As a Vanguard customer, I can understand why people are so enthusiastic about their products, and have known for a while that passive investment, and Vanguard in particular, was growing while active management was on the decline.
At no point did I think the difference in inflows was anywhere close to 8.5x. And it does worry me.
I'm familiar with the contention that even having some active players in the market will arbitrage the prices back to fair value, but when they compose such a small share of such a large market that's no longer a trustworthy assumption to make.
There's no law that I know of that prevents active players from exploiting the knowledge that passive money will go wherever the market tells it to. There have got to be a lot of opportunities here for profiting, legally, at the expense of those passive investors, that goes beyond simple margin arbitrage.
My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.
I think you have identified that this is a self-correcting problem but are selling yourself short by thinking that the economy will be destabilized. If everyone goes towards passive investments, there will be huge opportunities in active investment because the passive investing is not correctly identifying value. These opportunities are likely to cause an outflow from passive into active if that is where the money is.
And the market is so huge, that even a slight amount of mis-pricing is a huge opportunity for active investors. A systematic mis-pricing of 0.1% is worth $18 billion dollars. That means the incentive to try to exploit even a minuscule amount of mis-pricing is huge.
I assume they're basing it on the combined market cap of the S&P 500 [1], the most common passive fund championed by Buffett [2]. At a market cap of $18 trillion, .1% would be $18 billion. Although, they may be basing it on old data, as of March 31 it's closer to $21.2 billion
I think the question might have been what a "systemic mispricing of 0.1%" means.
If the majority of the market is passively rebalancing, does the true value matter or does the weighting swamp it?
I see how one would make money on arbitraging pre- and post-90s mandatory rebalancing by major passives. I'm less clear on how one arbitrages difference between the prices passives are investing at and a "true" price.
> I'm less clear on how one arbitrages difference between the prices passives are investing at and a "true" price.
If the market is systematically over-pricing companies, you create a private company and then take it public to cash in on the inflated prices. If the market is systematically under-pricing companies, you buy up a company for less than it is worth, and then run it as a private company for profit-making purposes.
In real estate you'd call it investing via a gentrification strategy. Lets say in a net inflow market where the net flow is going in and supply (of new stocks) isn't keeping up with demand, you buy company A B and C and greater supply/demand effects (plus inflation, I suppose) mean they all go up, A goes up 10%, B 20%, C 30% and your investment strategy is to own equal dollar values of A B and C.
Perhaps A is large caps, B is small caps, and C is metals, it don't really matter for the sake of discussion.
You started off with purchases equal to your 33% 33% 33% goal ratios but after a year of unequal growth you're overweight C and underweight A.
Active rebalancing is selling enough C and buying enough A to get roughly equal ratios of A:B:C.
Passive rebalancing is if you're contributing $5K IRA per year or whatever, dump all your contributions into underweight A. Or whichever is underweight at any time.
Basically if your position ratios don't match your goal ratios, if you're selling thats active rebalancing and if you're merely changing the ratio of what you buy because you're a net investor thats passive rebalancing.
Going back to the real estate analogy dumping money into purchasing a lot in a gentrifying neighborhood is an analogy for passive rebalancing. If you sold your best performing property to fund it, that analogy would be active rebalancing.
VLM wrote about it excellently from the buyer's side, but I was thinking about it more from the market side.
Depending on the weighting method of the index you're tracking (and other indices that include your stocks), the indices need to rebalance purely in response to "price changes happened and reallocation is needed."
This requires buying at minimum (or buying and selling as VLM pointed out). That buying moves the market when there's a significant amount of money in index following funds.
The initial comment was about reaping arbitrage when (I think) the price the index following funds made diverges from the actual (ex index involvement) price.
I was wondering how that's operationally relevant or whether the "Don't fight the Fed" rule comes in, given that there's a massive amount of money in index funds.
Someone with more knowledge would have to chime in as to the effect in aggregate of rebalancing playing against active moves (for fundamental reasons).
Passive trackers do not need to rebalance in response to price changes when full replication is used, at least for market-cap weighted indices (I know there are also indices which are not exactly market-cap weighted and rebalance a few times per year, and of course some trading is required when the composition changes).
I think the relevant mispricing introduced by passive investing is the relative one. The question is not that passive investors are driving the S&P 500 index higher than it should. The thing is that they are failing to distinguish company A, which should ouperform because it's doing well, from company B, which should underperform because it's not doing so well.
> These opportunities are likely to cause an outflow from passive into active if that is where the money is.
Sure. But it's unclear where the equilibrium is between the volume of passive investing and the volume active investing (or if there is one).
In the meantime, the increasing share of passive investment is causing the prices on all these assets to become more correlated. This increases systemic risk. When everyone diversifies completely, you lose the benefits of diversification.
It's unclear to me how well investors recognize this shift in systemic risk. Obviously there will always still be some active investors. But how can you be sure that the economy won't be destabilized from this?
It not so much the economy as the market. If everyone is blinding buying s&p500 every month those stocks will continue to climb regardless of actual "value" based on fundamentals.
I actually think there is a valid point in that idealogies have a momentum of sorts. Passive investors historically have had privileged access to isolated "pie" via a barrier-to-entry of patience. Without this barrier-to-entry, which happens when passive-investing becomes the go-to default, the pie is distributed amongst larger people so the "patience" arbitrage is reduced. Active investors have access to smaller pie as the flow is going to passive investing but if the denominator reduces faster than the numerator individuals still receive more pie despite total pie decreasing.
So the momentum of the idealogy has shifted from people trying to beat the market to people throwing up their hands and following heuristics. The larger the momentum of the heuristic the more robust it is. (Which is bad, in an antifragile vs robust sort of way)
To use a real world example, you could say that the overall restaurant industry is vibrant only because individuals naively underestimate the difficulty in starting one. The naive trying is what produces a competitive landscape that discovers 'quality'.
Similarly, the naive trying to get VC capital (despite the majority of ideas not having the scale/growth potential needed to fit the VC model) creates a vibrant technology and new-lifestyle scene.
So during a momentum re-stabilization phase, it's possible that the truck topples over the railing instead of back onto the road. Also, the overall reduction in number of individual of thinkers also increases the impact of bad-faith agents in positions of unfair leverage.
The flows to Vanguard are largely driven by retail investors and I think you are grossly overestimating the pricing value that "active" retail investors provide.
Retail investors don't act as a rational pricing mechanism. 99% of them don't discount future cash flows, examine balance sheets, or evaluate growth prospects. In fact they statistically buy high and sell low which only serves to make boom and bust cycles more severe. They are the greater fools in the Greater Fool Theory.
Turning "dumb" retail money into passive index fund flows can only serve to make markets more efficient and stable. That said, if I had to guess the massive flows to index funds will come to a grinding halt as soon as the next market correction.
While indexing has historically been the best strategy over the long run, the low interest rate environment has made it appear to be the best strategy even in the short term. This is not normal and is due to the high correlation still lingering after the effects of QE. Once interest rates rise enough to make alternatives more appealing this will balance itself out since investors chase returns.
To expand on random_comments mention of volatility. Volatility is a big deal. Stock markets can be expected to beat inflation by several percentage points over the "long run", but "long run" is often defined in economics as "greater than your life expectancy". So there's a chance that you'll have to pull money out before it has a chance to grow, or worse, after it's lost a lot of value.
Generally you should avoid putting money into stock markets with anything less than a 10 year window unless you love risk. And you should never put your emergency fund in the stock market since stock market crashes and needing said emergency fund tend to be highly correlated, which means when you pull your money out, you are all but guaranteed to be selling low.
Hah, had my blinders on. I was trying to figure out how there was an argument for active investing in the stock market in the short term, not comparing against bonds and whatnot.
If you're a Vanguard customer (buying the flagship fund classes, I presume), you're expressing faith in CAPM[0] and EMH[1] on a significant level. Some active investors will probably in the long term scoop up some extra gains, but the question still remains: which of them, over what time horizon, and is that a risk you want to take? Vanguard gives you lots of no-commission funds with 1 day liquidity even in the mutual funds - plenty of room for you to try and time the market if you think you can have a go at active trading around some predictable flows if too many people are passively investing. Nothing stops you.
Say more. Why do I believe in the Capital Asset Pricing Model and Efficient Markets (both proven wrong) if I invest in Vanguard's cheap S&P 500 ETF?
I invest in their S&P 500 ETF because it's the cheapest way to get diversified exposure to the 500 largest American companies, and I believe that the 500 largest American companies will be more valuable in the future as a combination of valuation, scale, and cash flows to owners, than they are right now.
If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks within the S&P 500 and thereby outperform the index. A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.
I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.
You say "A disbeliever in EMH should look to identify these managers and pay them some fee".
In the next breath you say that even if the EMH is false "individuals investors should act as if it were true".
This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it."
Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)
Here's perhaps a better way to say what I'm getting at: identifying and investing with a manager that predictably outperforms a benchmark is just as difficult an intellectual challenge as constructing a portfolio that outperforms that same benchmark. Both of these tasks are so difficult as to be essentially impossible for an unsophisticated retail investor.
I'll throw you a better analogy, identifying and hiring an outperforming programmer should be much simpler than identifying and hiring outperforming investment managers because there is relatively little effect of chance on programming output and measurement of success is mostly objective.
Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide.
Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers.
Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.
Is it really worth saying that Lotto winners "Identified the correct lottery numbers"? It's true, I guess. But it doesn't really have any value, if that's all you mean.
(And yes, I understand that you agree with the conclusion there. But I'm saying what's the point of the verbal gymnastics in the first place?)
> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate.
I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of.
Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate
New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders
> I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate.
Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't!
It seems more plausible to me that (handwavy):
1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research)
2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record)
3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds)
Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.
> If the Efficient Markets Hypothesis (in its stronger forms) is false, there should be managers who are able to identify the cheapest stocks
This isn't how causation works.
> A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.
It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly.
> Furthermore, a smart manager will charge fees that are equal to the alpha they generate.
Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him.
Logically even if the EMH is false that doesn't necessarily imply the existence of investment managers who can reliably identify mispriced securities. It's entirely possible that the EMH is false and yet no one is able to take advantage of that. But your recommendation makes sense either way.
Right, those anomalies could simply exist unexploited until the market is better understood. For example, you used to be able to earn money buy buying the 501st largest company in the US: if it happened to become the 500th largest, all the S&P 500 index funds would be forced to buy its stock, and it would outperform the other stocks that had already been in the index. Similarly, the 500th largest stock would be a good sale candidate: if it becomes the 501st largest company, the index funds will become forced sellers. Now this effect is very well known, and there's no more money to be made by exploiting it.
The S&P 500 is a reasonable, good investment. I think Efficient Markets is saying "you can't do better". That claim may be false. And yet, it may be close enough to true, especially for a small investor, that Vanguard's ETF is good enough (that is, it's not worth the time and effort to try to find something better).
I think the other commenters hit on the important points and anticipated my distinctions. Note that I said "on a significant level". That did not imply blind or absolute faith. There are other investment options to match your bullish outlook if you think CAPM and EMH are wrong to the approximation that suits your involvement, knowledge, and risk profile, but you chose an index ETF. Why?
