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http://www.irishtimes.com/business/financial-services/us-fund-giant-will-use-machines-not-humans-to-pick-stocks-1.3030623

 

Score one for the machines. From the moment Laurence Fink, the chief executive of BlackRock, created the largest fund company in the world by snapping up the exchange-traded fund business from Barclays in 2009, he has faced a thorny challenge. The explosive growth of these low-cost, computer-driven funds has been leaving in the dust his firm’s old-school stock pickers, and investors have been fleeing in droves.

 

After years of deliberations, Fink has opted for the promise of the machine. This week, BlackRock laid out an ambitious plan to consolidate a large number of actively managed mutual funds with peers that rely more on algorithms and models to pick stocks.

 

Some $30 billion (€28 billion) in assets (about 11 per cent of active equity funds) will be targeted, with $6 billion rebranded BlackRock Advantage funds. These funds focus on quantitative and other strategies that adopt a more rules-based approach to investing.

 

As part of the restructuring, seven of the firm’s 53 stock pickers are expected to step down from their funds. Dozens more are expected to leave the firm. The initiative is the most explicit action by a major fund management firm in reaction to the exodus of investors from actively managed stock funds to cheaper funds that track every variety of index and investment theme.

 

“The democratisation of information has made it much harder for active management,” Fink said in an interview.

 

“We have to change the ecosystem – that means relying more on big data, artificial intelligence, factors and models within quant and traditional investment strategies.”

 

Investor revolution

BlackRock, with its fleet of iShares ETFs, has certainly benefited from the investor revolution – one that threatens to disrupt the mutual fund industry in the years ahead. Still, the monster in the mutual fund room has been the indexing giant Vanguard which, via its index funds and exchange-traded funds, has had historic inflows.

 

Last year, for example, $423 billion left actively managed stock funds and $390 poured into index funds, according to Morningstar. Of that amount, Vanguard captured $277 billion, nearly tripling the amount that went to its nearest rival, BlackRock.

 

Fink has always professed to be agnostic as to whether a client bought a no-frills exchange-traded fund tracking low volatility stocks or an expensive mutual fund investing in small US companies. Let the client choose has long been the BlackRock leader’s mantra. Left unsaid, however, has been the reality that at his root Fink is now a true believer in systematic investing styles that favour algorithms, science and data-reliant models over the stock-picking smarts of individual portfolio managers.

 

In recent years he has hired Andrew Ang, a star finance professor from Columbia, to push BlackRock into factor-based investing, a theme-based approach to allocating assets. And since last year, BlackRock’s dyed-in-the-wool stock pickers have worked in the same division as its quants. Called scientific equity, these managers, many boasting PhDs, might buy (or sell) Wal-Mart’s stock on the basis of a satellite feed that reveals how many cars are in its parking lots as opposed to an insight gleaned from the innards of the retailer’s balance sheet.

 

Power of machines

In sum, Fink has become convinced that BlackRock must bet big on the power of machines, be it Aladdin, the firm’s risk-management platform, robo-advisers, big data or even artificial intelligence. Just about any interview or conference call featuring Fink bears this out: invariably, the conversation comes around to technology, with scant mention of what the firm’s stock pickers are doing. But simply going all in on machine-driven passive investing over active has not been an option for Fink. While the assets of the firm’s actively managed stock funds have shrunk to $201 billion today from $208 billion in 2009, the business is still very profitable for BlackRock, representing 16 per cent of total revenue.

 

According to data from Morningstar, only 11 per cent of Blackrock’s actively managed equity funds have beaten their benchmarks since 2009. Since 2012, $27.5 billion has left BlackRock actively managed mutual funds, per Morningstar data. The new push, which is being overseen by Mark Wiseman, a top executive at Canada’s top pension fund whom Fink hired last year to revamp his equity business, highlights strategies in which a portfolio manager makes big bets on a select group of stocks.

 

Still, there is no mistaking the larger message: expensive, actively managed funds looking to make a mark picking US stocks must adapt to the new realities at BlackRock. Take BlackRock’s Large Cap Core fund, which invests in big US companies. Since 2009, the fund’s assets have halved, to $1.5 billion, lagging the index by 1.3 per cent over the last three years. The fund’s lead manager will be replaced by three portfolio experts from BlackRock’s quantitative investing team, where all varieties of computer models are crunched in pursuit of stock picking ideas.

