[groundlogic]

Not an economist, but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds.

What's the limit - 30% 40%, 50%, 60%? What's the current level in terms of managed capital? (Edit: https://www.cnbc.com/2019/03/19/passive-investing-now-contro... says 45% for US stock-based funds, half a year ago, so maybe like 48% now)

I wonder if the endgame is that index funds won't be allowed to trade on the the stock exchanges? I can't imagine how that would be enforced.

"Mr/Mrs/Ms Fund manager, you've been trading too close to the index, we'll be forced to terminate your access to the markets"?

[avvt4avaw]

You only need the marginal investor to be informed, so it's not clear that you couldn't have a much higher percentage of passive investment (say 90%) and only a small amount of active investors who are providing price discovery.

The bigger problem is that most passive investments are not really passive - for example, choosing to invest in a "passive" S&P 500 ETF over a "passive" Russell 2000 ETF is an "active" investment choice (preferring large cap over small cap) so valuation errors and bubbles could develop in segments of the market, even if constituents with an index are all fairly valued relative to one another. These valuation errors could sustain for a long period of time, because it takes much more money to correct a valuation error in a huge market segment than it takes to correct a valuation error in an individual stock.

[davidw]

This lists 3575 stocks among its holdings, which includes both large and small cap stocks:

https://investor.vanguard.com/mutual-funds/profile/overview/...

[avvt4avaw]

Sure, which is why I said that _most_ passive investments are not really passive. Vanguard Total Stock Market is pretty passive, as long as you consider your investment universe to be "US stocks".

But even in this case the fund only holds stocks (no bonds or real estate) and only US stocks at that (no international or emerging market exposure).

[groundlogic]

Mind explaining the concept of the marginal investor in this context?

[TheCoelacanth]

It should be self-regulating, though. The higher the portion of the market that is passively investing, the easier it should be to beat their returns by actively investing so the more incentive there will be to actively invest.

[whatok]

Once indexing gets to be a certain size, you run into the "markets irrational longer than you can stay solvent" issue at a much higher level. Active management "correction" doesn't really work if active managers are a much smaller portion of the market or no longer around at all.

[TheCoelacanth]

You're only taking into account making money via stock trading. There is always the option of buying a company to actually run it for a profit which is not reliant on the market's belief in the company's value.

[whatshisface]

Holding doesn't change the price: buying moves it up and selling moves it down. An index fund holding 50% of all shares on the market but not trading them would have no influence at all on prices.

[derivagral]

Does this exist, though? If you presume some % of America is putting their paycheck into indexes via Vanguard, Betterment, and some other % is selling due to being retired or whatnot, then this isn't an equilibrium.

There's maybe some room for redeeming index value and "caching" that demand from within Vanguard, etc, but I tend to doubt this action wouldn't hit the market at all.

[FabHK]

It can lead to pricing inefficiencies with shares inside vs outside the index. And those should be kept in check by non-indexing value investors.

[whatok]

Did you mean to reply to my post? I don't see the relevance.

[whatshisface]

An index passively holding 99% of the market would not interfere with price discovery because the remaining 1% would go about its business as if nothing was different. Indexes can't sustain irrational prices because they have no impact on prices.

[whatok]

A single entity holding 99% of anything will absolutely have an impact on liquidity which absolutely impacts price discovery.

[usefulcat]

> An index passively holding 99% of the market would not interfere with price discovery because the remaining 1% would go about its business as if nothing was different.

That may be true at the point in time where it's already at 99%, but consider the impact on prices as funds were poured into it over time on the way to 99%..

[toomuchtodo]

There’s an equilibrium to be reached, for sure. The market just hasn’t discovered what it is yet.

[abakker]

I am not an economist either, but it seems that there is a danger in assuming there will be an equilibrium. I think it is entirely possible that there won't be one.

If there is an equilibrium, it may take a significant price shock to discover where it is. I.e. that equilibrium could be years behind us, and if there is a crash we might never recover the value that our current market assumes is there.

[nostromo]

> index funds can't work after a certain amount of the money poured into the system is managed by index funds

That's not true. They'll still function just fine.

What will likely change is that they will begin to underperform other strategies, including different types of indexing and active investing.

At that point the market will self-correct and simple indexing will fall out of favor.

[groundlogic]

Index funds have become successful since they've performed well compared to active investment funds. Why would the active investors suddenly get better at guessing the future?

[gizmo686]

Active investors are already really good at guessing the future. Index funds work because they follow the decisions made by active investors without needing to pay said investors.

As more of the market moved to indec funds, a smaller amount will be controlled by active investors, which will make the entite market dumber (I would say less efficient, but that would include the cost of managing the fund). As the market gets dumber, an active investor can make more profit without needing to be any better then he currently is.

At some point (in theory), the marginal profit one can make with an active fund will equal the added cost.

[edmundsauto]

I think all available evidence points to active investors NOT being good at guessing the future, when compared to the general consensus. The second half of your argument seems like an interesting opinion, but I'm curious where the evidence is for it.

[gizmo686]

What do you mean by "general consensus"?

If you mean "current market values", then those are being set by the aggragate opinions of active traders. If there are less active traders, there is less brainpower being devoted to finding this consensus, so it would be suprising if the consensus did not get less accurate.

[edmundsauto]

Isn't the price set by everyone, not just the active traders? It's set each time a sale happens, but the price itself is also related to how many people are holding the stock long term.

I don't really consider it possible for pricing to be "accurate". It is what it is, but accurate implies there's a correct valuation, which I don't think there is.