Perhaps GP believes he does not have the skills to identify market inefficiencies, or believes he does not have the skills to identify fund managers who have the skills to identify market inefficiencies. Those would seem to rule out picking securities himself or choosing an actively-managed fund.
Or maybe he just believes the market might stay irrational longer than he can stay solvent.
While you may not believe in CAPM and EMH and still invest in Vanguard funds, many do both. I used to participate in the Bogleheads forum and encountered many doctrinaire EMH proponents there. It's not an unreasonable inference to connect the two.
I think the parent commenter is more concerned about the economy's overall stability, and believes passive investors could be exploited due to mis-pricing index fund underlyings. I didn't interpret it as a worry about missing out on active investment, but I could be wrong.
My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing.
(We started out letting active players make the market by placing good/bad bets and winning/losing. We got a market that was at least trying to find the right price and we did well due to the low expense ratios. Now that we're in the majority, I'm concerned that no-one is trying to find the right price anymore.)
tldr; I have mixed feelings about passive investing over the long term if we're no longer small fish in a big ocean.
I don't understand the fear. If index funds dominate the market to the point of a near risk-free rate because that's what everyone's doing, you've effectively democratized the capital system to the benefit of the regular joe: companies still turn profits, and those become dividends. Dividends are why we buy stocks. That's what drives the whole system - not a zero-sum bilking of active investors. Yes, major growth spurts will probably be concentrated into a fewer select group of niche sectors and active traders, but that'll be their voluntary risk profile.
EDIT - I highly recommend watching some of Robert Schiller's Financial Markets lectures on Yale Coursera about general investment theory. Bogle is saying good things, but he simplifies it in a way that I can see might sound disconcertingly incomplete. You're not wrong to ask these questions if you're conscientious and smart enough to want more in-depth answers.
But then, say you come a long with a new company going public... you're not large enough to be in the S&P 500, so if everyone only invests in S&P 500 index funds, no one will buy your stock.
Similarly, if you're Apple (the largest company), and you have a really bad quarter, say you lose $100B, no one would sell your shares, because they're passive investors.
Obviously, these are edge cases (we'll never be 100% passive), but there is some concern that there will be a lock-in effect for companies currently in the S&P... It will be harder to grow if you're not in it, and it'll be harder to fail if you are.
It's a perfectly valid question. In my very cautious humble opinion, I think what it means is that the style/size matrix[0] will get squeezed more into a single spectrum: large companies will be pressured into stabilizing and delivering dividends and small ones will compete to grow large enough to get a piece of the passive investment gravy train. Apple can have a bad quarter, but it's just one company. It can't keep having a bad quarter. And if they start to and have to downsize to stay alive, they would by doing that hasten themselves out of a market cap that would qualify them for the index.
There's also no reason why passive indices have to reflect the total market weighted for market cap.
As per the article, Vanguard's biggest fund is the Vanguard Total Stock Market Index which tries to track the CRSP U.S. Total Market Index. That index is "Nearly 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market." I don't think you have to worry much about a bifurcation between large and small companies. My worry would be that the "investable equity market" is shrinking and that most the growth in the future will come from companies pre-IPO where non-accredited investors cannot invest.
The number of total publicly traded companies isn't projected to get anywhere close to historical levels in the near future. There are steps being considered to change the current definition of accredited investors and/or to permit non-accredited investors to participate in private investments. See helpful reading/viewing:
"My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing."
I'm intrigued by your suspicion ... but I can't put my finger on the exact manner that this might play out ... it's really hazy.
It seems to me that the effect of everyones money going into index funds would be that firms large enough to be in the index would have less and less pressure to issue dividends ... if there is a ready market of buyers of your stock based solely on your size then why bother ?
If money flows, by autopilot, into an asset class wouldn't we expect that asset class to return less and less as time goes on ?
Size-based index funds are just one type, there are others, including ones that track stock of high dividend yielding companies. Just because passive investors aren't trading daily doesn't mean they won't adjust to better funds, forcing companies to pay out.
I think the long long term problem is that the stock market has an increasing disconnect between investment in new businesses doing anything well new, and to an increasing degree novel business practices in existing businesses.
Yes, there are some IPOs, but overall new business starts are still in decline, and large portions of financial markets seem both too systematically risk averse, and yet willing to follow other risks blindly.
> the less active money there is around, the less accurate our concept of a correct value can be
The problem is deeper than that. Active shareholders actually give a shit about corporate governance. Collectively, they put honorable and competent people on the board of directors, and make sensible decisions when other issues are put to shareholder votes. Vanguard and other indexing funds could barely care. Their incentive to care is so small, we may as well call it nothing. Whereas the employees who control these voting blocks at Vanguard can easily make decisions that cause 10,000x more financial impact than their total compensation. And whenever someone is endowed with such power, human behavior throughout our existence has shown most people will be corrupted by it (e.g. see government employees).
Some researchers have looked at the effect of passive investors on corporate governance[1] :
> Still, these funds retain the power of voice, the ability to exert shareholder influence on management and governance-related proposals. But critics say passively invested funds, with their lower fees, lack the resources and often the will to monitor their large and diverse portfolios. The Economist calls them “lazy investors.”...
> My fellow researchers and I set out to test that claim. In our forthcoming research paper in The Journal of Financial Economics, we show that passive institutions do indeed positively shape firms’ governance policies. Our findings run contrary to the presumption that passive investors lack the willingness and ability to influence firms’ policy choices.
> The results of our analysis suggests that passive investors affect firm governance in several ways. For example, we found that an increase in passive ownership is associated with a statistically significant increase in the share of independent directors on firms’ boards. In addition, firms with higher passive investor ownership were more likely to remove firm takeover defenses (for example, so-called “poison pills” and limitations on shareholders calling special board meetings). They were also less likely to have the unequal voting rights of a dual-class share structure.
I don't know how to say this, but I would trust a common sense understanding of human behavior over research. If there's one rule in life, it's that high finance will exploit legal and immoral loopholes to accumulate wealth, and there is plenty of opportunity for that here, despite the rigorous academic studies done by an institution that is highly connected to the people who can profit off of it.
This exact sentiment is exactly how research was born. In large complex systems, a few ideas pop up that take the system in non-intuitive directions; non-linearity of influence of small factors, hidden factors, etc.
Also, I would counter that in a firm, the legal and immoral loopholes that would give one party greater wealth would do so
1) at the expense of other parties inside the firm and 2) run the risk of bad optics / PR to institutional investors who look out for things like this when evaluating a firm.
Lastly, the aggregate of these factors is baked into the return on investment of a stock. In other words, I suspect that might be happening in firms that are making alot of money and providing healthy returns for shareholders. Alot less so at firms that are struggling and not providing much growth.
You claim that Vanguard doesn't care about corporate governance, but that doesn't match their voting record.
For instance, at the 2016 Alphabet meeting, they voted for Alphabet shareholders having one vote per share and adoption of a majority vote for election of the board. Those are the very core corporate governance oddities that Alphabet is using to allow the founders and Eric Schmidt to have total control of the company and Vanguard voted their shares towards better governance.
Obviously, since Eric Schmidt and the founders have the majority of the votes, these didn't pass, but they voted the way you would have liked and against management.
So you found one anecdote where they cast a meaningless vote in a direction that you agree with (not necessarily the correct direction, but whatever), and you think this constituted a rebuttal to my statements? I'm sure there are hundreds if not thousands of instances where Vanguard voted in a direction you agree with, but that doesn't change my argument.
I'd make that narrower than "active shareholders". The only kinds of active shareholders who can exercise informed and effective oversight are large, professional active shareholders, who buy significant percentages of companies (enough to have a voting share that matters) and have in-house research and legal departments. Many active shareholders don't really look like that. The retail stock-picker buying stocks on ETrade isn't in a position to exercise oversight of the companies they're buying any more than they'd be if they were buying them through index funds. So I don't think much is lost in terms of corporate governance if that group of people moves from stock-picking to index funds. In principle, something could still be lost in the stock price signal if they move to index funds (a different question than corporate governance), although whether retail stock pickers, even taken collectively, are contributing anything useful to the price signal is not necessarily certain.
Individuals buying smaller amounts of stocks may not be exercising their votes or have a board member in their back pocket, but they can in the aggregate greatly influence one thing upper management does care about: the stock's price. Unfortunately, if you think management is too focused on the short term, if everybody investing with long horizons buys mutual funds and day traders focus on individual stocks, management is likely to be even more short term focused.
Whether they are mentally capable of making good decisions is another story. But presuming those people exist, then the system should at least be structured in such a way that they're incentivized to use them to properly manage their own assets, rather than in more shifty/nefarious ways.
Tell me what you think the result of this scenario might look like. A manager wants to conduct an LBO that grossly undervalues a stock. He couldn't get the votes from shareholders if they were paying attention, but instead he walks up to management at Blackrock, Vanguard and State Steet, and offers the people in charge of voting a very lucrative job at the new private company. How do you think they'll vote?
What would you think about a system where a major institution (e.g. Vanguard) holds index funds, but the shareholder voting for each company in those funds is done by a different in-house team whose compensation is tied to the performance of that particular company? (More realistically, you'd just need a different team for each company in a given industry, but one team could vote for multiple companies that don't compete with each other.) It's "passive investing with active shareholder governance" in the sense that only voting, not dollars, are actively directed.
I don't like it. It suffers from the same problems, but just window dresses them. There's no way to make that team financially culpable without charging fees related to the results, and those fees are largely what people are trying to avoid when using these low lost index funds. And those fees need to be very sizable to be consistent with the value of the decisions they're making.
I think a better approach would be to pass through voting to the owners, but given that most shareholders don't know enough for their vote to be more than a random guess, that wouldn't much solve the problem, either. But at least the people who are affected by the decisions being made are the ones making the decisions.
I don't understand why that would be the case. Just charge a flat fee for the fund and distribute proportionally to the teams whose companies do best.
It sounds impossible to satisfy your desiderata with unsophisticated investors. They will have to delegate the task of assessing board decisions to someone.
Actually Vanguard claims they care more: active investors will get out if things go bad - they might even make decisions that are good short term bad long term. Vanguard is in for the long term so they care more. One of the things Vanguard can do is ensure good management is in place.
By "active management" I mean actively taking a role in shaping company management, board makeup, corporate governance, say on pay, etc.
While Vanguard may vote all their shareholder proxies, they almost always vote along with the recommendations of management - practically never holding management accountable.
Yet, this is a general problem of all kinds of investment funds, not only of index ones.
It is a huge problem (and probably responsible for much of the lawlessness we can find on Wall Street), but the switch from active to passive investment shouldn't change a thing.
It's not necessarily active vs passive. It's skin in the game vs no skin. Low fee index funds offer no incentive for the managers to do any actual managing. They follow an equation, and collect a few bps.
Yes, it's not even that simple. It's about having enough skin on the game.
No big fund manager has enough skin on the game. That has been true for most of last century and all of the current one, and the expected results are visibly there.
This is why my push isn't to necessarily increase the active management profession, but instead increase the intelligence of individuals and freedom of necessary information for them to properly manage and understand their own assets. Even if they do just end up choosing to invest in a market cap weighted broad based index, it's important for them to understand how to behave with the management of those assets and to have the ability to manage them (see the distinction versus investing in index funds, because Vanguard's investors do not manage their assets). And if they do not have the requisite intelligence to manage and understand the things they own, maybe they shouldn't own them.
