And if passive funds cause poor allocation of capital, that will increase the returns of smart active investing - a negative feedback on pure passive investing.
If you can allocate capital better than the index through an active investment (that is, you can find investments that give a better return), you will beat the index, so passive investors will want to invest with you instead - a negative feedback to indexing investment.
The problem is that the value of the components of the index is heavily tilted by peoples perception of the value of the index, and not the values of the components.
> the value of the components of the index is heavily tilted by peoples perception of the value of the index
“In the short run, the market is a voting machine but in the long run, it is a weighing machine” [1].
Dividends don’t care about peoples’ perceptions. Neither do interest payments and other cash-yielding payments. Active investing will always find a way to take advantage of stupid prices.
Not at all. Arbitrageurs will always trade away such market inefficiencies. Ultimately valuations always converge to DCF, although it can take a while.
Wouldn't agree with you because a company that can return a higher rate of return on capital than one that can't get an allocation based on market cap.
Typically with an index fund, imagine a pie of the money. It's split up and invested into companies, but the allocation depends on the market cap of each company relative to the whole pot.
This means returns aren't based on the ability of companies to perform it depends on how big they are at the time. The bigger they are the more allocation of capital they get. Say you have a small company with a very high return rate on its investments, it would get a meagre rate of return compared to say Phillip Morris/Altria which has a lower rate of return, but is just big so it gets a bigger allocation.
You'd think its Darwinian but it has odd effects because what's big stays big, and it has nothing to do with the ability of the company to perform now, but what it did decades ago.
Index funds are good. They are a way of saying "I don't know how best to allocate capital, i'll leave it to the professionals who do, and simply capture the market return for myself". Ideally, most money will be managed by index funds, and a small pool of extremely efficient money managers (some mix of quant and discretionary) will manage a comparatively small pool of capital that actually determines the prices of everything. There is nothing bad about this. This is the way all economic activities become more efficient.
That is essentially affirming the authors take on the story though, is it not? If it is really preferential for investors and society at large to follow the signal of professional managers, than in the future this might even be further consolidated by advances in tech, and the result will simply be a rationally managed system that allocates capital by planning or design, rather than through numerous 'amateur', active market participants who act on spontaneous price mechanisms.
I also don't see anything intrinsically wrong with this, but funnily enough it does seem to imply that the title of the article is correct
everyone seems to be reacting to the question in the title, rather than the point of the article, which is skeptical about perfecting the algorithmic trading robot (the mythical middle between a marketless communist ideal and market-dependent capitalist ideal). that is, capital allocation is (NP-)hard and a decentralized capital market might just be the most optimal (though imperfect) solution.
yes, but i would just amend your prelude to "i'll leave it to professionals to allocate my capital efficiently...". some folks might know how to calculate an efficient portfolio, but may not want to manage such a thing (tracking dozens/hundreds of equities and adjusting periodically).
interestingly, like other industries, there's a tension between available surplus and efficiency in finance. the less money siphoned off by active fund managers, the more efficient the market.
This is exactly where my mind is at. I know how to diversify, allocate, and adjust an efficient portfolio, but I don't want to do it myself.
Same reason why I use managed services in IT ... I know how to run a mail server, web server, frontend, backend, etc, but I still use managed services (gmail, dropbox, squarespace, etc) to do it for me, because I'm optimizing for my time.
This is an asinine argument that seems to be driven by the belief that there is such a thing as efficient allocation of capital in the real world. Or perhaps just sour grapes that some of the unsophisticated investors they like to take advantage of are instead putting their money index funds.
It's certainly not true that "what makes sense for investors" is any meaningful indication of what makes a good policy for a society as a whole, and I rather think it's usually the opposite.
Okay, but the burden of proof is on those who think that limiting investors is beneficial in this case. I don't think there's much of an argument for it.
> Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
Indexing can be active. Particularly when it comes to exchange-traded funds. There are many to choose from which mix different equities in different amounts. You can invest by particular sectors, or geographically or whatever.
Choice of investment instruments in the financial market (some of them automated) is just capitalism at work.
Funny how when a factory is automated, the financiers call that capitalism. When their own jobs are automated, it's suddenly communism.
The author of the article seems to think that their performance on the capital market is the only thing that determines a company's success. But if companies lose money on the actual market they serve with the products they produce, they're still losing money compared to the company that makes a profit, and they are still at risk of going bankrupt.
The capital market may be important, but it's not what it's really about. It's not the actual market. It's just a facilitator. At best.
> There is no America. There is no democracy. There is only IBM and ITT and AT&T and DuPont, Dow, Union Carbide, and Exxon. Those are the nations of the world today. What do you think the Russians talk about in their councils of state - Karl Marx? They get out their linear programming charts, statistical decision theories, minimax solutions, and compute the price-cost probabilities of their transactions and investments, just like we do. We no longer live in a world of nations and ideologies, Mr. Beale. The world is a college of corporations, inexorably determined by the immutable by-laws of business. The world is a business, Mr. Beale. It has been since man crawled out of the slime. And our children will live, Mr. Beale, to see that perfect world in which there's no war or famine, oppression or brutality. One vast and ecumenical holding company, for whom all men will work to serve a common profit, in which all men will hold a share of stock, all necessities provided, all anxieties tranquilized, all boredom amused.
Capitalism is earning from capital. So Index funds are in fact pure capitalism.
Potentially they can benefit the less wealthy as much as the wealthy. For some, alike that feels innately wrong. And any fiscal equalizer always feels communist even if it results from free markets.
Index funds can also potentially benefit the fiscally naive as well as the savvy. But if this is the objection then it is cherry picking: the same parties rarely object to inheritance which benefits unsophisticated investors on a vastly larger scale.
And if passive funds cause poor allocation of capital, that will increase the returns of smart active investing - a negative feedback on pure passive investing.