Semper Augustus

Cigarbutt · February 27, 2018

The letter contains a lot of useful data and analysis. I second John's appreciation and gratitude to SlowAppreciation and Dynamic.

So, many interesting topics covered in the letter.

A word here about passive investing. The growth in ETFs has so far continued unabated.

Some suggest that this is not a problem as long as some residual investors continue to do the "active" work. Too easy?

Here's a link that covers an asset class that has been influenced by this relatively new trend, the high yield debt market.

https://www.bloomberg.com/view/articles/2018-02-26/passive-investing-has-brought-marxism-to-the-junk-bond-market

The title is sensational and the conclusion contains a forecast type ending which is not necessary but the graphs and data are interesting. Passive investing is now a large part of the high yield debt market and I agree that this likely explains the increasing correlation between the different components of the asset class. Obviously, there are cyclical forces that will tend to drive spreads up and down from time to time but this increasing correlation in a very benign environment is quite unusual. (see page 17 of the letter for the two graphs showing the historical evolution of yield and spread).

I submit that going in the high yield debt market requires an eyes wide open approach. I think that the rise of passive investing is contributing to the synchronized dampening of yield and spread. It is not a problem in itself. It just means that (here assuming that the credit market is cyclical) the price action and momentum in the other direction may be magnified and that may give rise to contrarian opportunities.

Dynamic · February 27, 2018

Haha thanks for clarifying, and sorry to all that it's a little clunky

It's not at all clunky. I think it's great and is really useful for tracking great Value Investors and the stocks they own, but it had slipped my mind which stock picker was behind Semper Augustus, so I thought I'd be explicit for the benefit of anyone else who's similarly slow-on-the-uptake, or is new to Semper Augustus letters and their great analysis!

Your tracker is superb for tracking all these investors and brilliantly fit for purpose for idea generation.

My BRK Look-Through is focused elsewhere, so it's great to have yours too

John Hjorth · March 5, 2018

I got mailinglisted at Semper August about two years ago, after our "discovery" of the "first" Berkshire related Letter from there. Today, I've received the last letter by e-mail, attached to this e-mail from Chad Christensen :

Attached is a PDF copy of the year-end client letter. The theme switches to literature from rock and roll but don’t take that to mean we’re growing up...

The letter examines market valuations at extremes; bubbles in passive investing and monetary policy, with both likely to unwind unpleasantly. We update our intrinsic value summary for the portfolio and compare our holdings fundamentally with the market.

We think Berkshire Hathaway is the largest beneficiary of the 2017 Tax reform just passed. We look at the impact of the tax changes and update our intrinsic valuation analysis. Despite the shares up 21.9% last year (and 23.4% the year before), considerable upside remains.

Throughout the letter we contrast our investment approach and discipline with passive investing. We include a chart that shows the degree to which money is unnaturally distorting the big stock market indexes and how risk is building. It’s eye opening.

Berkshire released their annual report and Warren Buffett’s Chairman's letter at BerkshireHathaway.com.

Chris was inspired by the Winter Olympics and broke the Semper world record for long letters.

We welcome your comments and feedback.

[ : - ) ]

chrispy · March 8, 2018

I have enjoyed the first half of the letter and now need to find time to read their BRK analysis.

Their commentary on holding cash through various cycles and how they never plan to again once they deploy their current cash holding was very interesting. I believe it was Racemize who posted research that concluded being 100% invested almost always works out better (when emotion is removed as a variable).

With regards to indexing, they continue to make one point that I dont agree with, nor does my math. If folks only invest into an index fund, then every stock in that fund goes up by the same amount. They disagree though and state that the top holdings go up the most and subsequently smaller holdings go up less and less. My math cannot recreate their finding... Anything that I am missing?

racemize · March 8, 2018

I have enjoyed the first half of the letter and now need to find time to read their BRK analysis.

Their commentary on holding cash through various cycles and how they never plan to again once they deploy their current cash holding was very interesting. I believe it was Racemize who posted research that concluded being 100% invested almost always works out better (when emotion is removed as a variable).