> Collectively, they put honorable and competent people on the board of directors, and make sensible decisions when other issues are put to shareholder votes.
I don't believe this. They bring in axemen to cut jobs for a bump in stock price. For one, why do they allow for huge severance packages even when they fail?
Talking about honorable and competent people on the board of directors. I recently realized that Apple's board of directors includes Al Gore. He's certainly a honorable man, but what does he know about making and selling iPhones? Why is he on Apple's board of directors?
> Talking about honorable and competent people on the board of directors. I recently realized that Apple's board of directors includes Al Gore. He's certainly a honorable man, but what does he know about making and selling iPhones? Why is he on Apple's board of directors?
His job isn't to make and sell cell phones. His primary function is to make the C-suite accountable to shareholders. The C-suite's job is to make and sell cell phones.
Frankly, Boards function mostly on business metrics and people skills that are generic to any business.
Al Gores real job on the Apples board had been to have Steve Jobs back. Jobs wanted a card blanche to lead Apple (and never be fired again) so he picked a respectable board loyal/friendly to him.
He has a working knowledge of how governments operate, and as such knows the right person to call and the right procedure to follow to get stuff done. He probably also still knows a bunch of people whom could be useful to know if you're operating a huge multinational company.
Yeah, the slow and steady rise of stock prices across the board is in large part just an effect of increased money supply. Sure, lifting along with that passively is cheap and reliable way to make money. But since these types of passive investments care little about how efficiently the beneficiaries make use of these investments, there's the danger that inefficient companies end up with too much capital.
If that happens, you end up with resources such as labor being wasted. The efficient usage of the available resources is of course a much better indicator for the quality of the economy than the rise of stock prices.
> there's the danger that inefficient companies end up with too much capital
I can't see why this is any kind of danger. Companies end up subjectively with "too much capital" all of the time in this market without being part of a large index. Look at tesla.
ETFs can be arbitraged much more efficiently due to creation/redemption features. There are market markers like Jane Street who do a ton of this.
The more risky effect is that all stocks in an index become more correlated with it over time, leading to larger jumps in single names around earnings seasons when real information is released to the public.
> This situation has the potential to de-stabilise the economy sooner rather than later.
If these passive investment funds create a positive feedback loop for some stock prices - I don't know if that's the case - then this could be a pretty high risk.
On the other hand, I would intuitively expect them to have a dampening effect on the "pump and dump" schemes that created so many bubbles. So, in a way, they could even help stabilizing the markets?
> My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.
That won't happen (probably).
The less accurate our concept of correct value is, the more competition it will draw as the margins increase.
Realistically, we can be probably something absurd like 80% passive funds and 20% active investors and be fine.
Vanguard is not as passive as you think. they don't trade often, but they do trade. Their S&P500 fund doesn't just hold stocks in the S&P500, it also holds other stocks that could have been but S&P500 had S&P not limited the index to 500 stocks. Vanguard fund managers regularly make active decisions on what stocks to buy/sell.
Vanguard is not nearly as active is most mutual funds, but they are not entirely passive either.
Active and passive are just marketing labels. The frequency of trades should be correlated with the expense ratio. If you do more trades, you better be hiring more analysts to figure out those trades.
Vanguard has lower costs because it employs fewer people to execute fewer trades. That's all I really care about.
Expense ratios for actively managed funds aren't that tied to trading frequency, I don't think. Most of the cost goes to paying for research, and that can be for positions held on all time scales. Someone picking a handful of blue chip stocks based on fundamentals is still definitely "active investing" even if they buy and hold for a long time.
Vanguard offers a range of products. Some do really hold the stocks in the benchmark. "Vanguard S&P 500 ETF is an exchange-traded share class of Vanguard 500 Index Fund. Using full replication, the portfolio holds all stocks in the same capitalization weighting as the index."
> My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.
Could that be mitigated by people not completely jumping on the passive bandwagon (e.g. by keeping say 5% in active funds)? Wouldn't all that you need is an active enough and large enough market to resist manipulation?
Active money is trading much faster these days. A smaller percentage is enough to make the market efficient.
The outflow is mostly from active domestic equity mutual funds (average expense ratio: 1%-1.5%) to index domestic equity ETFs (average expense ratio: 0.1%-0.2%), so it's really about lower costs and the relative underperformance of active management.
Your last sentence is terribly wrong, and unfortunately, many people share that mistaken view. Let me explain...
Active managers go around with the notion that as they die off to be replaced by index funds, that there there will be no price-finding.
But here's the thing - before managers, and before mutual funds, most people were buy and hold investors. There was very little "price discovery" compared to today, as most stocks sat on a shelf (literally, as people had paper certificates for the shares they owned).
In that world, the price discovery function was quite small, but clearly adequate.
Today, there are many highly-paid managers who "actively" manage money. ( I challenge the "actively" portion, because many are closet-indexers. If you google "active-share", you can find more about this.) But even if they aren't closet indexers, in any given year, most cannot beat their benchmark. When they can't beat their benchmark (which, ironically is an index), they are inefficient.
That statement bears some emphasis - When Active managers cannot meet or beat their benchmarks, they are __REDUCING__ the market's efficiency. Put simply, they were wrong on what they thought the correct price should be, thereby hindering price discovery.
Read that last paragraph again - it's extremely important. Also, note that there are many people on Wall Street who are highly compensated, and afraid that their jobs will go away because of indexing (note that the S&P 500 is only one index - there are hundreds of others, including MSCI and Russell indexes). They are right to be concerned. After all, as in anything in life, if you can't keep up with the benchmark, you will get cut. This happens in professional sports, people in college with poor grades, and anybody in a sales job. And it's been happening in finance since before any of us were born.
One final note: Back in 2001, the US markets moved from fraction pricing to decimalization. In short, the price increments went from 1/16 of a dollar to 1/100 of a dollar (i.e. a penny). That's a six-fold improvement in pricing accuracy. To think that having less active money will destabilize our economy is unfounded.
It's been a looong time since I've studied financial economics but I do think there's an active research literature around this topic (under the topic of market microstructure maybe?).
If I recall correctly (and again, it's been a while), I think the amount of passive funds has to be quite substantial for markets to be really bad at reflecting value over the long run.
And it's a recurring topic in Matt Levine's Money Stuff newsletter. The finance community is not only aware but actively thinking about the ramifications of the situation.
If most people ends up investing in strictly index funds, it would end up badly foe them but I don't see it by itself causing a destabilization. Just a lot of people making sub market profits. It would take a large amount of people doing fad based investing and switching all at once cause destabilization, such as what happened during the dot com bubble and the housing bubble.
If investing decisions get slower in general, then I think it would be a good thing. The number of company decisions made only for only the next quarter rather than long term profitability would be much less if it took time for people to switch the companies they invest in rather than doing so instantly, which would in turn make a more efficient and stable market.
With index funds so big, who determines prices? An index fund tied to the S&P 500 just buys stocks in the proportion that they're in the S&P 500. The price of the stock plays no role in that decision. At some point, this has to create problems, but so far it hasn't. It does mean the active traders, who are basically moving the same money around all day, have an outsized influence on prices.
Index funds are so successful because managed stock funds, as a class, underperform the market indices. So do hedge funds, which are a net lose for their investors. People are finally aware that Wall Street's stock pickers mostly aren't very good.
> With index funds so big, who determines prices? ... At some point, this has to create problems, but so far it hasn't.
Any active trader remaining in the market. Fortunately, active traders still make up a large part of the market. And the bigger indices grow, the larger the opportunities for active traders to profit. It's not a real problem — it's self-correcting.
> And the bigger indices grow, the larger the opportunities for active traders to profit. It's not a real problem — it's self-correcting.
I appreciate that finally someone puts forward a rational argument as to why index fonds will keep working. Books and online resources tend to not take a critical look at the system at all or they offer an answer along the lines of "Trust me!"
Having said that, only hindsight is 20/20! It feels like we are rushing into the next great financial experiment. In a complex world there is simply no telling what's actually going to happen. I assume (any sources?) that currently more money than ever is flowing into index fonds. Furthermore, chances are this is just the beginning. For instance, the buy-and-hold hype is just arriving in Europe. Blogs and online communites on this topic are currently mushrooming here! Yesterday I even saw an ad on Germany's biggest TV station right before the evening news. This is very unusual to say the least as the common people of Germany by and large have an incredible amount of distrust in anything but savings books! This current gold rush mood is just scary to me as usually, when something hits mainstream media, the magic is gone!
Anyhow, the question I am asking myself is: What will the market do now that it has access to more cash than ever? Are the markets even productive enough to put those sums of money to good use? Or is this bonanza just FU-money that encourages more reckless behavior?
I can only speculate as to what is going to happen but my hunch is that in the long term the gap between returns from index fonds and savings books is going to become a great deal smaller as more people are willing to shoulder risk for companies and thus risk premiums go down. There may still be active traders who try to find opportunities but I suspect structurally the percentage of passive investors will expand quickly and won't go back below today's percentage.
You're talking as if there's a swarm of fresh money flowing into the market, whereas it's more a case of people shifting away from traditional actively managed mutual funds etc. into indexing.
Money is cheap at the moment because growth is low, and that in turn means risk premia are lower and so on, but I don't think that's related to the rise of index funds. Then again I never understood why active management was so popular in the first place.
> You're talking as if there's a swarm of fresh money flowing into the market, whereas it's more a case of people shifting away from traditional actively managed mutual funds etc. into indexing.
Yeah, the question seems to be about fresh money. You could be right that we are mostly witnessing a shift from actively managed funds to indexing. As far as my home country (Germany) is concerned indexing seems to become more attractive to people who never invested, though. Now that I think about it I am not sure whether or not this kind of money would be "fresh money" as these people stored their money in banks who were probably investing it.
> Money is cheap at the moment because growth is low, and that in turn means resk premia are lower and so on, but I don't think that's related to the rise of index funds. Then again I never understood why active management was so popular in the first place.
As I understand it, risk premia is not related to growth. It is simply the costs to transfer risk to someone else. Active management was probably high in the past as banks had little incentive to sell passive investment plans: If people don't constantly buy and sell they don't cause transaction costs and thus income for the bank. Active and passive management are both neither inherently wrong or right. Until now active investment has been irrational but it could theoretically change if the share of money passively invested is high enough, say (made up number incoming) 80%.
> As I understand it, risk premia is not related to growth. It is simply the costs to transfer risk to someone else.
My point was that investors targeting a particular rate of return are having to take on more risk (because growth is low), which in turn lowers the risk premium through ordinary supply and demand.
"Money is cheap at the moment because growth is low, and that in turn means risk premia are lower and so on"
Maybe. Money is cheap if you are a bank or a government backed borrower (like a conforming mortgage loan in the US).
If you have collateral, like the car you're borrowing against, money is kind of cheap ... also if you have a perfect credit history.
But I am not so sure that money is cheap right now out in the real world. If you are a new business with no track record or a consumer with poor credit history I think money might be quite expensive for you ...
> But I am not so sure that money is cheap right now out in the real world. If you are a new business with no track record or a consumer with poor credit history I think money might be quite expensive for you ...