 

Fees

Fees will also be halved. Of course, none of these moves are likely to immediately halt the outflows of the past years. In fact outflows are likely to increase, as few investors want to stick with a fund undergoing an existential makeover. But as Fink and his new equity deputy see it, it is better to take the pain now than later.

 

The old way of people sitting in a room picking stocks, thinking they are smarter than the next guy . . . that does not work anymore,” Wiseman said. “These are stormy seas for active managers, but we at BlackRock are an aircraft carrier, and we are going to chart our way through these seas.”

 

Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

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Somewhat weird, considering that Mark Wiseman was the guy promoting active management at the Canada Pension Plan Investment Board before leaving for BlackRock.

 

Here's what he wrote shortly before he left:

 

"It has now been a decade since the CPPIB decided to actively manage the CPP Fund, rather than pursue a passive strategy of simply mirroring public market indexes. It’s not a decision we took lightly. Active management requires more resources, and therefore more expenses, than a passive strategy. But we firmly believe that it generates significantly higher risk-adjusted returns for you."

 

http://www.theglobeandmail.com/report-on-business/rob-commentary/yes-please-hold-cppibs-feet-to-the-fire/article30282937/

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

 

Ok, I only conjectured from Buffet's famous bet, and admit that's no proof. Let's say that it's inconclusive ... then it still makes sense to look for alternative strategies (e.g., AI driven / guided) that could work better than either one of them. Not sure if that's the case for Blackrock's algorithms, but they could have found enough evidences that algorithms work better than the both active and passive strategies.

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Schwab711, you realize that algo driven != passive, right?

 

Passive should be defined as market-weighted indexes. Anything else makes the whole definition broken. Smart-beta is not passive. Algo is not passive. Value/ROE/Moat-based automated funds are not passive. The fact that you know supercomplicated algorithm beforehand and your fund just follows it is not passive.

 

"Oh, yeah, I am going to create a fund which will follow buying/selling decisions of Valueact, but it will do this automatically, so it's passive".

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There is a very hard - though also very interesting - question:

 

Compare:

- Passive (market cap based indexes)

- Fully automated formula funds. (Spectrum from simple formulas to very complicated algos)

- Human-in-loop active

 

funds.

 

What is the best for average investor?

 

Bonus points: Fully automated funds gonna evolve. Yes, they will.

Different bonus points: consider asset allocation.

 

Not that this is solvable.

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There is a very hard - though also very interesting - question:

 

Compare:

- Passive (market cap based indexes)

- Fully automated formula funds. (Spectrum from simple formulas to very complicated algos)

- Human-in-loop active

 

funds.

 

What is the best for average investor?

 

 

On average I don't see how anything will beat passive.

 

From the little I can gleam the hedgies that do well with formula/algo investing are constantly tweaking and adding to the algorithms to stay ahead of the curve.  It just becomes an arms race but with tech / quant people instead of traditional managers.  Instead of picking the best manager you have to pick the best/most innovative team of geeks.  We are just right back to where we started with active where it is a guessing game.  Do you pick the team with the best performance?  Was there something about the last couple years that made their algorithms do particularly well?  Have other tech teams caught up / surpassed them?  It's still ugly.

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

 

In aggregate,

 

active performance = passive performance - fees.

 

So on average, its nearly impossible for active management to beat passive. This isn't a mathematical identity but for practical purposes it might as well be.

 

It isn't a mathematical identity because active managers can also make market making fees (e.g. algo traders) off of passive managers and these fees can become significant in the extreme of close to zero active management. But we are very very far from that extreme, which was discovered by the brilliant blog:

 

http://www.philosophicaleconomics.com/2016/05/indexville/

 

 

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There is a very hard - though also very interesting - question:

 

Compare:

- Passive (market cap based indexes)

- Fully automated formula funds. (Spectrum from simple formulas to very complicated algos)

- Human-in-loop active

 

funds.

 

What is the best for average investor?

 

Bonus points: Fully automated funds gonna evolve. Yes, they will.

Different bonus points: consider asset allocation.

 

Not that this is solvable.

 

Something that is passive in that the investor thinks it represents a good statistical estimate/sample of the performance of the asset so that they don't have the opportunity for a performance gap by piling into the active strategy when it outperforms and bailing out when it lags (they just pile in and out of the asset class but have 1/2 as many temptations).  They accept their plebeian fate and increase their chance of actually receiving patrician returns....om

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

 

Yeah, This strategy is setting up for the mother of all crashes.  First, something will happen to precipitate a downturn.  Then the cascade of effects will set off a negative feedback loop, and here we go, 1987 all over again, but perhaps way worse, with so many more automated systems, all feeding off data from the other "smart" algorithm.  This all rhymes with 1987, long term capital, Nasdaq 5000, and the 2007/08 financial crisis. 

