Dave, this is a brilliant and comprehensive analysis of the indexed investing world. I give a lot of thought to many of these issues.
In particular, I am convinced that specifically S&P 500 weekly/monthly cash flows in retirement/dollar-cost-averaging plans must mean that membership in the S&P 500, regardless of a securities weight creates a premium for that stock over similar stocks. Therefore, as S&P 500 index investing continues to gain market share, this premium would only grow.
Malkiel's point of wanting to own the entire market because all stocks in a market are structurally equal and prices move randomly was an argument I believed in throughout most of my investment career. I was an investor in Vanguard Total Market since 1989 and an investor in VTI since its inception.
I observed and wrote papers between 1980 - 2020 based on this presence. As one who has been involved in the chase for systematic "alpha-plus factors" throughout this span that I eventually surrendered, proving that some market factor led to above-average returns over some past period, only proves that it appeared in the time period measured.
Stock prices are determined by cash flows. Supply and demand. Period. If 30% of cash flows are directed proportionately into S&P 500 stocks, that represents a 0% allocation in that 30% to small cap stocks and stocks with other distinct "smart beta" characteristics that are not in the S&P 500. Therefore, to cancel this effect, the remainder of investors would need to allocate more their flows at a ratio of 1.4 to non-S&P stocks to 1 in order to counteract the S&P 500 effect. However, since most professional active managers are measured against the S&P 500 or a similar index, only those with small cap or other mandates could afford to "bet against" the structure of the market as their tracking errors as measured by consultants would be through the roof.
In other words, Dave, your concerns and focus on flows are right on time. Thanks again
Index funds are generally very eager securities lenders. When a stock enters the S&P500, it gets added to a lot of indexed portfolios, but it also gets much easier to short.
An S&P500 premium would mean that the same amount of capital would buy a larger stream of dividends (or coupon payments etc) outside the S&P500 than inside.
So you do the following trade:
Sell a perpetual total return swap on the S&P500 (basically an instrument that mimics the dividend payouts of the indexes stocks), use the proceeds to buy non-S&P500 stocks.
(Add some bells and whistles to do something about volatility, if necessary.)
There's one thing I don't understand: what's the difference between the scenario where the boomers spend down their assets for their own consumption vs donating their assets to charities who then spend them down for consumption (eg malaria nets)?
You describe one as the text book case and the other as the 'worst case'?
I don't understand. I can see that buying yachts and booking cruises would benefit different industries than manufacturing malaria nets, but at the high level of abstraction we are treating things here, what difference does it make?
Btw, you also didn't mention that, if indexing leads to any weirdness in prices, there are arbitrage opportunities available for the remaining active investors. The fewer active traders remain, the more opportunities per active trader.
For example, if there's a a premium that comes from S&P500 inclusion, you can write a perpetual total return swap on the S&P500 (an instrument that mimics the flow of dividends (and buybacks) coming out of the S&P500) and use the proceeds to buy non-S&P500 assets. If there's a premium, this trade should have positive expected value. You can use some of the proceeds to buy some insurance to smooth out your returns.
Fortunately, index funds are some of the world's most eager stock lenders (one of the few ways they have to boost returns), so that makes the jobs of short sellers to correct premiums easier.
Dave, thanks for sharing your thoughts on the unintended effects of increasing passives' market share. I had the pleasure of discussing Marco Sammon's "Who clears the Market" paper at the Four Corners spring meeting. The discussion was vibrant - and that's all that I will say under Chatham House rules.
One factor to add to your analysis - inherited IRA taxation. Under current tax law, heirs who inherit IRAs have ten years to draw them down. IRA distributions are taxable income. Therefore, many heirs will have to sell a portion of their IRA holdings to cover their tax bills.
Excellent point. Although according to FRED there's only about $1T in IRAs, across all age groups, so the vast majority of that wealth is going to be either Business Ownership, Real Estate, or taxable securities. Pressure is pressure, I just dont see it being as massive as I had once feared.
Amazing piece, thanks a lot. One point I find underrepresented in that debate though is looking at what investors outside the US are doing. The active/passive debate usually goes a long way analyzing employment data in the US, 401k plans, retirement projections, etc.
I am working in Asset Management with clients outside the US and couple of things are pretty obvious.
1/ Rest of World Investors are couple of years behind the US in terms of passive adoption.
2/ That passive share in investors portfolios is rising substantially every year, Retail and Institutional.
3/ Investors are firing their active managers and take a passive approach to - at least - 'global developed equities'. That is via ETFs, or more pronounced via segrgregated mandates as they are cheaper for the investor with certain minimum size.
The end result is the same: Close to 70% of Global Developed Equities is US stocks. i.e. for every additional EUR that is put into the market passively, 70% is going mechanically into US stocks. That number is probably even higher as US equities is the first market everyone is passivizing...
My point in brief:
As far as I understand, we are talking about flows mainly to analyze the impact on prices, multiplier, etc. Even if we were starting to see net otflows from passive by US investors, there is a quite a heavy 'army' of investors outside the US that just start to passivize their portfolios. The regulatory framework evolves, incentives are building up to go passive. And for every EUR they invest, a significant chunk will be directed to buy up the typical US stocks...