With regards to indexing, they continue to make one point that I dont agree with, nor does my math. If folks only invest into an index fund, then every stock in that fund goes up by the same amount. They disagree though and state that the top holdings go up the most and subsequently smaller holdings go up less and less. My math cannot recreate their finding... Anything that I am missing?

I think it makes sense if you continually add money and that prices are fluctuating. It effectively makes it a momentum strategy.

Let's assume two companies in an index fund, each at $50.

so Day 0: 50/50

When money is added in that day, then the index is equal weighted, so the extra demand from purchases would also be equally distributed, which I think is what you are saying. However, let's say earnings for company A are amazing and earnings for company B are really poor, so the prices of the two companies change in response (which admittedly requires some activists setting the price here) to $75 and $25.

So Day 1: 75 / 25

Now, when new money flows in, it flows in 75% towards A and 25% towards B, resulting in higher demand for A than B, so the relative price change would not be the same for the two companies. So the demand for A has increased dramatically than B over the first day. If it increases price more, then it would get worse with each new dollar.

I guess you don't even need the first day if you just started with the second day. But you could imagine a scenario that a small perturbation would cause an imbalance of demand for a company due to weight in the index.

That's how I've thought about it, but perhaps I'm missing something.

vinod1 · March 9, 2018

Race - I could not wrap my head around your example.

I cannot see any rationale when investing in say the total stock market index or the S&&P 500 index would cause some stocks to get overvalued. Passive investors are buying market weights of the stocks.

Stock A might have 10% weight, Stock B might have 5% weight and Stock Z might have 0.1% weight based on their market cap. Every additional dollar value of passive investors is invested in the same exact proportion. So I cannot see any reason for why this would benefit some stocks but not others.

One way some stocks could get overvalued is if a sector or a narrow index fund like say Social Media Index Fund (just making it up) attract a large investor base which would increase demand for all the stocks in such indexes to increase which would drive up their prices.

Regarding the letter. Blaming indexing and central bankers seem to be the common theme of all the value fund managers who are under-performing the index funds. If you read about either of these in their letter it is pretty good bet they are underperforming the index.

Vinod

Jurgis · March 9, 2018

vinod1 and chrispy are correct. 8)

When incremental money comes in, it will buy the percentages based on weight. But who does the selling?

racemize argues that it is easier to encourage small percentage (25%) stock sellers to sell without price going up while the big percentage (75%) stock sellers will be less willing to sell, so price for that stock would have to go up more compared to the small stock. Which would result to big stock becoming 76% and small one becoming 24%. But this means that sellers are active investors choosing what to sell. If the sellers are index investors, then this does not happen.

And even if sellers are active investors, racemize's argument is not very grounded. Why would the active seller choose to sell smaller company rather than bigger? Yeah, you can think of some anecdote like racemize did (smaller company had worse results...), but I can think of anecdote in the opposite direction (smaller company is cheaper based on some metric). 8)

racemize · March 9, 2018

Well, so first off, I'm not confident on this, and I've been trying to wrap my ahead around various passive indexing thought-experiments for a while now. But for clarification on what I was saying:

My Day 0 vs Day 1 example was to show that companies that had the same initial weight (and therefore the same initial allocation of dollars) will end up having different dollar demand based on price perturbations. Thus, I wasn't saying larger vs smaller, I was saying same IV, but price disparity ends up causing a change in the dollar amount of incremental demand by passive investors. Or saying this another way, if there are $75 going at the company that was $50 and $25 going to the other company that was $50, then the passive index is reinforcing the price change, not dampening it.

However, I think vinod is pointing out that for every $100 it is just 1 share of demand, so in a "share demand" framework, there isn't any difference (rather than the dollar amount above).