 

Blackrock's institutional clients will get hit but they wont bail to the same extent as all the dumb money that has piled into ETFs at a rate of a half tillion a year.  Right now, all we need is a catalyst that will reassert the stock cycle.  Its anybody's guess as to what that will be, and when it will happen.  Buffett and John Bogle will have alot to answer for.  Too much of a good thing, well it can be a bad thing. 

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

 

Yeah, This strategy is setting up for the mother of all crashes.  First, something will happen to precipitate a downturn.  Then the cascade of effects will set off a negative feedback loop, and here we go, 1987 all over again, but perhaps way worse, with so many more automated systems, all feeding off data from the other "smart" algorithm.  This all rhymes with 1987, long term capital, Nasdaq 5000, and the 2007/08 financial crisis. 

 

Blackrock's institutional clients will get hit but they wont bail to the same extent as all the dumb money that has piled into ETFs at a rate of a half tillion a year.  Right now, all we need is a catalyst that will reassert the stock cycle.  Its anybody's guess as to what that will be, and when it will happen.  Buffett and John Bogle will have alot to answer for.  Too much of a good thing, well it can be a bad thing.

 

I find this whole notion of passive investing causing a market crash really fascinating.

 

First, if you are arguing that automated (trades made by computers) investing can cause a crash, I suppose that it will and it has happened before. But that is not equivalent to passive investing.

 

Passive investing is not a good or a bad thing, it's a just normal (average) thing. It's basically analogous to saying "I will take the mean of the probability distribution of all performances as my expected outcome". So when more people decide to do passive investing, it will simply make the probability distribution of performances taller and taller around the mean and reducing the variance. I'd argue that in general, the greater the variance in performances indicates the greater the irrationality in the market. So I don't think making the probability distribution more normal itself increases the chance of a market crash.

 

One could argue that passive investing does not allocate the capital in a "free market" manner, because it either distributes the capital according to the market cap (if cap weighted) or just equally (if equal weighted). Especially in the former case, one could foresee a bubble developing because more and more money will be allocated to larger companies if everyone becomes a passive investor.

 

So how would we prevent the above scenario? It seems obvious to me that cap weighted investing is not the most efficient capital allocation method for the society. Perhaps in the future we will see more variety of ETFs that invests in the overall market but with different composition methods that maximize the return on capital for the whole market (and hence the society), i.e., allocating more money to more productive companies. These allocation methods could be devised by experts or learned by computers... I'd bet that the latter is more likely. So imagine that, an ETF that not only tracks the total market return but also maximizes that return by an optimal capital allocation!

 

Now, the argument about dumb money being piled in and that's a bad thing... so one could also conjecture that passive investing has caused more people to invest in stocks, and this has made all the stocks expensive as a whole, which increased the likelihood of a crash. So what then, should a society discourage passive investing to make stocks cheaper? Why not just discourage people from investing all together so that we don't make the entire market overvalued? So I don't think that argument is convincing at all.

 

 

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Guest Schwab711

Awesome conversation by all - very interesting.

 

Personally, I think there is a potentially predictable subset of active investors that can outperform passive investing. I think I have a hard time understanding how AI/Algo-investing fits in with active v. passive because I think it's likely some algo/AI is included in the set of predictable successful active investors (like the magic formula). Though, maybe that advantage declines over time as studies reveal the advantage.

 

In the long run, I think alpha will be generated by folks/algos/dart-throwing-monkeys that are better at valuing qualitative data. I think (hope?) studies and algos/AI will have a hard time revealing that secret sauce. I imagine it is at least partially the "temperament" Buffett/Munger frequently mention. The Superforecasting Jurgis has brought up before probably has a lot of relevance to investing, especially going forward.

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Ok, it's only 11% of their assets that are going to be moving to the algo-driven process, but quite frankly I am amazed that Blackrock have decided to entrust client assets into such an unproven strategy.

 

Well, at least one could argue that the alternative (human-driven process) have been proven to not work against passive investing...

