scale.<p>I don&#x27;t have time to explain it to you, but this post outlines the problems with passive ETF pretty well: <a href="http:&#x2F;&#x2F;www.zerohedge.com&#x2F;news&#x2F;2017-04-09&#x2F;horseman-global-unveils-new-shorting-philosophy-using-etf-flows-catalyst" rel="nofollow">http:&#x2F;&#x2F;www.zerohedge.com&#x2F;news&#x2F;2017-04-09&#x2F;horseman-global-unv...</a>

HN title doesn&#x27;t match article title, and in fact cites a thesis that the article disagrees with.

The market already doesn&#x27;t allocate capital. Companies almost never issue new shares, indeed they buy them back. Given that dividends are also trifling, the market is mainly a large scale gambling scheme. Not entirely, but mainly.

The seminal paper on this topic seems to be Anticompetitive Effects of Common Ownership[0] by Azar et al, and there&#x27;s a whole chapter on this topic in Radical Markets[1], a recent book by Eric Posner and Glen Weyl. Both are worth reading if this is a topic you&#x27;re interested in.<p>[0] <a href="https:&#x2F;&#x2F;papers.ssrn.com&#x2F;sol3&#x2F;papers.cfm?abstract_id=2427345" rel="nofollow">https:&#x2F;&#x2F;papers.ssrn.com&#x2F;sol3&#x2F;papers.cfm?abstract_id=2427345</a><p>[1] <a href="https:&#x2F;&#x2F;www.amazon.com&#x2F;Radical-Markets-Uprooting-Capitalism-Democracy&#x2F;dp&#x2F;0691177503&#x2F;" rel="nofollow">https:&#x2F;&#x2F;www.amazon.com&#x2F;Radical-Markets-Uprooting-Capitalism-...</a>

Is a wag&#x27;s take on this &quot;Idiots no longer wasting as much money betting on long shots that are longer than they thought&quot; ?

Interesting. When I click on the article, this is not the headline I see. I get &quot;Are Index Funds Communist?&quot; with a byline of &quot;There won&#x27;t be much left to do once the investment robots perfect capitalism.&quot;<p>If it were meant as clickbait, the communist headline would be better :)

He&#x27;s right, we don&#x27;t need finance or rich people to run the economy. Bring on the fully automated luxury communism!

This narrative is such a joke, and such a profound misunderstanding of economics i&#x27;m surprised Bloomberg would publish it. Simple rule: if your argument implies that there is or will be free money to be made in the stock market, your argument is probably wrong.

Is Bloomberg a tabloid? The answer may shock you!

The conclusions here seem to be based on a) a purely passive market, and b) a static amount of capital.<p>I’d like to see an analysis that offsets the potential inefficiency of a partially passive market with the gains to the economy from additional capital being available to invest.<p>Are we better or worse off with a market that is <i>n</i>% less efficient, but that has <i>y</i>% more capital from passive investors than a purely active market would have?

Since the public stock market is no longer a place where companies sell stock to raise capital to build things to make even more capital (Tesla excepted), is seems unproductive to give people who can do well in a prediction market of the future cash flow of public companies (the stock market, basically) lots of resources for doing that. It would be cooler and more useful if we supported prediction markets in all kinds of things that people want to know about. The average yearly temperature at 50 known recording stations in Europe from 2020-2030, 2030-2040, 2040,2050, 2060-2070, etc., would be one many governments, corporations, and people would like to know about.