Really? My understanding was that (non-mortgage) subprime lending was higher than ever, business loans were cheaper than ever...
I can only speculate as to what is going to happen but my hunch is that in the long term the gap between returns from index fonds and savings books is going to become a great deal smaller as more people are willing to shoulder risk for companies and thus risk premiums go down
Doesn't that suggest people on average have had a misplaced fear of stock (indices) in the past, and that capital is now more efficiently allocated? Sounds like it would make the world better off.
> Doesn't that suggest people on average have had a misplaced fear of stock (indices) in the past.
Yes, I think this bit is pretty much agreed upon today. Hence the run for indices.
> and that capital is now more efficiently allocated?
That sounds likely to me.
> Sounds like it would make the world better off.
As tempting as it is to argue one way or another ... I think that's an impossible statement to make.
But like I initially said, it's all just speculation anyhow. Tbh these kind of discussions are inherently whacky. Chances are everything you've quoted from me is flawed on so many levels if one takes a closer look.
Discussing finance is mostly a fool's errand.
Does anyone know what fractions of American equity currently belong to active and index investors? That seems like an important question, but the article doesn't address it.
Index funds buy or sell blindly, at whatever the prevailing best price is. Naturally, if there were only index funds in the market, the price would vary randomly.
That being said, consider what would happen if stock prices did start to vary randomly - if you had actual research suggesting the price was too high or too low, you could trade accordingly. This would net you a profit, and also help push the price in the opposite direction, towards whatever a reasonable price is.
The larger the deviation from the "correct" price, the larger the potential profits are to be had. So if the problem ever starts to be significant (i.e. a few cents of deviation caused by index funds), this means a very large potential profit for any active funds or traders out there. And so we would expect the system to reach an equilibrium - where there are just enough active funds and traders to snatch up the profits that arise from tiny price errors and distortions caused by index funds. In effect, the index funds are paying those remaining active funds and traders a tiny "management fee" (in the form of exploitable trading behavior) to figure out the appropriate price of stocks for them!
But the "correct" price is the one the investors are willing to buy at, right?
Imagine that 99.98% of all investors are index funds, and there is a company BigCo that is at some point is at the top of the market. So pretty much every index fund invests in it.
Then suppose BigCo makes some move that would traditionally be a mistake. Like it has some scandal, the sales drop off, etc. Say it even has a bad quarter.
How do I, an active investor (among the remaining 0.02%), make profit from the arbitrage? For the stock price of the company to fall, there'd have to be no buyers at the given price. But the index funds will keep investing in it. Why would it drop off even a little?
Even if it doesn't drop off, you can make money by investing into businesses who give you better long-term growth and (related) dividends than the one that everyone else is buying through index funds which you know isn't doing well.
This would require a long-term view similar to how Berkshire Hathaway is acquiring businesses. If active investors' short-term price speculation were reduced in favor of long-term bets, that might be a good thing for businesses and the economy overall.
And of course, if this situation actually becomes commonplace, chances are the market for index funds is going to self-correct since a well-performing stock needs either solid dividends or above-average growth. A market with 100% indexing can not give you above-average growth, and dividends depend on actual business performance.
Good stock pickers > Index Funds (blind money) > Bad stock pickers
By investing on index funds you are betting in the average of the average (a fund is already an average of undervaluated and overvaluated stocks).
However, by investing on managed funds your probability of having profits over index funds is low: even if stock pickers that beat the market (by definition) amount to 50%, extra fees make most of them still less profitable to investors than passive funds.
I'm assuming that is a reference to the random walk theory. That theory suggests that "the past movement or trend of a stock price or market cannot be used to predict its future movement". It's random in the sense of unpredictable, not in the sense of actauly being determined by chance.
The implication of the random walk theory is that current information is already uilt into the price of the stock. That is only true insofar as there are active traders acting on that information. The parent is merely explaining why those traders will exist, and why you only need a small part of the market to actively trade.
Random walk depends on all participants acting rationally based on the same information released at the same time. However, index funds are not rational, they always buy in the same ratios regardless of news.
You also have the situation that index funds must buy or must sell a stock if it enters or leaves an index. This creates an opportunity for active traders.
We'll see how the next large correction plays out. That the "problem" may be "self-correcting" is not very reassuring (the dot-com bubble and the subprime fantasy also ended with some nice self-correction).
I've been meaning to read this essay which I believe argues that with index funds so big, prices are determined by the remaining investors who think they know better than the market -- which in theory should mean that the market gets even better information than it has now and determines prices even more accurately: http://www.philosophicaleconomics.com/2016/05/passive/
I'm not 100% sure I understand the argument or have presented it correctly. It's reassuring.
The other takeaway here is that if you have a theory that ETFs are going to become increasingly popular, you could "test" that theory by investing directly in companies with run ETFs.
For example you could buy some NYSE:STT or NYST:BLK and that might help you invest in "people pay a premium for the liquidity and other benefits of ETFs". Of course, you'd want to believe that that theory will outperform the S&P 500 :)
I had assumed - perhaps incorrectly - that as more and more money is invested in index funds and similar passive vehicles, it becomes increasing easy to beat the market as an active trader.
My thinking goes like this - as less money in invested actively, the market becomes less efficient at pricing. As the market becomes less efficient at pricing, it becomes easier to make money as an active trader. As it becomes easier to make money as an active trader, more money is invested actively, and the market becomes more efficient at pricing.
I may be using "active trading" incorrectly -- I just mean any kind of non-passive trading, both long and short term. But presumably, any kind of active trading theoretically increases the pricing efficiency of the market?
Your intuition seems correct but with a big caveat. If you divide the market in two, active to one side and passive to the other, both of them will have the exact same returns as a group. That's because all the passive investor is doing is replicating the market average and not changing it so the mix of stocks the total passive investors hold is the same as the mix of stocks the total active investors hold. That means as more money gets invested in index funds pricing becomes worse and thus there are more active funds that make a lot of money and more active funds that lose a lot of money and on average they still make the same returns before fees than the passive funds.
It only stops being like this if pricing gets so poor that active funds can start to trade in ways that the passive funds can't replicate, either because they're faster or more frequent or have some other trading advantage that makes it very hard for the passive fund to replicate it effectively.
What do you mean by "pricing"? If there were only passive investors in the market, all the stocks would move together. Apple could announce that the next iPhone will be delayed until 2020 or Google could discover how to get energy from water and there would be no reaction in their stock price.
I believe the comment was talking about any kind of active trading (i.e. picking individual stocks to buy and sell), not only HFT, which uses millisecond fluctuations in security price to make a profit.
Vanguard seems to have gone a bit too far with cost-cutting in the customer services department. One of my most frustrating recent experiences was dealing with Vanguard's website and customer service. There were all kinds of issues, some minor annoyances, others serious time sinks.
Here's an excerpt from a long and boring story:
... One day, I couldn't log in to their website. Attempting to go through "forgot my password" had me fill out a long form with security question. I filled it out, pressed submit, and was presented with the same form, but blank. No error message, nothing else. I thought their website must be broken that day, tried again the next day with the same result. After doing this a few times, I called them. Turns out, my account got into some invalid state. It took them more than a week after that to figure out what was wrong with the account and fix it.
Then, my account fixed, I tired to buy some eft-s. Website replies: "Cannot perform this transaction, call us for assistance". I think that's a temporary outage, try again the next day. I called them again, waited a while to get an agent, found out they needed some more documents from me. I sent them in, but there was no way to find out if they were happy with the documents on their website ...
I don't understand how companies like that can thrive (but many do). If I have to pick up the phone to solve a problem even once, I'm angry. If I have to call them twice, I'm looking at alternatives. I may decide not to switch if the alternatives are even worse...but, I'm looking to get out of the shitty relationship I find myself in with that company. (This frustration is fresh in my mind because Security Metrics just told me to call them about PCI compliance...I refused, and will be going elsewhere for that service.)
Big finance seems particularly bad at user-facing technology. Which doesn't really give me confidence in their back end tech.
> If I have to pick up the phone to solve a problem even once, I'm angry.
> If I have to call them twice....I'm looking to get out of the shitty relationship I find myself in with that company. [emphasis mine]
You are way too sensitive and demanding, IMHO. You're probably a developer: is this how you want people thinking of you when you inevitably push a bug? I can understand looking elsewhere after a pattern of problems and repeated frustration with no improvement, but getting pissed off just because you have to talk to someone one or two times is just unreasonable. Have a little empathy for the people on the other side.
I wasn't saying anything about demanding perfection. I was saying that talking to someone on the phone is the worst customer service experience in common use.
It is because I have empathy for the person on the other side that I'm angry at the corporation for making me have a conversation I really don't want to have. I am always nice to the person I speak to, despite being angry at the company they work for for wasting my time and making me interact with them in a way I really don't want to.
My anger is over the fact that I've been given no option but a phone call.
> I was saying that talking to someone on the phone is the worst customer service experience in common use.
I disagree with that pretty strongly. The phone is the second-best method for communicating a complex or unusual problem, only behind a face-to-face meeting.
Anyway, the worst customer service experience in common use is actually the fixed-option support menu (that usually obscures how to contact a real person).
The real determiner of good customer service is how the process was designed and how empowered the representatives are to fix your problem. Case in point: Amazon's famous customer service. I had an unusual problem with an order recently. Their chat support utterly failed to help me after several tries, leaving me very frustrated. Their email support couldn't help me either, but explained I needed to call. It turns out only their phone support is empowered to escalate things to someone who could help, plus the it was much easier to relate my issue to them. None of that frustration had anything to do with the phone vs. chat vs. email, but everything to do with Amazon's (poor) support choices.
> My anger is over the fact that I've been given no option but a phone call.
I can understand feeling frustration at that, but not anger.
Not really. They aren't better than Fidelity or Schwab for the vast majority of people, their brokerage accounts are all very, very similar.
Plus Schwab and Fidelity both offer better additional products. Both offer totally free, no catches, ATM reimbursement, no minimum balances, no fees alternatives to a checking account. Fidelity also offers a no annual fee 2% cash back on everything credit card.
Vanguard has a different cooperate structure, however, if that's important to you.
I'd love to hear a case made for Fidelity/Schwab being even with Vanguard. My understanding is that Vanguard's expense ratio is the best (and it goes without saying this makes a big difference over time). Has Fidelity's expense ratio recently moved to match Vanguard's?
This is obviously a Fidelity marketing spiel...but it's not a lie...Fidelity's active funds (which they made their name on) are definitely more expensive than Vanguard, but if you buy their passive index funds, you basically get equivalent expense ratios. (Same is true at Schwab.) And IMO, their website is far better than Vanguard's. I'll give Vanguard credit for jump starting passive investing for the little guy, but they aren't significantly different than their competition anymore.
>The $96.4 billion Fidelity 500 Index Fund (FUSEX), which tracks the S&P 500 Index, will drop its annual expense ratio by 0.5 basis point. The gross fee is now 0.10%, with a current net fee of 0.095% due to fee waivers. That will fall to 0.09% on July 1. In comparison, $45 billion Vanguard 500 Index Fund (VFINX) has an expense ratio of 0.16%
Fidelity also offer iShares ETFs (also low expense funds) as well as their own low expense ETFs commission free.