Perhaps though, the indices to exacerbate momentum, they just stabilize it. Or saying it another way, these momentum artifacts are just what happens normally in late stages of bull markets and don't have much to do with indices.

racemize · March 9, 2018

Here's Einhorn talking about it, which is a reflection of how I've thought about it. Perhaps this just isn't true though:

But it seems to me that passive money management strategies are fundamentally momentum strategies. In other words, the more the stock goes up, the more it becomes weighted in the index. The more it becomes weighted in the index, the more important it becomes. It continues going up. It doesn’t ever revert. You get a bigger and bigger weighting into the stocks that are already rising. And the stocks that aren’t doing well, which tend to make them smaller parts of the index or sometimes they get replaced out of the index or replaced by something else that’s going up. So I think when you have a momentum-oriented market you wind up with better performance for passive strategies. When you have something other than that you probably have a better performance for active strategies.

I think we’re clearly in a momentum market. I think here in this market there’s clearly two groups of stocks. There are stocks that are very, very expensive and almost indifferent to valuation. You see people talk about them and they just don’t tend to put a lot of numbers next to the themes that justify these stocks.

Jurgis · March 9, 2018

Well, so first off, I'm not confident on this, and I've been trying to wrap my ahead around various passive indexing thought-experiments for a while now. But for clarification on what I was saying:

My Day 0 vs Day 1 example was to show that companies that had the same initial weight (and therefore the same initial allocation of dollars) will end up having different dollar demand based on price perturbations. Thus, I wasn't saying larger vs smaller, I was saying same IV, but price disparity ends up causing a change in the dollar amount of incremental demand by passive investors. Or saying this another way, if there are $75 going at the company that was $50 and $25 going to the other company that was $50, then the passive index is reinforcing the price change, not dampening it.

However, I think vinod is pointing out that for every $100 it is just 1 share of demand, so in a "share demand" framework, there isn't any difference (rather than the dollar amount above).

Perhaps though, the indices to exacerbate momentum, they just stabilize it. Or saying it another way, these momentum artifacts are just what happens normally in late stages of bull markets and don't have much to do with indices.

I got what you said. Perhaps I was not clear in my post. But overall the answer is that purely passive (market cap index) investing cannot cause prices to go from 50/50 to 75/25. They cannot cause relative market cap change.

In market with active investors, the active investors cause the price changes. It depends on what you mean with "reinforce" and "stabilize momentum", but you may be right that indexing supports or enlarges the influence of active investors. In a sense that $1 actively invested in a company with $99 index investment could drive up the price disproportionately, because indexers are not selling at any price and if they sell, they sell proportionately all stocks in index.

Edit: Also active investor selling active positions and buying index causes the index skew towards the stocks they did not own. But it's their selling that's causing the skew. If they sold and went to cash they would still cause the same skew.

racemize · March 9, 2018

I got what you said. Perhaps I was not clear in my post. But overall the answer is that purely passive (market cap index) investing cannot cause prices to go from 50/50 to 75/25. They cannot cause relative market cap change.

Right, I was saying the active investors cause it in that case (or just random perturbation in a smaller case).

In market with active investors, the active investors cause the price changes. It depends on what you mean with "reinforce" and "stabilize momentum", but you may be right that indexing supports or enlarges the influence of active investors. In a sense that $1 actively invested in a company with $99 index investment could drive up the price disproportionately, because indexers are not selling at any price and if they sell, they sell proportionately all stocks in index.

Edit: Also active investor selling active positions and buying index causes the index skew towards the stocks they did not own. But it's their selling that's causing the skew. If they sold and went to cash they would still cause the same skew.

Perhaps this is the effect I mean--momentum clearly already happens, but if the passive indices reinforce or amplify that momentum, then it could potentially cause issues both during the bull market and the reversal after, since I'm assuming it would work similarly in reverse.

chrispy · March 11, 2018

Good points.

That is the big question, how does this work in reverse? My understanding: Companies with the largest proportion of shares held by active owners, where the active owners are willing to sell shares in a downturn, will have an outsized decrease in share price?

Dynamic · March 13, 2018

I've finally got round to reading the indexing section in detail.