That should be accounted for when modelling out the marginal investor behavior I would assume
Dave, thank you so much for presenting some of the salient points of the debate. As we discussed before on Mike's substack, the most important thing is to get people talking, and hopefully with enough of the right people talking, influence those in a position to do so & derive a reasonable solution to these problems. Now that even Mike and Barry have actually managed to discuss it, the work you're doing in highlighting some of these issues without taking sides, becomes super important. We don't know the future and could always be blindsided by a meteor strike, but if that hopefully doesn't happen, we can at least try to address the problems we can imagine, even if they seem far off and have unknown timeframes
Great read. One thing worth pondering could be the median millenial's situation upon inheritance. It increasingly looks like they will need the cash. It also is the case that they're disillusioned with "the system" ergo bitcoin will be a relatively higher percentage of their portfolio, likely to a very significant extent. Also, the depressionary growth prospects due to demographics, coupled with the consequent unemployment prospects, exacerbated by ai and automation, leads me to think "the" peak could be in some time before 2035. Thoughts?
We can just agree to disagree, but with total BTC market cap at 1T, or just a few % of the $35T were talking about the millenials inheriting. If you're makign the case their going to dump all their bonds and stocks to buy BTC< I'm a bit of a seller on that narrative. From a population perspective we passed "peak" in 2020 -- thats when Millenials outnumbered Boomers for the first time.
Technology has never lead to permanent unemployment in the past.
Luckily, we can make 'synthetic' bitcoin, if there's a lot of retail demand for exposure to that specific asset. By synthetic bitcoin I mean that traders can just write cash settled bitcoin futures on the CME (or can do essentially fractional reserve banking via share lending of bitcoin ETFs etc).
So we can give retail investors more explosure to bitcoin without on net more money flowing into bitcoin. (As long as someone is willing to take the other side of that trade for a reasonable price.)
Compare how there was a big drop in bitcoin prices just after the CME traded bitcoin futures were introduced. Those futures where the first real significant opportunity for traditional finance to provide these 'synthetic' bitcoins to the market.
(What I call synthetic bitcoin is not a 'real' bitcoin, but it mimics two important characteristics: it gives you economic exposure to bitcoin and you can convert it to bitcoin on demand. Much like a bank account, from which you can withdraw cash.)
AI seems to be different than the past technological revolutions hence all the talk about UBI. As per bitcoin, the point was more about less flows into spx.
Dave, this is a brilliant and comprehensive analysis of the indexed investing world. I give a lot of thought to many of these issues.
In particular, I am convinced that specifically S&P 500 weekly/monthly cash flows in retirement/dollar-cost-averaging plans must mean that membership in the S&P 500, regardless of a securities weight creates a premium for that stock over similar stocks. Therefore, as S&P 500 index investing continues to gain market share, this premium would only grow.
Malkiel's point of wanting to own the entire market because all stocks in a market are structurally equal and prices move randomly was an argument I believed in throughout most of my investment career. I was an investor in Vanguard Total Market since 1989 and an investor in VTI since its inception.
I observed and wrote papers between 1980 - 2020 based on this presence. As one who has been involved in the chase for systematic "alpha-plus factors" throughout this span that I eventually surrendered, proving that some market factor led to above-average returns over some past period, only proves that it appeared in the time period measured.
Stock prices are determined by cash flows. Supply and demand. Period. If 30% of cash flows are directed proportionately into S&P 500 stocks, that represents a 0% allocation in that 30% to small cap stocks and stocks with other distinct "smart beta" characteristics that are not in the S&P 500. Therefore, to cancel this effect, the remainder of investors would need to allocate more their flows at a ratio of 1.4 to non-S&P stocks to 1 in order to counteract the S&P 500 effect. However, since most professional active managers are measured against the S&P 500 or a similar index, only those with small cap or other mandates could afford to "bet against" the structure of the market as their tracking errors as measured by consultants would be through the roof.
In other words, Dave, your concerns and focus on flows are right on time. Thanks again
Index funds are generally very eager securities lenders. When a stock enters the S&P500, it gets added to a lot of indexed portfolios, but it also gets much easier to short.
An S&P500 premium would mean that the same amount of capital would buy a larger stream of dividends (or coupon payments etc) outside the S&P500 than inside.
So you do the following trade:
Sell a perpetual total return swap on the S&P500 (basically an instrument that mimics the dividend payouts of the indexes stocks), use the proceeds to buy non-S&P500 stocks.
(Add some bells and whistles to do something about volatility, if necessary.)
Dave, thanks for writing the article.
There's one thing I don't understand: what's the difference between the scenario where the boomers spend down their assets for their own consumption vs donating their assets to charities who then spend them down for consumption (eg malaria nets)?
You describe one as the text book case and the other as the 'worst case'?
I don't understand. I can see that buying yachts and booking cruises would benefit different industries than manufacturing malaria nets, but at the high level of abstraction we are treating things here, what difference does it make?
Btw, you also didn't mention that, if indexing leads to any weirdness in prices, there are arbitrage opportunities available for the remaining active investors. The fewer active traders remain, the more opportunities per active trader.