I can't comment on Schwab because I don't use them but from what I hear they have very similar offerings for low cost mutual funds and ETFs.
There was also just a commission price war a month or so ago initiated by Fidelity and as a result most brokerages dropped their commission significantly.
From what I understand Vanguard offers more services if you have a profolio over $1 million.
I'm very happy with Fidelity. I only purchase low cost index ETFs through them. You're going to pay more if you want active managed funds, but that's not the topic of discussion.
Even if you don't use their brokerage services you should use either Fidelity or Schwab's checking account. Really, a no brainer, banks don't offer anything even close to as good.
It's very competitive market nowadays and as another commenter pointed out, Fidelity has a much better website.
EDIT: What I meant by "their brokerage accounts are all very, very similar" I really mean "their brokerage account offerings are all very, very similar in price for someone interested in investing in low expense ratio index funds."
Schwab recently introduced much lower fees on their index ETF's. According to this, they're lower or equal to Vanguard (depending on how much you invest).
Every time I've had a 401k provided by work, there were multiple options from multiple providers. Is that not common?
That said, we probably agree that it's a market without a lot of competitive pressure, and that often results in poor customer service (just as in the case of telcos).
I try to choose service providers that won't demand I talk to them on the phone. It works out OK. I very rarely have to talk to strangers on the phone.
The fact that Vanguard is growing faster than everybody else combined is interesting indeed. The article itself, however, reads like one big ad for Vanguard. The fact that the NYT is somewhat affiliated with them ("They number well over 20 million and include New York Times employees: Vanguard runs the company’s 401(k) retirement plans.") doesn't help either. What I miss is a critical examination of the situation. They're just drinking the Kool-Aid.
Although negativity on HN is often too high I am glad it is here when it comes to articles like this one!
>The fact that the NYT is somewhat affiliated with them
So a disclosure that they use a massively popular product is now an advertisement?
Just one time I'd like to open the comments and not have someone saying "fake news" or "this is just an ad" or "stick with the facts".
Vanguard is an interesting company doing big things. They invented the index fund. They are massive. The New York Times profiles companies like this often.
Personally I find this more interesting than a Musk tweet announcing an announcement six months in advance.
No it isn't. I merely said that the article reads like an advert (not: it is an advert) and furthermore I said the affiliation would not help to shake this impression off. This is merely an aside and still doesn't imply it is an ad. My main problem with this article is that it is not critically examining what it is reporting about. Whether or not it actually is an ad is secondary.
Pardon my ignorance, but how would NYT directly benefit from a boost in Vanguard popularity? Say this article somehow elicits a bevy of people/companies to invest in Vanguard, raising their mutual fund from $4.2 to a $4.5 trillion. Given that NYT stake in this fund remains constant, it's not clear to me how this helps NYT employees - unless $4.5 trillion is the tipping-point for market manipulation (but isn't this fund simply tracking major indexes?). Or would the biggest benefit come in the form of even lower fund fees (<0.1%)?
It wouldn't. It's utterly insignificant that Vanguard hosts their 401Ks. That's like saying, "Full Disclosure: Many NYT employees have accounts at BOA!"
Vanguard gives discounts to large institutions. If a NY Times story helps Vanguard, Vanguard could cut their rate a bit.
I don't think this is likely, but I think it's clearly possible, and noting this potential conflict of interest seems prudent. This is what the disclosure is for.
> Pardon my ignorance, but how would NYT directly benefit from a boost in Vanguard popularity?
I never said they would. I could imagine they got paid for this article but if I said so I would go out on a limb as I don't know whether that's the case.
All I am really saying is this:
> What I miss is a critical examination of the situation.
Its the plight of the newsreader, whereby you add nothing when writing about a subject, do no research on it, and avoid thinking critically about the news you've been told to publish or read to the viewers on TV.
Newsreaders are not journalists, and being unable to form an opinion of their own, they are often willing to regurgitate anything their sources tell them without fail.
I don't know what world you're living in. The news is too full of opinion these days. If only I could find a source that JUST reported the facts I would give them all my money.
There's no such thing as neutral factual reporting - facts can be distorted or omitted to meet a bias at any level.
In my opinion the Reuters/AP feeds and The Economist do a good job of providing enough info you can make up your own mind based on your own preconceived biases, though.
That was my point, rather than research a topic and give the reader/viewer hard facts, major "news" orgs bring in opinion panels that degrade the conversation and add nothing of value.
"Journalists" are not journalists, and being unable to form an opinion of their own, they are often willing to regurgitate anything their sources tell them without fail.
I seem to have struck a nerve. You know it is true. The white house press corps, the science coverage, etc. Most reporters are undeserving of the association with journalism on the level of an, e.g. greenwald. They act as propaganda channels for "authorities".
I'm fascinated at how Vanguard's essential idea plays out over the long term.
The basic value proposition seems to be that Wall Street is extracting more value in fees than they're making in smart stock picks. Which thus far has been pretty accurate, but is the contribution of stock pickers actually zero? Is it negative? Where do we reach a fixpoint, and how? Do the stock pickers, clever scamps that they are, figure out a way to take advantage of the Bogleheads and their naivete? Are they already doing so? Is this going to turn the stock market into just one big house of cards?
I mean, don't get me wrong, I absolutely buy that Wall Street is a bunch of crooks-- it's a hell of a lot easier to extract fees from your customers than it is to beat a market full of highly motivated Ivy Leauge MBAs. But where does it stop? If I've seen any trends in the financial markets, it's that every good idea will eventually be flogged to death, usually with catastrophic results.
This may sound snarky, but it's not meant to be. When I've worked in large corporations I was astounded by the amount of... shall we say "irregular" stock activity. For a while I've been struck with the thought that you could probably make a pretty good living simply buying long stock the day before executive stock options are issued and then selling them again when executives are selling theirs (either through planned trades or when blackouts are lifted).
Interestingly (for me, anyway) the very large places I've worked at often let the peons listen to the analysts meetings over the phone system. Again, I was shocked by the complete lack of knowledge that analysts at big investment houses have in the companies they were analysing. They would be completely unaware of large acquisitions, law suits and any number of things that even the casual observer would know about. I really got the impression that their job was literally to attend the meeting and report the company's projections. The company's could get away with murder because nobody was paying attention to what they were doing.
Not sure if things have tightened up since that time in my life. I haven't worked for a big company since the early 2000's, but somehow I get the impression that there are probably plenty of ways to ride on the coattails of less than scrupulous executive compensation.
I have an engineering background and worked with a major telco for several years before moving to work as a financial analyst for a while.
Few of the other analysts had an industry background in the companies they covered. Mostly they had an accounting/commerce/economics background. They were good at pulling together financial models from the data and information provided to them in briefings, but they largely missed the implications that even someone with a year or two of industry experience would understand.
I am reminded of the story of Max Planck and the chauffeur and the two types of knowledge [0].
Was this before or after the large Enron scandal? One would hope that things have been tightened up since then and tightened even further on the aftermath of the late 00s financial meltdown but maybe they haven't been.
> Which thus far has been pretty accurate, but is the contribution of stock pickers actually zero? Is it negative?
Net of fees, probably. There's a certain amount of value contributed to the real economy by accurate stock prices, and a certain amount of that is created by reading the news, being aware of industry trends, etc. But the number of people needed to do that efficiently gets smaller all the time.
> Do the stock pickers, clever scamps that they are, figure out a way to take advantage of the Bogleheads and their naivete? Are they already doing so? Is this going to turn the stock market into just one big house of cards?
It's smoother than that. The more people are indexing, the more profitable the various types of active investment become. There's an equilibrium to be reached. We're probably in for higher volativity than present, sure - but the present low volatility is a historical aberration.
> If I've seen any trends in the financial markets, it's that every good idea will eventually be flogged to death, usually with catastrophic results.
More like it will get flogged until there's no more money in it and it's just a boring utility, like has happened to HFT.
I think a few stock pickers are really good at their jobs while a lot of others are mediocre to plain bad. The problem is that the ones that are consistently good are usually boutique hedge funds not open for normal people, some of them like Renaissance Tech only invest their own money and take no external funds anymore. Part of this is that their edge only works if their moves don't alter the market too much and for that there's a limit to how much money they can manage. But at the end of the day if you are not a rich investor with access to stuff like that I wouldn't be surprised if chances are an index fund is going to outperform most stuff Wall Street might try to sell you.
The real dangerous issue, as I see it, is good pickers trading on their edge for increased fees, because presumably they're pretty smart and can justify them based on past performance. But if the edge goes away.... you're still stuck with the fees. Caveat emptor.
Dunno. Maybe the wealthy have access to wonderful investments we don't; I certainly wouldn't know.
can't be sure about the wonderful part, but otherwise, yes, there are plenty of investment opportunities available to the "wealthy" that others are generally not allowed:
I've read people who theorise that as index funds grow larger their shortcomings increases the rewards for more active traders who now have more opportunities available that aren't being taken advantage of by those index funds, no matter how closely and quickly they track a given index. Presumably that theory would lead to some equilibrium between the two investing styles.
I'm crossing my fingers for the ol invisible hand evening this whole thing out-- Wall Street takes a haircut on fees until they reach pricing equilibrium. It's not like financial analysts are without value. I just don't know if they deliver the value they extract. Bogle made a pretty compelling argument that they do not.
You might want to consider the boring scenario: maybe there are fewer professional traders, but their computer models improve, so prices get set as efficiently as before and maybe better.
I saw an article the other day that argued that because of skewness caused by a few companies having outsized gains, the value of picking stocks is typically negative. Sorry - can't find the article right now :-(
Agreed - Intelligent, civil, and welcoming. Been reading (& posting occasionally) since 2007. The demographic tends to skew older, so there is a lot of life experience behind some of the commsnts. Check it out!
I don't think market conditions have much to do with it. Whether to invest in the market, or in a certain asset class, is a separate decision from whether to pick stocks or buy a passively managed fund.
Passively managed money has been increasing because there are more low-cost funds available, and lots of education about stock picking versus passively managed funds (e.g. Warren Buffet, A Random Walk).
My theory predicts that when the next major recession happens, Vanguard and other passively managed funds will become dramatically less popular (which will amplify the fall), and actively managed funds will come back.
Your theory predicts that none of this will happen when recession strikes.
This doesn't answer your question directly, but Matt Levine has written some great articles, in particular, about index funds and their effect on the market.
Here's one: [1]
"Second: One of my little stock-market obsessions is that index funds free-ride on the work done by active investors. Someone needs to make decisions that allocate capital to businesses. A world in which everyone indexes, and in which no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses. That's not the world we live in: A lot of people still actively work to allocate capital..."
That the stock market is an efficient mechanism in allocating capital to the right businesses is a myth.
For one, the stock price of a company has no direct bearing on its capital. Only at IPO time or when a company is raising additional capital is the stock price relevant for the capital. E.g. Google's stock price has increased 15x since their IPO, but that has had no effect on their capital. Any other time besides the IPO and when raising additional capital, it is just money changing hands between stockholders, the company doesn't see any of that. Of course, the initial investors often only invest in the capital with the understanding that they will be able to easily sell their shares later. And there are some secondary concerns: employees might have stock or stock options, stockholders can influence the board and hence management, and too low a stock price might engender a hostile take-over.