I think I'll need to re-read it, having thought about it, to see what is and is not being suggested in it.

It reads like a good narrative, with good reasoning and feels like it has a lot of either validity or truthiness. I certainly don't feel I'm as equipped as the author to know from the top of my head or from long experience and study how all these things work.

I can certainly envisage the instinctive actions of a large number of retail investors acting on instinct. The group I'm thinking of would be the type to start investing in equities only after a sustained period of 'consistent good performance' has been demonstrated, such as the last 2-5 years (i.e. certainly not buying low, more likely to buy near the top) and who tend to panic and sell if the market seems to be going down (i.e. a tendency to sell low). They have no concept of value being different from price, only a number that mysteriously moves up and down and shows 20% gains in each of the last couple of years.

What I am still puzzled about is whether index rebalancing has any multiplicative or reinforcing effect on 'price momentum' or even a countervailing effect on it at time when there is no net inflow or outflow as various indexing investors add funds and withdraw funds over a period.

After that, sure if there are net inflows it will tend to boost each company in proportion to their weighting.

I believe that the S&P500 index figure represents a fixed fraction of the market cap (or free-float adjusted market cap) of the companies involved.

The S&P500's total market cap at 31st Dec 2017 was $23,938,148.8 mn, float-adjusted: $22,900,164.8 mn, Index value = 2673.61

On that date, for example, AAPL was priced at $169.23 and had Mkt Cap of $858,675.6 mn (approx - I've assumed no change in share count in the last couple of months, but that doesn't change the gist of what I'm working out).

AAPL should make up 858675.6/23938148.8 of the index = 3.587% by Market Cap on 31st Dec 2017 and would still represent 3.587% of the S&P500 index value of 2673.61, meaning 95.90 index points. I we assume 1 'point' is worth $1, than means for every purchase of 1 unit of S&P500 at $2,673.61, $95.90 of that was APPL, so the number of shares of Apple purchased was $95.90/$169.23 = 0.5667 shares of AAPL.

With 5,074 mn shares in issue, that's 1/8,563,000,000 ths of the shares outstanding in AAPL represented in the index.

It should be that every other firm in the index also has 1/8,563,000,000 ths of its market cap (or perhaps that fraction of its free float market cap) represented at present. So a firm XYZ Corp valued at exactly 1/100th of AAPL's market cap on 31st December would represent 0.03587% of the S&P on that date or $0.9590.

If AAPL happened to do a 2-for-1 stock split on 1st Jan 2018, it would represent 1.1334 shares, still worth $95.90 (as the AAPL price would be $84.615) - no change in index weighting.

If it didn't split, and rose to $181.72 (close on 12th March 2018) while the index rose to 2783.02, that 0.5667 shares would be worth $102.98 out of every $2,783.02 unit of index fund (at 12th March). This is now 3.700% of the index, but didn't involve index funds buying more shares in AAPL, it just reflects its rise in stock price having increased faster than the rest of the index increased.

If rebalancing were carried out today, it would only be a reflection of changes in the number of shares in issue.

For example if AAPL were to buy back and retire 10% of its stock this quarter, effectively the index funds would have to sell 10% of their AAPL holdings to rebalance exactly. This is extreme, and no company is likely to buy back that much - maybe 2-4% in a quarter on rare occasions, and index funds could take their time rebalancing and accept some tracking error.

So having got that straight, what happens when net inflows into index funds are occurring?

Today, for every net $2,783.02 coming in, the fund will be buying typically 0.5667 shares of AAPL give or take some tracking error. This is 1/8,563,000,000 ths of its market cap.

Likewise, XYZ Corp shares would be bought at 1/8,563,000,000 ths of its market cap (i.e. they'd buy 1/8,563,000,000 ths of the shares outstanding).

Relatively, the amount of buying demand on both index constituents is the same proportion of its shares outstanding. If APPL happened to fall 10% relative to the S&P500 (still at 2783.02), and the cash inflows for the index funds were the same, they'd still buy typically 0.5667 shares of AAPL for every net $2,783.02 coming in. If nobody repurchased their own shares, it would still be 0.5667 shares.

