Index Investing Economy

Hi RIP investors,

if you’re following me you know I’m a big fan of ETFs and passive index investing. I’ve dedicated several posts on index investing, ETF 101 and a recent analysis on which ETF to buy.

The problems solved by passive index investing for a non professional investor like you and me are:

• Built in diversification. Buy a S&P500 fund and you own a piece of 500 companies! Now, try to diversify manually with individual stocks…
• It’s cheap. Fees compounds quickly over time, like profits. Index funds follow a script and their maintenance costs can be minimized down to the order of few basis points (0.0x%)
• It’s emotionless. The main enemy of an average investor is himself. The investor who performs better is the dead investor. Greed and fear are your worst enemies. “Professional” investors don’t beat the market and so on. Passive index investing prevents you from “trying to be smart” and beat the market. Ok, you can still damage yourself by timing the market, buying and selling fund shares, but while you’re in the market you’re essentially matching the market results.

Thanks index funds, thanks ETFs! The average amateur investor like me can now stay invested in the market with low costs and almost guaranteed market performance!

“Is that all? A 200 words post saying nothing already seen on 34585 blogs? RIP, spit it out!”

You know me, my friend 🙂

Well, according to everybodieh on the interneth yes, it’s all! Passive investing for everyone is the cure for financial cancer! one day we’ll all invest only in index funds and we’re going to be all rich and experience a 7-10% annual growth forevah!

That didn’t fully convince me though.

If one day there will be none “trying to be smart”, no day trader, no active fund manager but only passive index funds around, who will kick a company out of S&P500? What would drive a stock price?

The death of Sergio Marchionne, former CEO of FCA (Fiat Chrysler Automobiles), on July 25th was a big loss for FCA and the entire auto industry, but it was also a giant loss (-14%) for shareholders.

Why did it happen? No, I’m not talking about why Marchionne died. Here I’m interested in why FCA stock lost 14% in one day.

Probably Marchionne leadership and managerial skills were positively valued by “the market” and his unexpected death made investors lower their expectations on FCA future. Maybe it’s a “fear driven” mass reaction that – like 2 years ago during Brexit – will get fixed soon and the stock price will get back to its “normal value”. It may also be that the new CEO will be better than Marchionne or that competitors will do worse or that Tesla runs out of money and FCA stocks will double by end of year. We don’t know, nobody knows. Except Warren Buffett, he know everything.

What I want to to point the finger to is that without active investors trading stocks based on available (or insider) information, without speculators and without good old “greed and fear” investor there will be no reaction to economic facts.

By active investors I don’t necessary mean humans. There are already hedge funds trading bots based on Machine Learning. Didn’t check how they’re performing though.

“RIP, what’s the problem if there will be no active investor around? Passive index investing is the holy grail, isn’t it? You said that!”

Yes, I know. I’m just growing up and trying to capture a bigger picture now that I’m more experienced. And I would like to share it with my readers.

Let’s go a little bit on a tangent: do you know why ETFs have embedded arbitrage mechanism?

Before that: do you know what arbitrage means?

From Wikipedia:

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

I’m arbitraging if I know you want to sell an apple for 1 dollar and I know someone else who would like to buy an apple and he’s willing to pay 2 dollars. In an efficient market the two traders can meet and agree on a price of 1.5 dollar (I’m uber-simplifying here). But in an inefficient market I can go to the farmer, buy her apple for a dollar and sell it to the other person for 2 dollars and realize a profit.

Arbitrage is everywhere. Inefficient markets are everywhere and they justify the existence of so many middlemen exploiting arbitrage opportunities. In the stock trading world, where markets are almost as efficient as they could get, arbitrage opportunities are hard to exploit. That’s essentially the job of high frequency trading companies.

If we remove additional services, which is what every industry is focusing on today, the following professions would not exist in efficient markets: real estate agencies, loan agencies, hotels, taxis, retailers of any kind, restaurants… Ok, I’m being extreme. But I’m pretty sure hotels exploit the fact you need a place to sleep and are willing to pay 100 dollars while there is someone in town who’d be very happy getting 30 dollars and let you sleep at his place. Inefficient market, arbitrage opportunity.

Essentially the sharing/gig economy was born to kill middlemen and make the market more efficient. Even idealistic! Couchsurfing, I’m staring at you. It turned out the sharing economy introduced another layer of middlemen, more subtle and monopolistic, like the biggest taxi company that doesn’t own a cab or the largest hotel chain that doesn’t own a building but let’s not digress…

Although arbitrage means opportunities for some, it’s definitely not good for society. It adds no value and reduces purchasing power of many.

Let’s get back on our ETF arbitrage problem now.

ETFs and index funds are publicly traded and are essentially containers of underlying assets. A share of an ETF should just reflect a share of the market value on underlying assets, also know as Net Asset Value (NAV). With no extra emotions/speculation added. Imagine for a moment if this were not true. Imagine an S&P500 ETF by BlackRIP (fictional fund provider) constantly beat other S&P500 index funds by 1-2%. Maybe due to a better index replication, lower tracking error, lower TER (even though competitors are already close to 0% TER). What could happen? Even though the fair share price (share price based on NAV) is 100, traders could be willing to pay 105, 110 or who knows how much. Maybe there will be hype around BlackRIP funds and everybody wants to buy BlackRIP ETFs altering the share price independently from its NAV. It may even be that someone will pump&dump BlackRIP ETFs! When Sergio RIPponne, CEO of BlackRIP, will die would BlackRIP ETFs be affected? In one sentence: greed and fear would go meta.