 

What is the proof that active investing is not as good as passive investing? I don't think I've ever seen compelling evidence proving either side is better. I'm not sure why there would be evidence proving passive > active investing. With a sufficiently representative sampling, we should expect passive outperformance relative to active would be capped at around the difference in management fees charged. I've seen studies that show both active > passive or passive > active in short time periods or specific long-term periods. Vanguard's own study on active v. passive shows that the answer is almost certainly inconclusive. This is the answer I would expect.

 

I think pushing passive investing helps remove risk for large institutions and it's why you see so many news articles about it. If they can convince everyone to invest passively then economies of scale becomes the only thing that matters and the incumbents will guarantee profit streams indefinitely. Otherwise, the large institutions have to compete against small up-start firms (like they always have) on numerous variables (better temperaments, cultures, analysis and risk management skill, and so on).

 

https://personal.vanguard.com/pdf/ISGACT.pdf

 

I think this passive/indexing thing is way overblown and the hype is being driven by the long bull market. We've had very few downturns over the last 8-9 years. Lets see how much people believe passive > active after the S&P 500 takes it on the nose for a prolonged period.

 

Yeah, This strategy is setting up for the mother of all crashes.  First, something will happen to precipitate a downturn.  Then the cascade of effects will set off a negative feedback loop, and here we go, 1987 all over again, but perhaps way worse, with so many more automated systems, all feeding off data from the other "smart" algorithm.  This all rhymes with 1987, long term capital, Nasdaq 5000, and the 2007/08 financial crisis. 

 

Blackrock's institutional clients will get hit but they wont bail to the same extent as all the dumb money that has piled into ETFs at a rate of a half tillion a year.  Right now, all we need is a catalyst that will reassert the stock cycle.  Its anybody's guess as to what that will be, and when it will happen.  Buffett and John Bogle will have alot to answer for.  Too much of a good thing, well it can be a bad thing.

 

I find this whole notion of passive investing causing a market crash really fascinating.

 

First, if you are arguing that automated (trades made by computers) investing can cause a crash, I suppose that it will and it has happened before. But that is not equivalent to passive investing.

 

Passive investing is not a good or a bad thing, it's a just normal (average) thing. It's basically analogous to saying "I will take the mean of the probability distribution of all performances as my expected outcome". So when more people decide to do passive investing, it will simply make the probability distribution of performances taller and taller around the mean and lowering the variance. I'd argue that in general, the greater the variance in performances indicate the greater the irrationality in the market. So I don't think making the probability distribution more normal itself increase the chance of a market crash.

 

One could argue that passive investing does not allocate the capital in a "free market" manner, because it either distributes the capital according to the market cap (if cap weighted) or just equally (if equal weighted). Especially in the former case, one could foresee a bubble developing because more and more money will be allocated to larger companies if everyone becomes a passive investor.

 

So how would we prevent the above scenario? It seems obvious to me that cap weighted investing is not the most efficient capital allocation method for the society. Perhaps in the future we will see more variety of ETFs that invests in the overall market but with different composition methods that maximize the return on capital for the whole market (and hence the society), i.e., allocating more money to more productive companies. These allocation methods could be devised by experts or learned by computers... I'd bet that the latter is more likely. So imagine that, an ETF that not only tracks the total market return but also maximizes that return by an optimal capital allocation!

 

Now, the argument about dumb money being piled in and that's a bad thing... so one could also conjecture that passive investing has caused more people to invest in stocks, and this has made all the stocks expensive as a whole, which increased the likelihood of a crash. So what then, should a society discourage passive investing to make stocks cheaper? Why not just discourage people from investing all together so that we don't make the entire market overvalued? So I don't think that argument is convincing at all.

 

I dont think I used the word passive investing anywhere.  Investing in ETFs is active investing by the investor.  They are buying a notion that their money is somehow safe because they are diversified.  There is no such thing as passive investing when a market crash is in full swing. 

 

I call the people who are pouring hundreds of millions into ETFs, during market highs,  the dumb money, because that is what they are.  Whatever precipitates a market downturn may suddenly cause a cascade effect of these so called passive investors panicking out of their ETFs which will of course feed on itself.  Its happened before and it WILL happen again and the day of reckoning is getting closer and closer. 

 

I spoke with "professional" fund managers in very late 1999.  They were convinced they had to be invested in Dot.com stocks because that was the wave if the future, No matter what the valautions.  How did that work out? 

 

Now everyone is convinced they should be using ETFs.  And how is this passive investing going to work out.  For the late comers, not well.  There is nothing to argue, really, because this is how it will unfold.  It has over and over.