Likewise is XYZ Corp fell 50% the S&P500 would barely budge, yet it would still have index funds buying the same 1/8,563,000,000 ths of the shares outstanding for every net inflow of $2,783.02 into these funds.

If the S&P500 fell consistently or very sharply for a few months, especially with a serious geopolitical or economic event as a 'reason', what I would imagine is that most index funds would see net outflows of capital and would then switch to being on the selling side. For every $2,783.02 of net outflow today, they'd have to sell 1/8,563,000,000 ths of the shares outstanding (or free float) in every stock in the index, give or take tracking error, meaning 0.5667 shares of AAPL worth $102.98 and almost a dollar's worth of XYZ Corp etc.

Now, I imagine the know-nothing retail investors herding into and out of index funds based on emotions will also be accompanied by retail investors herding into and out of active managed funds too (with the exception of those few Value Funds that successfully manage to discourage this adverse behaviour among their partners, either by persuasion or by penalties for withdrawals without sufficient notice).

It's likely that the active funds will also have to sell many of their positions regardless in order to fund the net redemptions, though they might be selective and strategic about which positions they sell in ways that index funds will not.

I can certainly see how the net flows of capital will shift the balance of supply and demand and the herding behaviour would, for a time, reinforce the price action that caused the herding - a positive feedback loop (positive feedback loops in 'control theory' being unstable, causing overshoots and wild swings, whereas negative feedback loops tend to cause stable more gradual response to a sudden stimulus). Negative feedback loops are more 'positive' emotionally, while positive feedback loops can often produce emotionally 'negative' outcomes.

I think it has always been this way.

It seems you need to force out most of the emotional actors from the market before only the more rational actors are left and the self-reinforcement over downward 'momentum' can correct. The longer the boom, the more irrational actors are drawn in and the higher the market will peak before it busts, and the deeper the bust will go before they are driven out.

Buffett's words may encourage many more people to buy index funds when the 'going is good' than the number that will be persuaded by his words to have the emotional detachment to stick to investing regularly even when the market has been in decline and looked scary. Only the latter group will reap the full rewards of investing in the wide range of businesses represented by the index. Those who bail out when fear abounds will tend to capture most of the falls and miss most of the rises.

What I'm not seeing is how a rise in indexing is really any different to any rise in retail fund investing (e.g. mostly actively managed in the past booms). In the past, the range of active funds was wide, and although there was herding, there were many popular approaches including momentum-based and sector-focused that paid relatively scant attention to intrinsic value, especially as retail investors piled in towards the peak of a boom. In aggregate, I think the net inflow of funds still caused increased demand in almost all stocks causing prices to tend to rise, and when there was a net outflow of funds, that caused increased supply of almost all stocks, causing prices to fall.

I'm thinking that it could be the active funds where they wish to advertise that you're taking part in the 'performance' of sexy well-known stocks like Apple, Facebook, Amazon, Google and the likes (and even Berkshire!) that may be over-weighting these stocks to increase their appeal to market their funds to bright-eyed retail investors who want a piece of that recent 'performance' as "it's sure to continue in future" in their minds. It can be subtle things like that which will sway them into picking specific funds (and the fund's market departments know it), and perhaps its that which would drive the relatively higher demand for these market darlings who have recently 'performed' so 'well' (or as we'd put it, whose price has become less attractive in relation to their intrinsic value).

Equally, if you're trying to manage large funds actively, if a lot of additional money is flowing into your fund, it really forces you to look at investing in those stocks with the biggest market caps so you don't drastically distort the supply and demand of the smaller names by making up a great proportion of their daily volume.

I admit I'm struggling to see how it's indexing rather than just the general flow of capital into funds of all kinds, that is driving the concentration of gains into a narrow range of large-caps.

