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.