If ETFs were free to go wild, we would have arbitrage opportunities. With arbitrage opportunities come bubble risks. We don’t want another layer of speculation, another tool to make things go wrong with no actual macroeconomic reason. That’s why ETFs have an arbitrage mechanism. Vanguard funds won’t be affected when John Bogle will die (hopefully never).

How does the ETF arbitrage work?

I’ve found this nice article on Investopedia (not a source I really like, but on some investing specific topics it has better articles than Wikipedia)

First, ETFs have total transparency over assets basket and costs over time, which helps making the market more efficient.

Second, creation and redemption mechanisms are activated when the shares are mispriced more than a well defined (fraction of) percent. Adding or removing shares from the market helps balancing supply and demand for the ETF shares. This is done thru an authorized participant (AP), usually a large financial institution that is essentially the one officially allowed to cash in the arbitrage opportunity.

The third mechanism is free for all who can take advantage of it: Pair Trades. Buying an ETF and shorting another one on the same index to cash in the intraday discrepancy between the ETF and its NAV (or the index). You could actually “try this at home”: exploit ETF arbitrage monitoring the spread between the share price and the underlying NAV and buy or sell (or short) the ETF. Good luck!

The fact you don’t do this (and you shouldn’t!) doesn’t mean nobody does. Like everything else, if the opportunity is profitable someone will take it. Which means we can assume the ETF is mostly arbitrage free. Essentially ETFs are priced at their book value. Even better, for an ETF book, market and liquidation value should be the same.

So we’re safe! ETFs don’t add an extra layer of risk due to divergence between their share value and actual underlying NAV…

“Oh, great! thanks RIP, you scared me at first! I invested all my money in ETFs and I thought that…”

… or do they?

“…”

I’m not talking about the increased volatility of underlying assets due to ETF arbitrage. I’m not even talking about non-arbitrageable funds, like Berkshire Hathaway. Yes, I consider closed funds and investing companies bubble makers, potential Ponzi schemes. Bernie Madoff, I’m staring at you!

I’m talking about the actual impact of passive investing on stocks prices.

What pushes a stock price up and down?

You would answer: performance, earning reports, acquisitions, layoffs, growth expectations, broader economic factors… but in the end everything boils down to supply and demand.

If I confess you that this supposed gold coin is actually made of chocolate you’d expect its price to go down. But if my coin is in the “list of 500 cool thingz you need to buyz” and (stupid) robots will keep buying buying buying, then its price won’t fall. Which is definitely not a good thing in the long run.

“yeah but RIP… the world is full of active investors and banks and investing firms who react to economic news, facts and predictions!”

A-ha! Now the bad and stupid “daily trader” is necessary to your system to work, isn’t she? 🙂 Do you actually know what’s the fraction of world shares owned by index funds? It’s astonishing! I wasn’t able to find a verifiable source of truth, but here are some claims:

• in 2014, 12% of total equity market was owned by index funds (Quora)
• in 2017, 18% of stocks are owned by index funds (Reuters)
• in 2024, index funds are projected to surpass active investing (Reuters), i.e. there will be more (stupid) robots who buy and sell stocks based on a predictable algorithm like “buy shares if the company is in S&P500, according to its market cap proportion within the index” than humans or other active investing bots who will act based also on other factors like “doesn’t the CEO of that company look like Elon Musk?“

“What does it mean, RIP, you’re scaring me 🙁”

I don’t know if being scared is a good or bad thing. I guess we’re still ok for the next 5-10 years, before stupid robots will drive trading. I think it’s healthy to realize that passive investing should be called parasite investing because we’re all relying on someone else keeping the market’s feet on the ground. Which sound crazy, because before index investing bubbles were the norm! Mean reversions were strong and scary.

It seems that since a decade, with the explosion of passive investing, volatility is getting lower and optimism (true one or robotic one?) is driving the market high. Is that a good thing or is it an indicator of the next bubble? I have no idea.

Apparently I’m not the only one concerned. Look at the following resources:

• Ariel Investments CIO Rupal Bhansali’s August 2017 interview on Bloomberg (ok, she’s skin in the active investing game).
• Alan Kohler’s September 2017 article on theaustralian.com. This one is really pessimistic and calls index investing a Ponzi scheme: “ETFs and index funds show that size begets size: money goes to the largest companies, simply because they are large, which makes them still larger, by market cap, and attracts still more funds — rather like a Ponzi scheme“.
• Ryan Vlastelica’s September 2017 article on Marketwatch. 77% of trades on stocks are based on “fundamentals”, while 23% are passive funds trades.
• James Ledbetter’s March 2016 article on Newyorker. Probably the best article on the topic. No opinions, just facts.
• Dividend Geek’s December 2017 article on his blog. He critiques roboadvisor like wealthfront and betterment because they lower the bar to access passive investing accelerating the adoption.
• Erik’s July 2018 post on his blog. Deep and nicely written article with thought experiments and a call to action about critical thinking.

I still don’t have a well formed opinion, but something deep inside tells me that there is enough material to be alert.

As Warren Buffett says: “be fearful when others are greedy and greedy when others are fearful”. When Dumb Money will flow in the passive world it will be time to leave. When everybody at the bar will be chatting about sports, car and passive index investing, it will be time to run away screaming.

Or… are we already the dumb money?

In the end, the system might be able to support itself and in the best case it could become a demographic Ponzi scheme. Workers will buy and retiree will sell. Supply and demand. Are there more people buying or selling? Is your generation large? Not good. Are generations younger than yours larger than yours? Good! Is life expectancy of generations before yours growing? Definitely not good!

Are you still scared?

“of course I am!!”

That’s a good thing, unless you want to be the dumb money!