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Assuming most stocks of all sizes have similar percentage turnover of their shares in issue during a year (notable exceptions like Berkshire being the rare counter-example), and ignoring companies newly entering or leaving the index (especially large-cap entrances like BRK.B a few years ago), I cannot see index funds being responsible for the momentum multiplying effect causing the largest caps to experience the largest gains. To my mind, it seems more plausible that our culprit is the majority of non-value active managers possibly aiming to attract the most Assets Under Management as higher priority than long-term performance, that are most likely to focus on the 'big names' and large caps as all this new money comes in as we near the peak of the boom. To me it seems like that's the more likely mechanism for this concentration that precedes so many of these crashes.

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But I'm willing to be persuaded, and would be glad to be shown if I'm wrong in any of my assumptions. I try to remain a true skeptic - willing to change my beliefs on the basis of good evidence.

Cigarbutt · March 19, 2018

"I admit I'm struggling to see how it's indexing rather than just the general flow of capital into funds of all kinds, that is driving the concentration of gains into a narrow range of large-caps."

I actually agree with that statement.

My assessment is that mostly the shift to index funds can be explained by the move away from mutual funds and even if index funds are passively managed, the underlying investor population, in essence, has a passive mindset.

I submit though that there may be pockets of ETFs where this does not apply: specialized, leveraged and synthetic ETFs. These funds may attract a momentum crowd and liquidity issues with precipitated attempts at price discovery have not been tested (remember how that worked out with packaged real estate subprimes securities).

IMO the infatuation with indexing is simply part of the larger picture and is based on momentum (may work in both directions as markets don't usually follow a straight line).

Isaac Newton would have said: "what goes up must come down" but markets tend to go up and his investment record is not impeccable.

I thought you would be the type to be interested in the following:

www.goldmansachs.com/our-thinking/public-policy/directors-dilemma-f/report.pdf

http://mathinvestor.org/does-indexing-threaten-the-market

If pressed for time,

-the first link shows a nice graph (exhibit 4, page 6).

-the second link refers to well done specific studies evaluating the relevant underlying questions.

Apparently, according to Mr. Bogle, the father of indexing, as long as 25% of funds are actively managed, we're probably OK.

I wonder if that number has a margin of safety.

Dynamic · March 20, 2018

From the first article, it seems that about 13% of the US market cap was in index funds, but that represented about 25% of all funds, since they make up about half of the market cap. This has certainly risen substantially in the last few years and accounts for most of the outflows from managed mutual funds, it would seem from their graphs.

The second article seems to provide a sampling of evidence (I've heard of a couple of the studies like Malkiel's before) that indexes don't cause significant market distortion at current levels. I found it more interesting that some new indexes are created based on backtesting, and that while over 70% outperform in the backtest, only 51% outperform after the creation of the index. Nonetheless, the backtest result seems to draw in AUM, hence the creation of the new index and tracking funds aiming to attract AUM.

It seems Wall Street marketing departments are motivated to create new index products to attract AUM, especially if backtesting provides a favorable 'story' to sell the product.

Nonetheless, a broad market index (rather than sector index etc) seems to be a sensible thing to track.

I dare say there must come a point where excessive indexing as a proportion of all trading volume would remove most of the 'price-setting function' of markets. This could provide opportunities for intrinsic value investors and arbitrageurs to profit from long and short-term discrepancies between price and value, hence providing a degree of limitation to the distortions that it might create. But we're probably still a long way from that point.

Jurgis · March 20, 2018

Non-market-cap weighted indexes are active strategies by definition since they do not track the market. There is no point to include them into passive-index total or consider them as passive for any other discussions.

StubbleJumper · March 20, 2018

Non-market-cap weighted indexes are active strategies by definition since they do not track the market. There is no point to include them into passive-index total or consider them as passive for any other discussions.

Why? Both are just an arbitrary list of relatively static securities. The s&p is a list of 500 companies chosen with an arbitrary set of rules, including the cap weight rule.