Secondly, the market is frequently very wrong about pricing stocks. It was happily 'allocating capital' to internet stocks during the dot-com bubble, to financial stocks up to 2008,... A metaphor created by Benjamin Graham, and often repeated by Warren Buffett, is that of Mr. Market [1]: a manic-depressive fellow who has periods when he pays way too much for stocks at certain points and sells stocks at way too low prices at others.
That said, it mostly works. To a company it doesn't really matter all that much that the stock market undervalues your stock by 20-30% or more at some times (a good opportunity for share buybacks!), and overvalues it at other times (a good time to raise additional capital, or use your stock for takeover bids of undervalued companies). Of course, companies often do exactly the opposite: share buybacks when their stock is overvalued and takeovers overvalued companies when their own stock is undervalued...
> the stock price of a company has no direct bearing on its capital. Only at IPO time or when a company is raising additional capital is the stock price relevant for the capital. E.g. Google's stock price has increased 15x since their IPO, but that has had no effect on their capital. Any other time besides the IPO and when raising additional capital, it is just money changing hands between stockholders, the company doesn't see any of that.
But all the capital decisions are in the context of the stock price. If an outside group looks at investing, that will be in terms of current shares; if the company gets bought by another or does a merger, that transaction will be determined by the current share price.
> Secondly, the market is frequently very wrong about pricing stocks. It was happily 'allocating capital' to internet stocks during the dot-com bubble, to financial stocks up to 2008
Some of those internet stocks were worth far more than even their inflated valuations at the time (of course, many were worthless). The market price is always going to be a best-guess consensus estimate, sure, but a lot of these things are just inherently hard to figure out how much they're actually worth.
No, the decision is in the context of the market capitalization, not the stock price. If $10M company has a share price of $50/share, then it has 200,000 shares outstanding. If it has a price of $100/share, then it has 100,000 shares outstanding. A buyout, merger or acquisition is based on the total value of the company, not based on the smallest unit of ownership in that company.
And market cap alone is misleading without considering debt as well. But all that is technical nitpicking. The point is that the stock price is a measure that directly feeds into the overall value of the company that potential buyers etc. will consider.
This is an absolutely crucial point that is not discussed nearly enough in the context of passive investing. Thanks for the link, I didn't know Matt Levine had stated it so eloquently already.
A tangentially related point is that membership in e.g. the S&P500 imparts a big financial advantage to companies for a somewhat arbitrary reason, due to passive investing.
An ETF or Fund like vanguard is a company that issues "coupons" and then buys and sells them (and various related administrative things, e.g. forwarding dividends while combining them).
So when you buy an ETF "share", what happens is that you buy a newly issued coupon from this company. This company gets notified, and as a result will put in market orders for these shares (while combining them in smart ways), and once it has bought the shares, issue the "share". (needless to say there's aggregation happening)
When you sell the reverse happens. You essentially request the company destroy the coupon. In response the company will sell shares. Once the shares are sold, the company will transfer that money (ie. whatever they got) to you.
So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases. Ie. whether you're buying or selling the lag will add to your disadvantage compared to the rest of the market. So simplifying things, if a flash crash happens and you own an ETF or a fund you'll only be "allowed" to sell once the drop is over. If you try to buy at the bottom your order won't be filled for a while. Mind you this will be in the seconds range, or in particularly bad cases a few minutes.
In the US, there is also regulation that allows funds to pause redemptions. So if you own a fund that fears it may be significantly affected by a market drop, it can then block your money (regardless of what a contract you have with them says) for a period of up to months. Given what has historically happened, for small funds this means if there is a large drop, they will block your money making things worse (but somewhat avoiding feedback in the market that would cause individual share crashes). You will lose something like 20-80% of your capital if this happens. The smaller a fund the more likely this is to happen.
So an ETF should only be used for amounts of money that are truly too small to buy individual shares, something under maybe $10k. For everything else you should put in the work to buy the individual shares. If you don't do this, yes there are costs that will be imposed upon you in adverse scenarios.
When you buy an ETF, you don't buy a newly issued cupon. You buy it from another market participant on an exchange - hence Exchange traded fund. What you're describing is closer to classic mutual fund. Each ETF will have "Authorized Participants" who make sure that the ETF mirrors the underlying assets.
I'm leaving that part out, because it obfuscates things. In one interpretation "Authorized Participants" on the exchanges keep the number of available "coupons"/shares at a fixed number.
So the market depth for any ETF should be constant, regardless of the value of the underlying assets (assuming non-extreme values and outside of crashes or rapid movements).
And yes, to be more exact, the market depth for an ETF should be a function of the amount of trading occuring in that ETF, not so much a constant. In any reasonable timeframe it should be constant.
>> So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases
So the lag is due to inability to quickly buy/sell the percentages that were allocated for different stocks to build a share, right?
And if I understand correctly, this means if people keep their emergency funds in ETFs, in a crisis, they probably won't be able to access those funds quickly enough to get it at list price (because the price will move because of the lag).
Authorized participants (APs) exist for all ETFs. their purpose is to make sure that the ETF mirrors the underlying assets, and to provide liquidity.
Consider a ETF that consists of a single stock. IF the stock drops, the AP will lower its Bid/offer spread, and force the ETF down to the same level as the stock. But as this is a reaction to the stock falling, there is going to be a lag between the stock falling, and the ETF falling. This doesn't mean that you can sell the ETF at a higher price, necessarily.
Yeah it was slightly loose speech. When most people put in sell orders the price drops till someone steps in to buy, if only the market maker, so the number of shares sold and bought match.
Another effect is over-valuing of stocks with sufficiently high caps to enter the index being tracked.
(A similar already occurs with huge institutional investors (e.g. retirement fund managers) that have too much money to invest to worry about small caps - Warren Bufett also has this first-world problem. Yet another similar effect occurs through bigger caps getting more publicity, so more people invest in them, disproportionately driving up the price.)
The result is smaller caps become more attractive (to small investors). Which results in greater investment in them - but only up to the point allowed by the above effects. So the undervaluing persists.
Kinda similar to tiny startups finding tiny markets attractive, that aren't worth it for incumbent to pursue.
> will everyone try to sell the same set of funds and will crash the funds themselves?
The ETF is backed by stocks in other companies, so if one person tries to sell someone else should be willing to buy, so long as the sale price * the number of shares is below the collective value of all of the shares held by the ETF.
Collective ownership of companies is a more interesting question. If everyone owns fractions of every company, what are the incentives for good governance at any one company? If it goes bankrupt, it's only a tiny fraction of everyone's portfolio.
Matt Levine has covered the latter beat for quite some time.
> If everyone owns fractions of every company, what are the incentives for good governance at any one company? If it goes bankrupt, it's only a tiny fraction of everyone's portfolio.
And all the other companies in the same market segment will then gain a share of the customers and income of the now bankrupt company, so there is little to no effect overall.
Of course this is exactly why some people choose to invest in markets instead of individual companies, because that has less risk.
Of course this is also why other people choose to invest in companies they assessed are way ahead of their market, because that is more profitable.
Active traders will have an outsized impact on the movement of stocks. Which could allow for fun games in the derivatives market. E.g. force a stock up and short it in a derivative. This kind of activity was much easier in the past so its not unprecedented.
I wouldn't be surprised if most of the money was coming from people's savings books. With zero interest rates, the next best thing to store one's savings is an ETF.
I feel like the increase in stock prices in the recent years is caused by this demand, not by an increase in productivity. The sinking ROI of dividend-driven stocks is an indicator for that.
It's not just the proletariat's savings. It's eveyone's. Some places have negative rates. You pay the bank. This means that money had to go some where. We have it in the market. As a result smart people and dumb people like me have waited for the market to adjust down 25% or more. I lost 2k on a market short ETN.
Given the amount of money just looking for a home the market has no where else to go but up until that money stops.
Vanguard is the reason why Betterment and wealth front never made any sense to me. There is no way they can be better than just putting in vanguard funds myself. I still do t understand what their value proposition is.
Tax Loss Harvesting. This is the sole reason why Betterment(/Wealthfront) is superior to Vanguard. The benefits of this technique more than offset any fees they charge.
That's really debatable. After 10~15 years of investment in Betterment or Wealthfront, in all likelihood all of your investments will be in the black, and there will be no opportunities for loss harvesting. But you're still stuck paying the 25 basis points per year unless you sell (and thus incur the capital gains, anyways).
I've got a fair bit of money in Wealthfront and tax loss harvesting has directly saved me quite a bit of money over the last couple years. For instance, the beginning of last year was tumultuous and their tax loss harvesting let me realize around ~55k in losses. The market then shot back up and my investments were right back where they were barely a month later. Because I had a source of capital gains in 2016, I basically earned free money.
So even if my investments were in the black in the macro scale, with tax loss harvesting I can realize additional gains from the inevitable dips that happen on the more micro scale.
I'm really talking about what happens after you've been invested with them for over a decade. Wealthfront has not yet existed for 10 years, so I know you haven't had your money invested with them for that long. The fact that tax loss harvesting can be beneficial is not in question.
Once you tax loss harvest once, you lower your cost basis on the investment to less than you originally paid. You can only subsequently tax loss harvest on the same security to the extent that the value of the investment is lower than your new lower cost basis. This will become harder as time goes on and you have previously tax loss harvested many securities.
Their white papers all use a timeframe of 10 years to show that Wealthfront is cost effective. I'm pretty sure they don't want customers thinking through all the implications of longer investment time horizons.
Oh gotcha with the cost basis raising over time. I wonder what strategies you could use to mitigate that. Perhaps buying a similar asset, holding that instead of the other, wait for the original to go down, and then re-purchase. Seems fragile and risky of course...
> Perhaps buying a similar asset, holding that instead of the other, wait for the original to go down
If you're presupposing the assets are similar, this is unlikely to happen to any significant degree.
The standard way to increase your odds of being able to tax loss harvest is to own as many different uncorrelated securities as possible. You can take this to mean a fund per industry (as Betterment and Wealthfront do) or even to the extreme of only owning individual companies. That way, some are up and some are down, and you can TLH. The more slices you divide your portfolio up into, the longer you'll be able to do it. But I think realistically (especially factoring in inflation), this strategy will stop giving results before 15 years.
What about the effect of a (let's be honest, inevitable) market crash? You'd be able to realize quite a bit of loss as that is happening by selling assets. Then as the market recovers and assuming those assets are actually worth more than the crash-adjusted value, you would be able to harvest losses again on that asset.
I think you'll see that in the last 90 years, even the worst market crashes don't take the index down to a level lower than what it was 15 years prior. To put it another way, pick any time in the past 90 years, the S&P 500 is always higher 15 years later than that date and every day afterwards. Maybe slicing up your investments into finer-grained categories than the entire S&P 500 will help ... but I'm very skeptical that anyone can TLH for long periods successfully.
If you want to pay a perpetual 25 basis points per year for Wealthfront or Betterment, go ahead, but it seems unlikely to me you'll come out ahead of a simple index fund if you are investing long term.
