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?
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.
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.
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.
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.
For financial products, there is a correct price but it cannot be known for certain until far in the future. Stocks in particular represent a claim on the future dividends of the company, whether issued during operation or at the dissolution of the company. If both those future dividends and future inflation were known, you could accurately calculate the present value of that cash flow and get the correct price.
I'm over my toes here, being a programmer and not a finance person, but isn't this viewpoint controversial? IE, does everyone (relatively well informed) agree there are correct prices?
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.
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.
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"
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).
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.
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.
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.