I could create SJ's Scrabble 500, which would be the 500 listed companies whose names form the highest Scrabble score. In fact, I think I would have it Scrabble score weighted instead of market cap weighted. If people recognized the genius of my passive investment find, and piled scads of capital into it, why would it be any different than the observation that semper Augustus has raised about the s&p funds?

Sj

Jurgis · March 20, 2018

Because the market cap based index matches the market and does not influence relative security prices when people buy/hold or sell it. That's the definition of it. And that's the reason it's truly passive.

Everything non-market-cap based does influence relative security prices when people buy or sell it. And by that fact it's an active fund. Active means that you are trying to get a different result than the market - and you get that with non-market-cap based weights. It does not matter whether your weights are fundamental (P/E, P/B whatever), technical, arbitrary (Scrabble), based on some manager's picks or whatever. In all these cases, you are taking an active position that your weights are different from the market's.

Edit: to rephrase the above: if you buy/hold/sell anything that is not market cap based index, you are engaging in price discovery. Even if it's a Scrabble index. If you buy/hold/sell market cap based index, you are not engaging in price discovery. That's IMO very significant difference.

I'm kind of surprised that some people do not realize that there is this difference between market cap based fund vs anything non-market-cap-based. And conversely that there is pretty much no difference between mechanical weight determination based on some factors and what people call "real active" stock picking. This is rather basic definitions + math... ::)

Cigarbutt · March 20, 2018

Interesting.

Sticking to the strict mathematical definition, for a fund, the difference between passive and active investing is crystal clear.

When you put the underlying investor into the equation, the concept becomes qualitatively blurred.

Then, you may want to consider passive and active, not as two extremes, but as part of a spectrum.

Say you have an investor who changes his/her asset allocation from the classic definition and decides to invest 100% of funds into plain vanilla index funds. Passive?

Or if an uninformed investor actively decides to suspend the dollar cost averaging schedule in a standard index ETF and invest once per year on his/her birthday. Passive?

What about the so called actively managed mutual funds that very closely mimic indices and that rarely outperform?

My point is that the generic notion of passive investing may simply mean that the underlying process is not concerned with the use of price discovery and fundamental analysis of individual issues in order to significantly outperform the stock markets.

Some say that the rise of passive investment is relatively new and extraordinary. I submit that, in a lot of ways, many ETFs are simply a new name for many of the so called actively managed mutual funds. And I say that the typical retail investor will continue to buy high and sell low. At least, that’s what the record shows.

Perhaps I agree that passive investing mitigates the key man risk (fund manager). But it does not mitigate against those who want to have a quick and easy way to gain access to the market.

This post initially came as a rant but was modified as I reached conclusion.

Purely from the opportunistic point of view, the more the better.

Jurgis · March 20, 2018

Cigarbutt, you raise some reasonable questions. Some of them are due to extreme overloading of the terms "passive"/"active": they are just used too much and for different things. E.g. does a person means passive == "market cap based", passive == "no human active manager", passive == "buy and hold and not sell"? And so on... There are yet other questions similar to yours that I am aware of, but I won't mention since they would muddy the water further. 8)

I just think that people should be careful with their definitions and the products they discuss when they talk about passive/indexing and price discovery/price influence. Otherwise we get quite a few misleading and unsubstantiated claims. 8)

Peace.

Cigarbutt · March 20, 2018

You are correct.

The strength of a conclusion is based on solid reasoning based, as a foundation, upon the quality of clearly defined assumptions.

I got carried away with empathy after reviewing the indexing topic and after reading this article.

https://www.bloomberg.com/view/articles/2018-01-30/the-dumb-money-is-about-to-become-very-influential

Riding the wave is so much fun.

I'll try no to let it happen again (on this Board). ;)

Jurgis · March 20, 2018

Nah, I think your post had good and valid observations. Carry on. 8)

Dynamic · March 21, 2018

I agree that these are valuable observations and discussions.

We sometimes need to be precise about in what way a person, group of people or a fund is acting passively or actively.

For example, assume there exists a substantial portion of retail investors as a collective, the presumably large group who tend to put money into funds at the end of the boom cycle and withdraw it upon signs of trouble, not returning until the market has again showed multi-year gains in the recent past.