I suppose there is no harm then in milking the tax loss harvesting for as long as it is profitable and then reevaluating performance in ten or fifteen years to see if it makes sense to switch to a lower cost provider like Vanguard.
Like I said though, I have seen very significant returns from my loss harvesting. Even without a yearly source of capital gains, it definitely does not hurt to collect the losses and use them later in life (for instance if you sell an investment property).
There is a harm. In 15 years, if you decide you don't like Wealthfront, in order to move, you will have to sell all your assets and incur the capital gains.
This is true any time you move brokerages, is it not? If, at some time in the future, you chose to move from Vanguard to Wealthfront to take advantage of tax loss harvesting, you'd pay capital gains tax as well.
> This is true any time you move brokerages, is it not?
No. If you own the assets directly, and they are traded on the exchange (like the ETFs WF/Betterment use) they can be transferred around without triggering a sale event. Target date funds and the like would probably have to be sold.
I have my tax advantage at VG and my taxable has been all over the place finally settling with CS for now.
Okay, you have me a little confused now :) I read my parent as saying that in order to move investments out of Wealthfront, you'll need to sell and pay capital gains. I read your comment saying this isn't necessarily the case. There seems to be some disagreement here. What am I misunderstanding? The ins and outs of investments and tax ramifications can sometimes seem very opaque to me, so I appreciate any education on this front.
I stand corrected. I thought they had their own mutual funds that they charge an expense ratio on, but I took a closer look at their site and it looks like they put you in third-party mutual funds from e.g. Vanguard and iShares. Since this is the case, you can just do a transfer-in-kind to another brokerage if you want to leave, and this is not a taxable event. (Sorry for my mistake!)
Looking further, they don't support outgoing ACATS (what most brokerages do), but do support DTC which I'm not at all familiar with[1]. So hopefully you could do Betterment until the TLH stopped being worthwhile and do a direct security transfer to another brokerage.
Although Betterment offers fractional shares, which is confusing, not sure if they're actually ETNs representing fractional ownership of ETFs. I don't know how that works legally.
Which is why I said own the funds 'directly'. I'm not sure if WF/Betterment pool your money and then carve up % of funds or if you end up the actual owner. They may force you to liquidate to leave, which IMO is another strike against using them.
With regular brokerages you can move stocks/funds around with a transfer.
I think it's telling that in their promotional materials designed to show their merits, Betterment shows a maximum time horizon of 10 years. I think they know that their strategy is much weaker on longer time horizons, yet the fees remain constant. 10 years may seem like a very long time to some people, but when I invest I'm thinking about time-frames of 30 to 60 years. Meanwhile you can tax loss harvest yourself with a little education.
Couldn't they employ tax gain harvesting for users that are interested in the short/long term capital gains differential in TLH? They don't do this, but I'm curious.
i.e. cycle long term gains after one year of ownership so that they are more likely to produce harvestable losses in the next year. Obviously this prevents the basis gains of TLH, but wouldn't it be dwarfed for users whose long-term capital gains tax rate is much lower than their short-term capital gains rate?
Yea, tax gain harvesting is definitely something you can do. Though it's harder than tax loss harvesting. You have to take into account the entirety of a person's tax situation to do it, as opposed to tax loss harvesting, which only require knowledge of the account transaction history, which Betterment and Wealthfront of course have. To do tax gain harvesting you have to wait until late December when you have most of the information, and you essentially have to complete an entire tax return.
Yes, but this only works for those who are exploiting a difference between their marginal tax rate and the LTCG rate. That is, those in the 15% marginal bracket whose LTCG rate is 0%. For other investors it is preferable to pay no taxes (continue to hold the security long-term even after it qualifies for long-term tax treatment)
No, you are not understanding how it works. Your portfolio can be in the black every single year, but you can still use TLH to improve your returns every single year by harvesting losses in individual securities.
TLH only comes into play with taxable accounts. I would bet a lot of VGs AUM is from tax advantaged accounts.
Even in taxable accounts TLH is really oversold. It's another way to shift taxes around, which can be good, but the obvious methods of maxing out tax advantaged accounts should be done first.
Some of it may be that a vanguard fund needs a minimum of $3000 per fund (for most of the low fee index funds). Betterment IIRC has 10+ funds:
https://www.betterment.com/portfolio/
Total market cap of S&P 500 have increased from $13T to $21T from 2012 to 2017 without having corresponding underlying financial growth in companies. This $8T difference feels tantalizingly close to new investment money flowed in via ETFs. I am wondering if current rise in S&P 500 can almost entirely attributed to new money flowing in to ETFs. If this thesis is correct then we can continue to expect more bull market for next few years as we are very likely not even half way through this cycle of money flowing from active strategies to passive strategies. In other words rise of S&P 500 indexes would become self full filling prophecy for at least next few years.
New money into ETFs does not necessarily mean new money into the market. A big part of that is money just switching from actively managed mutual funds to passive index funds, e.g. recently pension funds in some states.
Active strategy may be investing in small/mid caps, currency, commodities, bonds, emerging markets and so on. Lot of that money would be pulled in to biggest popular indexes now such as S&P 500.
There's been something I've been thinking about: with so many people purchasing index funds, what happens when there is a major downturn in the market?
What happens when millions of people sell off their shares in say, VASGX (basically an 80/20 stock/bond index fund)?
Would that effectively tank the entire market rather than sectors doing poorly.
Really depends on what indexing implies. If you're talking about a world where everyone trades actively but instead of trading individual companies they only trade broad index funds then, yes, swings in the market would be amplified. Although in that world you would imagine that there would be a lot of alpha to be picked off by smart traders and so that should counteract the "dumb money" actively trading indexers.
If indexing also implies passive/"set and forget"-style trading then you would actually dampen market swings. You'd have fewer people selling as the market tanked and fewer people buying the big rallies.
One of the "Pros" of passive investment is that you are in it for the long haul and not reactive to immediate swings in the market. In your scenario I believe the investor is supposed to treat a downswing like you would a 401k account. Cry inside at the losses and wait for recovery since your target date is likely 20-30 yrs down the road.
I think lots of investors have herd mentality. If it's rising, pump more money, If it's descending, pull out money. I definitely see a big crash if people don't trust the market.
Right now things are great as there is a lot of hot money flowing. If people hide the money then you'd need something like stimulus to jump start the system again.
Ultimately this is a good thing for the stock pickers that remain - fewer dollars spent actively discovering the true value of companies means longer stretches and wider swings of mispricings.
I was a contractor at Vanguard around 2007-2008. IIRC, pay wasn't that good but rank and file FTE recieved 30k+ bonuses (allegedly). With this recent growth I wonder if compensation there has grown at a similar rate. I rarely hear people mention it as a good place to work or as having highly competitive compensation.
The compensation structure has been significantly revamped since then. Partnership isn't what it used to be, so people don't get the big payments like they used to.
How does control/governance for Vanguard actually work? It's apparently owned by the investors in the funds, but I own some ETFs through Vanguard and I've never seen a proxy form.
Very happy with the service, just curious about that aspect.
My understanding is that individual fund investors will never see a proxy form - the fund's decisions on how it will vote are determined by the managers.
I was referring more to control of Vanguard itself - i.e. choosing the Board of directors for Vanguard.
I did a bit of digging though, and it seems they are actually elected by the shareholders of Vanguard funds - but they are appointed for lifetime terms, and up to 1/3 of the directors may be appointed by the other directors. So they only need to go to a vote of shareholders occasionally - looks like the last was in 2009.
That is one of the major concerns regarding indexing and Vanguard in general. The process for selecting directors in Vanguard indirectly affects the proxy voting for corporate governance in stocks owned by the fund. Many people think it will lead to lower competition because of the objective of the fund is to keep in line with the market and not beat it.
It makes me a bit sad that such index funds are not available in my part of the world - even though this is one of the shittiest countries in the EU, services like these are needed precisely because all the other services are so bad.
which country is that? because there are many options available here in Western Europe (alternatives to Vanguard are iShares, SPDRs Europe, Amundi, ...).
To get the equivalent of a total stock market index, you'd need a lot of capital and would spend a lot on trading fees. There are other issues like re-investing dividends, re-balancing, IPOs/bankruptcies, taxes, etc. Also, Vanguard is structured as a mutual company, so fees only pay for costs. The fees are really low too: a 10,000$ investment in VOO (S&P 500 ETF) would only cost you about 5$/year.
I actually opened a Vanguard account a few months ago after reading "A Random Walk Down Wall Street" by Burton Gordon Malkiel (https://en.wikipedia.org/wiki/A_Random_Walk_Down_Wall_Street). I recommend it if you are interested in learning more about investing and ETFs.
Admiral shares are a function of the Vanguard mutual funds themselves; if you're buying the underlying companies directly, "admiral shares" don't matter, since you're not paying management expenses at all.
Vanguard isn't a non profit, which is an organization that in contrast to a for-profit company, has no obligation or goal to increase share holder's value.
Vanguard is a company like any other for-profit, with the distinction that Vanguard's own shares are being held by the funds it manages, so increasing fees, e.g., would probably decrease share holder's value.
Tracking indexes and buying and selling stock is not free in time or money. And the fees Vanguard charges for doing so are quite marginal. It probably doesn't make sense to even think about doing something like that until AUM is $10MM+. For more pedestrian account balances, if one wanted a market cap-weighted portfolio, one wouldn't even be able to purchase a single share of a huge swath of companies.
A fund may contain hundreds of stocks/bonds. Would you rather make one transaction or 100? (Bearing in mind most brokers charge a fixed per-transaction fee...)
If you are just looking to allocate to some ETFs by Vanguard, there's really no argument left that you need any of these tools. All you are going to do is by SPY or some other ETF and sit on it. Robinhood is very easy for that.
Oh, I've seen those. They're a limited selection of ETFs/Mutual Funds though. I thought you were referring to brokers who had unlimited free ETF trading.
Merrill Edge if you have sufficiently high account balance (>$50k) allows 30 free ETF and stock trades per month. There are nice credit card bonuses with BOA CCs, too.
I seems like there should be an opportunity for active investors to make money off of all the passively managed money.
All I can think of would be to take advantage of the margin of the index. For example buy stock #501 and a discount and sell when it crosses into the sp 500 since vanguard will prop up the price by buying it for tge index fund. Similarly shorting #499.
I'm sure that the market has gotten more sophisticated than this though. So how does it work in practice?
It's also possible that Vanguard just delivers the same products as their competitors, just at a significantly lower price (management cost).
Keep in mind also that "growing" in this context doesn't refer to huge profits (as far as I know). As far as I can see, as a non-expert, Vanguard just offers the same products as everyone else, except at half the yearly management cost. I mean, when you're looking for some index fund, and Vanguard is one third the cost, is it any surprise they're taking away customers from the incumbents?
Collapse how? And what would the fallout be, that investors lose some money through lawyer fees and auction write-downs? The value added is in the services of trading the underlying equities, not the companies issuing the actual stock, which are as sound as the market indices they replicate.
Imagine you have a class full of studious and competent students, they do well on exams and generally display the performance characteristics and output you'd expect from a class full of studious and competent students.
Then the rules change. From here on in, plagiarism is no longer a code violation. The obvious happens, everyone copies from the smartest kid in the class, measured by the heretofore pretty reliable indicators of proficiency built up in the previous system.