[yifanl]

Because when enough of the money is in an index fund, you can predict how a large part of the investors are going to invest (using the same algorithms they're using) and adjust based on that.

[jandrese]

That's it exactly. If the index funds get so big that they basically are the market, then active investors will have to adjust their view of the market to be effectively just whatever the index funds do.

It may be possible that although they can't beat other active investors enough to justify their fees, they can beat a big dumb index fund enough to make their services worthwhile. That remains to be seen however.

[groundlogic]

Kinda makes sense. Still, it sounds like a very fragile system.

So instead if active fund managers "knowing the market better", we'll get active fund managers, "knowing the passive investor crowd better".

This is madness.

[yifanl]

I mean, if the majority of the market is dumb passive index funds, those are one and the same :)

[noirbot]

I'd assume there's some stability to knowing that X% of the market is passively invested in indexes. It could give active traders some extra edge, since it would make things more predictable? If everyone's an active trader, it's everyone competing against everyone else, where everyone is a live actor. On the other extreme, if you're the only active trader, and literally everyone else is in indexes, you'd be the only person actually moving the market in response to news, and could use that to your advantage.

Obviously we're not in either state, but presumably the closer we get to the latter state, the game gets a little easier for the active traders, not that that necessarily means they'll get a free "win"

[whatshisface]

>I'd assume there's some stability to knowing that X% of the market is passively invested in indexes.

Indexes holding shares have no influence on the price. The price only changes when traders trade.

[kgwgk]

To make money you don't need to "Guess the future" in an absolute sense, you just need to "guess" better than the rest of the market participants.

When there is a majority buying/selling all the shares in block without any consideration to the differences in liquidity and fundamentals between stocks it may be easier to find opportunities than when everyone buys and sells individual stocks. (But one could also say that the average stock-picker is so bad that having more active investors actually increases the gain for the talented ones rather than pressuring profits due to competition).

[codingslave]

Index funds work because weve been in a 20 year long bull market. If the market goes sideways for a decade, or down for a decade then active investing is alot more profitable.

[roadnottaken]

It's been a ~10 year bull market. 1999-2009 was basically flat.

[groundlogic]

That has never happened (as far as I know, in modern history). Of course that's not a reason it can't happen, but I feel like you owe us at least a plausible decade downturn scenario.

[nostromo]

It has happened for specific stretches of time.

For example, if you bought near the top in 2000, you were still underwater a decade later.

[javagram]

https://www.marketwatch.com/story/john-bogle-has-a-warning-f...

> Bogle pointed out that as indexing increases to a certain point, it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. But past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place.

[neilk]

I’m know I’m a dummy when it comes to economics, and an investor in index funds because of that.

But it strikes me that index funds are parasitical in a way and depend on price signals from active investors.

Some people say that it’s ok, the situation is self-correcting.

But what if the smart active money is active in places we can’t see in the public markets? Again, I’m a dummy, but I believe a lot of investment is happening privately these days.

[fountainofage]

Private investment is absolutely where the money is these days. Look at how the media claims an IPO that doesn't pop 30% or more on day one is a "failure." No one who actually contributed to that company's value benefits from that pop, and best case scenario is really to either have the IPO be flat or even go down a little. But those elite that buy their way to the front of the line demand to have that 30% pop for contributing nothing.

I'll just point out there's the argument about market makers and underwriting and blah blah blah. If that's such an issue just price that into the underwriter fees to begin with. No reason the public markets should lose out on a 30% gain to people that didn't actually take a risk and invest early in the company, and only intend to hold the stock for 8 hours at most.

[perardi]

You are not a dummy. Over the past 30 years, index funds have outperformed active management, especially when you consider the fees.

You are a ”dummy” in the sense you don’t have perfect information awareness on every possibly tailwind or headwind that could impact a particular stock. But everyone is a dummy in that sense.

[davidw]

> But everyone is a dummy in that sense.

And even honest people well versed in economics will tell you that they are too.

[jldugger]

> What's the limit - 30% 40%, 50%, 60%?

I'd wager at least 90 percent. Passive investing is generally designed to track active investor activity without effort, so it shouldn't add much inertia to the system. If Dave thinks IBM is overvalued and Under Armor is overvalued, the act of buying and selling will shift those numbers, and the index investors, instead of taking the opposite trade and undoing that flow of information, hold their portfolio.

IMO, the real challenge is active investors competing for access to that 10 percent of active invested money. There's no shortage of people happy to manage money under the 'heads I win, tails you lose' fee structure, and one hopes that the same people fighting over a smaller pool of cash would (more strongly than status quo) favor people who can actually produce results.

[whatshisface]

>but it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds.

If you have one trillion dollars invested, and the entire exchange volume is based on me and my friend trading a single share back and forth, everything will still work. It doesn't matter how much you own, because my friend and I are going to want a fair price for that one share in any case. There's no practical limit to how passive things can get before a problem kicks up, as long as a few hedge funds stay in.

[kds3]

> entire exchange volume is based on me and my friend trading a single share back and forth, everything will still work

You are talking like such a market is extremely liquid (there are enough shares for everyone). I think when a third person enters such a market your example breaks apart. Now you have one person who constantly wants to buy a stock but is unable to do so. Because you and your friend trade at a fair price and index fund does nothing. So he have to buy at an unfair price and rises his bid until index funds kicks in the game.

[kccqzy]

> it's obvious to anyone used to thinking in terms of systems that index funds can't work after a certain amount of the money poured into the system is managed by index funds

How so? I can certainly see "lost opportunities" where good stocks are undervalued just because they aren't in the index funds, but I don't understand why you think index funds can't work. Can you elaborate?