For example, if there's a a premium that comes from S&P500 inclusion, you can write a perpetual total return swap on the S&P500 (an instrument that mimics the flow of dividends (and buybacks) coming out of the S&P500) and use the proceeds to buy non-S&P500 assets. If there's a premium, this trade should have positive expected value. You can use some of the proceeds to buy some insurance to smooth out your returns.
Fortunately, index funds are some of the world's most eager stock lenders (one of the few ways they have to boost returns), so that makes the jobs of short sellers to correct premiums easier.
Dave, thanks for sharing your thoughts on the unintended effects of increasing passives' market share. I had the pleasure of discussing Marco Sammon's "Who clears the Market" paper at the Four Corners spring meeting. The discussion was vibrant - and that's all that I will say under Chatham House rules.
One factor to add to your analysis - inherited IRA taxation. Under current tax law, heirs who inherit IRAs have ten years to draw them down. IRA distributions are taxable income. Therefore, many heirs will have to sell a portion of their IRA holdings to cover their tax bills.
Excellent point. Although according to FRED there's only about $1T in IRAs, across all age groups, so the vast majority of that wealth is going to be either Business Ownership, Real Estate, or taxable securities. Pressure is pressure, I just dont see it being as massive as I had once feared.
Amazing piece, thanks a lot. One point I find underrepresented in that debate though is looking at what investors outside the US are doing. The active/passive debate usually goes a long way analyzing employment data in the US, 401k plans, retirement projections, etc.
I am working in Asset Management with clients outside the US and couple of things are pretty obvious.
1/ Rest of World Investors are couple of years behind the US in terms of passive adoption.
2/ That passive share in investors portfolios is rising substantially every year, Retail and Institutional.
3/ Investors are firing their active managers and take a passive approach to - at least - 'global developed equities'. That is via ETFs, or more pronounced via segrgregated mandates as they are cheaper for the investor with certain minimum size.
The end result is the same: Close to 70% of Global Developed Equities is US stocks. i.e. for every additional EUR that is put into the market passively, 70% is going mechanically into US stocks. That number is probably even higher as US equities is the first market everyone is passivizing...
My point in brief:
As far as I understand, we are talking about flows mainly to analyze the impact on prices, multiplier, etc. Even if we were starting to see net otflows from passive by US investors, there is a quite a heavy 'army' of investors outside the US that just start to passivize their portfolios. The regulatory framework evolves, incentives are building up to go passive. And for every EUR they invest, a significant chunk will be directed to buy up the typical US stocks...
That should be accounted for when modelling out the marginal investor behavior I would assume
Dave, thank you so much for presenting some of the salient points of the debate. As we discussed before on Mike's substack, the most important thing is to get people talking, and hopefully with enough of the right people talking, influence those in a position to do so & derive a reasonable solution to these problems. Now that even Mike and Barry have actually managed to discuss it, the work you're doing in highlighting some of these issues without taking sides, becomes super important. We don't know the future and could always be blindsided by a meteor strike, but if that hopefully doesn't happen, we can at least try to address the problems we can imagine, even if they seem far off and have unknown timeframes
Great read. One thing worth pondering could be the median millenial's situation upon inheritance. It increasingly looks like they will need the cash. It also is the case that they're disillusioned with "the system" ergo bitcoin will be a relatively higher percentage of their portfolio, likely to a very significant extent. Also, the depressionary growth prospects due to demographics, coupled with the consequent unemployment prospects, exacerbated by ai and automation, leads me to think "the" peak could be in some time before 2035. Thoughts?
We can just agree to disagree, but with total BTC market cap at 1T, or just a few % of the $35T were talking about the millenials inheriting. If you're makign the case their going to dump all their bonds and stocks to buy BTC< I'm a bit of a seller on that narrative. From a population perspective we passed "peak" in 2020 -- thats when Millenials outnumbered Boomers for the first time.
And by peak I meant the inevitable spx peak
Not all, I just said "higher percentage of their portfolio" - relative to boomers. Even a few % would make a difference.
Technology has never lead to permanent unemployment in the past.
Luckily, we can make 'synthetic' bitcoin, if there's a lot of retail demand for exposure to that specific asset. By synthetic bitcoin I mean that traders can just write cash settled bitcoin futures on the CME (or can do essentially fractional reserve banking via share lending of bitcoin ETFs etc).
So we can give retail investors more explosure to bitcoin without on net more money flowing into bitcoin. (As long as someone is willing to take the other side of that trade for a reasonable price.)
Compare how there was a big drop in bitcoin prices just after the CME traded bitcoin futures were introduced. Those futures where the first real significant opportunity for traditional finance to provide these 'synthetic' bitcoins to the market.
(What I call synthetic bitcoin is not a 'real' bitcoin, but it mimics two important characteristics: it gives you economic exposure to bitcoin and you can convert it to bitcoin on demand. Much like a bank account, from which you can withdraw cash.)
AI seems to be different than the past technological revolutions hence all the talk about UBI. As per bitcoin, the point was more about less flows into spx.