But the next year comes along, and everyone's just that little bit less certain who the smartest kid in the actual class is, so instead they start measuring by how rich his father is, or how confident he sounds when he makes his declarations.
Iterate the system a few generations, and although the first iteration will indeed result in better results across the board for all students, as people become more and more unhinged from the underlying realities of scholastic performance for students as they come and go through the system, would it not stand to reason that eventually you're just going to have a bunch of idiots copying people who yell the loudest, and seem the most like they're successful?
This analogy has its limitations but let's go with it a small way.
Everyone has the choice to copy who they think is smart or write their own answer.
Each person compares the expected value of writing their own answer with copying whoever they think is smart.
Some win, some lose. As it gets harder to work out who is smart yet everyone is copying, beating that average becomes easier. That proportion of the class who are capable of beating that average have an incentive to try it.
Stock picking has been massively overvalued for a long time. The costs people have paid for that value have been far too high. The index wins because it is /cheap/, the costs of investing in the index are low. As the market is now adjusting to that mispricing, among those stock pickers who can actually do it, there will be some good opportunities. Stock picking, whether buy someone like Buffet, or by an algo shop or whatever isn't going to go away. Every time the market is mispriced there's an opportunity. Price will end up somewhere close to value in the long run. It's amazing that with index funds it took so very long to happen. Malkiel pointed it out pretty clearly in a popular book that hasn't been out of print since, what, 40+ years ago. It's great, everyone should read it for its market insights, especially if you want to pick stocks.
You're absolutely right, it does have its limitations, and they show in the issues you raised with it in a way that doesn't actually apply to the nature of the analogy as it criticises the original situation under examination. The nature of indexing is such that it's treated by practitioners as if it were an "objectively correct" (and obvious, no question about where the volume is flowing, the numbers are right there.) answer to the correct investment allocation, so it isn't actually so much the case that there are people just copying random other picks because they like their haircut or it's a popularity contest or whatever (although I suppose you can still make the argument that you're making some kind of decision in an index based on which index fund you're allocating your investment to, but even there you could take a no favourites approach by indexing index funds.)
The core point I was trying to make though is that the market is efficient in net across a great variety of actors all making their own judgement with regards to how much a given thing is worth because it's assigning so many eyeballs and independent evaluations to the pricing question for a given item.
When you swap that out and replace it with a system in which n% of the trade volume is just copying the rest of the trade volume, that reason applies inversely proportional to the volume that such indexing takes place, until a market with just one guy calling all the shots and everyone else indexing him may as well just be centrally planned, and thus afflicted with all the heinous cancers thereof.
Your point about the deleterious effects of the above also simultaneously lowering the bar on the challenge of beating the average though is something I hadn't thought of, and is completely correct. I guess that is how indexing would collapse when you got to some state where the market was mostly just ignorantly following the tiny minority of organic judgement being exercised, and that tiny minority turns out to be inadequate. The market then recovers by stock picking once again being conducted by specialists, and as you say, this would be a situation wherein stock picking was massively undervalued, as opposed to the (maybe present?) situation where it was massively overvalued.
Thanks for the book reference, I'll definitely check it out.
Post hoc ergo propter hoc. Articles like this showed up for Enron and MCI/WorldCom and all the others, extolling one virtue or another and showcasing their success. Now we have one for Vanguard, ergo it will fail.
I'm not serious, of course. But pride does seem to come before the fall, and just out of an excess of caution I might move some money out of my vanguard funds next week.
You've got to take in to account that Vanguard doesn't actually do much - just buy stocks on your behalf and charge 0.12% for doing so. If it stopped doing that because some other operator was doing it for 0.08% it wouldn't be a big deal.
The bigger deal would be if the general market collapsed for some reason but that would affect everyone, not just Vanguard.
Ok. I'm curious why you're telling me this. What's your motivation?
There's certainly no point in arguing with me, since I'm both reasonably poorly informed and aware of it; I have made no bones about the fact that my post was unserious. Yet you leap to the defense of what should, after all, be a very unexciting thing. And you aren't alone in doing so.
That, like this breathless article, is mildly troubling to me. These institutions should engender no loyalty, embody no attributes; only then does the market actually work. Evidence of those tendencies suggests the distorting effect of human psychology. And in tone it is too much like what we saw before the collapse for my liking.
Well I've known Vanguard for about 30 years and am a fan as it's saved the investing public many billions over that time, certainly if you compare them to normal fund management companies even if just buying and holding shares directly is probably cheaper still.
But I was just pointing out they offer a rather dull, value for money service and are not going to collapse Enron style. They could decline Sears style however.
You're comparing Vanguard to Enron & MCI / WorldCom. Would you mind explaining your analogy? It doesn't make sense to me. I don't think, for example, my investments in Vanguard funds are precarious because they are over-leveraged in bespoke weather derivatives.
> The scale of that inflow becomes clear when it is compared with the rest of the mutual fund industry — more than 4,000 firms in total.
No mentions of ETFs? SPDR is not a mutual fund company.
> Already, six out of the 10 largest mutual funds by asset size belong to Vanguard, with the largest, Vanguard Total Stock Market Index, now weighing in at $465 billion, according to Morningstar.
The elephant in the room is ETFs like SPDR. SPY (SPDR's largest fund) has $230 Billion in assets. It isn't quite as big as Vanguard, but clearly SPY needs to be mentioned.
The silence is deafening. "Classic" active mutual fund companies may be dying, but a new breed of investing has already begun... and its competing against Vanguard quite gloriously. Low cost, quickly traded, with large numbers of derivatives: ETFs.
I imagine they must have some kind of stop loss strategy; there's a bunch of research comparing various strategies to buy and hold, and buy and hold is pretty much 2nd worst, with the worst being an overly aggressive stop loss (like sell everything at a 5% drop).
I would very much like to invest in index funds, but Vanguard need a social security number, which I don't have. Does anyone know of an alternative that doesn't require an SSN, or something comparable to Vanguard in the EU?
You would have to go through a EU bank who would act as a middleman. There are many of them that have zero fees so it would be practically like if you were investing directly with Vanguard.
Thank you! Unfortunately, the UK is borderline not in the EU any more, and all these online brokerages require a NI number... I tried to use Interactive Brokers, which I heard was great for buying ETFs and index funds, but the interface was ridiculously complicated, and did not inspire trust.
I don't know what that is, I'm afraid. Is it something Vanguard would provide? If it's a US government thing, I don't live in the US, I would just like to invest in index funds (so anything that resembles Vanguard is fine with me).
SSNs are issued by the Social Security Administration for the purposes of keeping track of social security (read: government-backed retirement pension). The Internal Revenue Service keeps track of taxes and uses SSNs to keep track of all taxes (including payments into social security).
Some individuals (such as yourself) are not eligible to receive a SSN. For those individuals who need an identification number for US tax purposes, the IRS issues ITINs. See here for more information: https://www.irs.gov/individuals/individual-taxpayer-identifi...
AFAIK there are non-trivial tax liabilities and reporting requirements in the US for non US persons investing in the US. Just to be on the safe side, I wouldn't directly invest in another country without consulting a tax professional first.
If you want to invest in a US index, you can probably find a ETF traded in your country of residence that tracks a US index.
It'd cost a bit more than Vanguard's, but would cost you much less in hassle, effort, and regulatory requirements (which would be handled by whoever manages the fund).
You should ask your broker or bank about that before rushing to try and buy Vanguard's ETF directly from the US.
That's good to know, thank you. I managed to find a good brokerage firm (TD Direct Investing) in the EU, but I didn't know that buying US ETFs would have tax liabilities in the US. I will ask TD, thank you.
Sorry, I missed the part where you mentioned living in the EU. One of the siblings comments has a good explanation for ITINs. My wife used hers to open a Vanguard account despite having no SSN at the time. She did have a visa and a US address though, so I'm not sure how it would work for you (and if it would be worth the trouble; probably not).
I'm a French citizen, and wish I could help you regarding investing in the EU, but unfortunately I only got interested in it after moving to the US. Back in France it seemed like most people invested in real estate rather than in the markets.
Thank you anyway, I have a friend who's knowledgeable and he helped me find the tickers for the EU versions of the Vanguard ETFs. As I understand it, I won't need any tax presence in the US to buy them (e.g. https://www.bloomberg.com/quote/VWRL:LN), so I should be set. I'm trying to open brokerage accounts now, and it seems like everything should be simple after that.
Think I may need to dig deeper into this. But a few questions that one of you may be able to answer. Seems like you won't get super large returns but on the other hand you won't risk super large losses either.
But sounds like instead of having cash on a bank account, earning no interest, it may be worth putting them into EFT's? Or have I totally misunderstood? Is it only possible to tie your money up for longer periods for instance?
Any caveats as Dane looking at Vanguard? Fee's, cross rates or other I may have missed in this?
There is a risk, but it is averaged over hundreds of equities instead of just a few, as with directly buying shares (unless you can afford to spread a lot; if you do, you can afford a wealth manager).
If just a few equities are decreasing in value, it'll balance out. But if they all loose, like on October 19th, 1987, when the S&P 500 lost 20.47%, you'd be much poorer.
If your goal is to get rich, sure. But going with the herd isn't necessarily unsafe. The goal of "getting rich" is generally incongruous with passive investing either way.
The risk/reward profile of active investing and index fund investing are completely different, so that will be more than a decision of upside you want to pursue.
I've built my wealth significantly with index funds. "Get rich?" No, but that's not my goal because getting rich requires a ton more risk, usually leverage, and tons of work.
If an average is unusually high/low it will tend to go back to the mean after time.
In the stock market this means that looking over a short timespan one will see large variance in the returns but over a long timespan (30+ years) the returns will be more consistent and nearly all positive.
If this is not an Enron-like foreshadowing, it says something rather dark. It certainly looks like a 'bubble is about to pop' indicator, though it's generalized to the whole financial sector (to the extent that a blind index fund represents it, at least).
If it does pop, it suggests that an industry that is on average not as good as its own average, is itself overvalued (as numerous other comments strongly imply).
If it does NOT pop, it's speaking a deeper truth. It speaks to a collective, society-wide agreement: those with power should automatically get more power. Those with money should automatically get more money. The mechanism doesn't matter: it's like a moral duty to reverse Robin Hood and fill in the reasons later. If a dumb blind index beats everything and never fails, that means we've gone all-in on redistribution of wealth to 'the winner', defined as whoever has all the wealth.
And the only way to break that loop is pitchforks and guillotines. Some might say in the age of automation, AI and robotics, such disruptive things are impossible. But the original pitchforks and guillotines were in the age of early industrialization, and I'm sure nobody thought machinery and tools could end up turned against the rich and powerful. Everything's a tool eventually.
At no point did I think the difference in inflows was anywhere close to 8.5x. And it does worry me.
I'm familiar with the contention that even having some active players in the market will arbitrage the prices back to fair value, but when they compose such a small share of such a large market that's no longer a trustworthy assumption to make.
There's no law that I know of that prevents active players from exploiting the knowledge that passive money will go wherever the market tells it to. There have got to be a lot of opportunities here for profiting, legally, at the expense of those passive investors, that goes beyond simple margin arbitrage.
My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.