That group is making an active decision about the timing and amount of their added or withdrawn funds, regardless of whether the underlying funds make active or passive decisions about buying and selling stocks on their behalf in accord with the net inflow and outflow of investor funds.

On the subset of that group of investors that invest in broad-market index funds (market cap weighted), each fund unit represents the same fractional ownership of each company (or of each company's free float) aside from tracking error and tracker decisions to omit smaller caps or to rebalance them less often to save costs.

At the whole-market level the net inflows and outflows can be considered a contribution to price-setting (based on some kind of active momentum-like behaviour). It does not differentiate between one stock and another within the same index, however, as allocation is passive. Only flow is active and flow (assuming it is momentum-based) tends to accentuate general market rises and declines, but it shouldn't (for this subset) change the relative price-pressures on specific stocks within the index except by how it adds to or subtracts from buying or selling trends created by other market participants, unless it just so happens that, relatively to market-cap, those specific stocks happen to be among the most thinly-traded in general (daily volume as a proportion of their free float), in which case their buying pressure is outsized compared to more typically traded stocks.

Dynamic · September 5, 2018

Although I'm wary of resurrecting dead threads, I came across Howard Marks' Oakmark letter - Investing without people containing some interesting points while catching up on the Motley Fool's Berkshire Hathaway board in a post on June 19th.

It really got to the heart of another distinction I probably hadn't made in disagreeing with Semper Augustus about some aspects of passive funds and ETFs causing a thinning market.

Although index funds were the first passive funds and then ETFs were introduced to allow intra-day trading, not just "at close", there are now over 3,000 ETFs and they now include all manner of variations which might be considered passive or rules based investing. And of course, bonds as well as stocks can be traded via ETFs.

Many of these are not broad-market index based, some are based on a sector, region or some other category determined either by a human categorising them or by a set of algorithmic rules (e.g. value or growth or importantly momentum). Some are highly leveraged, some are reverse-weighted to an index and so on. There's a lot of potential for investors to actively choose to select and ETF that matches certain characteristics or strategies then passively invest according to those rules, as long as they hold the ETF, but then to actively time their ETF buys and sells, causing inflows and outflows of money, which may seriously affect the market in the event of a market shock or panic.

Oakmark's letter includes some interesting points.

One of them refers to ETFs being market-traded rather than settled at the closing price for the day, so there's no guarantee that in a big shock, the buyer will be willing to pay the current net asset value, so the seller may end up with less than the index would suggest they'd get. They say there are mechanisms built in that 'should' prevent serious discrepancies, but these haven't yet been tested in extremis.

Another is that deliberately selective ETFs, while being passive or mechanical in investment choice, may cause distortions and thinning of the market toward particular stocks if they should become particularly popular for inflows and outflows of funds. If there are particularly popular ETFs that hold high concentrations in FAANG stocks, for example. Thus it's important to distinguish between broad-market passive investing and narrow themed or categorised passive investing.

Also the author accords with some of our opinions in this thread that in a market cap weighted passive index fund, large inflows should not disproportionately favour the firms with the higher market cap. The important distinction they make is that some ETFs are not as passive in selection as others, so inflows into those ETFs could enhance distortions.

Reading Semper's letter with a distinction in mind between different kinds of passive, may change the validity of the passive versus active investing part.

Cigarbutt · September 5, 2018

Although I'm wary of resurrecting dead threads…

Reading Semper's letter with a distinction in mind between different kinds of passive, may change the validity of the passive versus active investing part.

There is a file which contains a few items, which is labeled "look again in 5 to 10 years", which lists potential missed specific investment opportunities. But, there is a also a section on passive investment risk. When looking back, often the conclusions is that you were wrong to be right or right to be wrong. Sometimes, to be approximately right can be extremely rewarding. To modify conclusions along with evolving evidence/anaysis and to "publicly" do so is one of the things I value most in people.

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