More passive than active?

nrsql

If we get to a situation where the vast majority of investment is in index trackers then the market will never change. The value of companies will just depend in the total amount invested and be relative to their current value - so no incentive to perform.
Changes would only be companies being removed from the market and new companies would find it difficult to enter.
Of course that won't happen unless everything is in a single index (world) tracker and trackers don't really work like that but it is something to think about.

Malthusian

nrsql wrote: »

If we get to a situation where the vast majority of investment is in index trackers then the market will never change. The value of companies will just depend in the total amount invested and be relative to their current value - so no incentive to perform.

This is just a variant of the "if all funds track the index there won't be any index to track" myth.

Companies which had high levels of earnings would still rise in value and companies which didn't make any earnings would eventually fall to zero.

nrsql

Malthusian wrote: »

Companies which had high levels of earnings would still rise in value and companies which didn't make any earnings would eventually fall to zero.

What would cause a company with high earnings to rise in (market) value if all investment was proportional to the market value.

It won't work due to the actions of market makers and all investment will never track the index - and it relies on a single index and truly passive investment and no stock manipulation - but if it did...

Malthusian

nrsql wrote: »

What would cause a company with high earnings to rise in (market) value if all investment was proportional to the market value.

It's called passive investing, not blind investing. If a company adds £1 million to its net assets by buying raw materials, adding value and selling product at a higher price, passive fund managers aren't going to blindly pay the same price for its shares than they did when it had £1 million fewer in the bank. Equally if it spends £1 million on stuff with nothing to show for it, passive fund managers aren't going to ignore that either.

Just because the people who work for passive funds don't charge 0.75% per year doesn't mean they're complete morons.

Linton

Malthusian wrote: »

It's called passive investing, not blind investing. If a company adds £1 million to its net assets by buying raw materials, adding value and selling product at a higher price, passive fund managers aren't going to blindly pay the same price for its shares than they did when it had £1 million fewer in the bank. Equally if it spends £1 million on stuff with nothing to show for it, passive fund managers aren't going to ignore that either.

Just because the people who work for passive funds don't charge 0.75% per year doesn't mean they're complete morons.

A passive fund is blind - the manager cannot choose to buy or sell any particular investment. The price of an investment depends on those people who do have a choice.

Alexland

Even if the majority of the market goes passive there will always be someone willing to buy an asset for less than they consider it to be worth which sets the price. Would you walk past a £20 note?

talexuser

Alexland wrote: »

Even if the majority of the market goes passive there will always be someone willing to buy an asset for less than they consider it to be worth which sets the price.

I assume that was Bogles' whole argument if that someone is going to be in a growing minority that concentration of power is not a good trend.

short_butt_sweet

IMHO, the effects of passive investing becoming bigger (or even a majority) are rather different when we're thinking about

1) price discovery (i.e. buying/selling which determines the prices of different shares)
and
2) corporate governance (i.e. shareholder votes, whether on executive pay, pay for other employees, environmental policy, tax policy, etc)

i see no reason why price discovery won't continue to work perfectly well with more than half the shares in an index being held by trackers, so just a minority of investors (by amount of money invested) are engaged in trying to beat the index.

for corporate governance, that's not the case: it would be an issue if (e.g.) vanguard controlled over 50% of the votes, for every company in an index; or even if a couple of fund mangers (e.g. vanguard & blackrock) did between them.

however, this problem could easily be solved, with a new law about proxy votes for shares held by collective investment schemes. instead of letting the fund manager of an collective investment scheme (e.g. vanguard) exercise the votes according to a policy they choose, they could be required to hand the proxy votes over to third-party companies, chosen by each beneficial owner of the units in the fund, and paid a small fee by the fund for carrying out this service. a range of third-party companies, offering to exercise votes on shareholders' behalf would spring up, each with different (publicly stated) policies about how they would exercise votes on shareholders' behalf. (they would also publish how they'd exercised votes in the past.) in practice, a different proxy company would appear for any significant strand of opinion among investors about how their votes should be cast. this would avoid excessive concentration of voting power in vanguard's hands, while allowing investors to continue to choose vanguard (or whoever) on the basis that they are cheap and competent at following an index.

(and arguably, such a law would be a good idea anyway - even apart from potential concerns about concentration of voting power - to restore the "shareholder democracy" that has been lost by the gradual shift to more shares being held by collective investment schemes.)

Malthusian

Linton wrote: »

A passive fund is blind - the manager cannot choose to buy or sell any particular investment.

Yes they can. Most passive funds use a sampling process and exclude shares that make up a really tiny percentage of the index and aren't worth the cost of acquiring them, or are too illiquid to hold efficiently. There is no such thing as 100% passive.

The index may dictate they need to buy X thousand shares in company Y but the manager still chooses what price to offer, and can choose not to be a complete moron and ignore the fact that the company has generated or lost money from its business since the share was last priced up. In a world in which companies are owned by 100% passives, the sellers can't hold out for the exact same price that was paid yesterday, because the sellers are also passives and are therefore obliged to sell a particular amount of shares. The buyers need to buy and the sellers need to sell, the fact that they are all passives makes no difference. In agreeing a price between them they will take into account all available information, as per the efficient market hypothesis. That includes the information of whether the company is making money or tanking.