 

What Buffett and Bogle are telling people in regard to ETFs is not wrong or evil.  They are telling people that ETFs are a good way to invest for the long term, toward your retirement or babies education.  The problem is not the advice its the people taking that advice.  When the going gets tough, the people who invested passively in ETFs will very quickly panic.  In various forms it has happened every few years.  ETFs are just the next greatest way to lose money, for the dumb money.  The huge inflows into ETFs just convince me that we are nearing a market top. 

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I dont think I used the word passive investing anywhere.  Investing in ETFs is active investing by the investor.  They are buying a notion that their money is somehow safe because they are diversified.  There is no such thing as passive investing when a market crash is in full swing. 

 

I call the people who are pouring hundreds of millions into ETFs, during market highs,  the dumb money, because that is what they are.  Whatever precipitates a market downturn may suddenly cause a cascade effect of these so called passive investors panicking out of their ETFs which will of course feed on itself.  Its happened before and it WILL happen again and the day of reckoning is getting closer and closer. 

 

I spoke with "professional" fund managers in very late 1999.  They were convinced they had to be invested in Dot.com stocks because that was the wave if the future, No matter what the valautions.  How did that work out? 

 

Now everyone is convinced they should be using ETFs.  And how is this passive investing going to work out.  For the late comers, not well.  There is nothing to argue, really, because this is how it will unfold.  It has over and over.

 

What Buffett and Bogle are telling people in regard to ETFs is not wrong or evil.  They are telling people that ETFs are a good way to invest for the long term, toward your retirement or babies education.  The problem is not the advice its the people taking that advice.  When the going gets tough, the people who invested passively in ETFs will very quickly panic.  In various forms it has happened every few years.  ETFs are just the next greatest way to lose money, for the dumb money.  The huge inflows into ETFs just convince me that we are nearing a market top.

 

I (nor the passive investing recommenders) would ever say that passive investing is safe. Again, it just guarantees the normal (average) return. And it's just as dangerous as the whole market. There is nothing safe about that!

 

Maybe most people don't recognize this, and assume that passive investing is safer. And perhaps you are suggesting that this delusion causes a mania. That could be true.

 

The scenario you are describing (mania induced buying and panic induced selling) is not really specific to ETF / passive investing, but is true with many other investing strategies. So I don't see that as a valid argument against passive investing.

 

But I do think there are specific characteristics of passive investing that could induce a market crash, which I pointed out in my previous post ...

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"I'd argue that in general, the greater the variance in performances indicates the greater the irrationality in the market"

 

Upon first glance maybe, but think of all the crashes in history. In the irrational period prior to the crashes, was there a wide or narrow performance variance? Seems like it narrows as we approach a crash, at least to me.

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Pretty sure Bogle hates ETFs.  Not sure Buffett knows what one is...I kid, but really he has only talked about index funds not in an ETF wrapper, but I don't see how that will make any impact in the crash.

 

I guess I should clarify for the purposes of discussion that the ETFs I have been referring are index  funds - say SPY - which creates more units which buy the underlying stocks in the S&P, in proportion to the amount each company makes up in the fund.  So, when I read that half a tillion per year has been going into index funds, I am thinking Vanguard, and knockoffs, Not publicly traded mutual funds units.  This has inadvertently created active investors out of so called passive investors.

 

"I'd argue that in general, the greater the variance in performances indicates the greater the irrationality in the market"

 

Upon first glance maybe, but think of all the crashes in history. In the irrational period prior to the crashes, was there a wide or narrow performance variance? Seems like it narrows as we approach a crash, at least to me.

 

And I think the narrowing is happening.  The Nifty Fifty of the early 70's is a near perfect example of exactly what index funds are doing today.  Valuations on the highest weighted stocks are getting driven higher and higher, as are valuations of lesser companies within the index.  It has become a self reinforcing cycle.  So, you have a situation where the biggest few hundred companies are getting lofiter and loftier in valuation, with no underlying earnings growth. 

 

The money keeps pouring into the index funds, driving the markets to valuations nearly double what they were in 2011, and there has been no earnings growth over that time.  Index funds are sowing the seeds of the next bear market, and serving to increase the potential volatility.  WHEN a panic hits the formerly "passive" investors will become active and the downside will get exaggerated in speed and depth. 

 

And going back to the original discussion.  The volatility will happen whether an algo is running the fund or a human is.  If anything the lack of human intervention will result in more volatility, not less. 

 

 

 

 

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