Worth noting that modern factor-based ETFs actually blend the best of both worlds - they maintain the low-cost efficiency of index funds while incorporating fundamental analysis through value, quality and momentum screens, potentially addressing some of his key concerns about blind price-agnostic buying.
There are other problems with index funds. Since index funds are passive, they generally do not participate in active shareholder actions. They are very likely to vote with the management on issues requiring shareholder votes, including on the question of executive compensation. It is also very likely that in most larger companies, index funds control majority of the votes. It is easy to see how management's accountability to the shareholders is materially diminished as index funds have grown.
Specific persons like Vanguard will actively vote on the companies within the index. But as you say, I'm not share on what level that will keep management accountable..
I guess the situation is even worse, because a lot of actively managed funds and institutional investors are following investment strategies that are close to passive investing.
They may be following the market with the bulk of the portfolio and try to achieve some alpha just with a part of it. A pension fund may be happy by just replicating the market performance and do some hedging to reduce the risk.
In that case, it becomes ridiculous to pay the fees. I would only invest in an actively managed fund if it steers away from an index. A manager that does something in between might get stuck in the middle.
I’ve always found the somewhat moralistic objections to indexing voiced by Klarman and Marks to be a little strange. At the end of the day, you’re buying a fixed percentage of every business beyond a certain size in a certain country, and while you may not know the valuation you’re paying for each individual component, you know what multiple you’re paying overall (or at least you definitely should!). It doesn’t actually particularly matter how things in that index are valued relative to one another if you’re happy with the overall multiple. Then those who put in the effort to buy actively can reap the reward of figuring out mistakes in the relative valuations. That seems to me like a healthy symbiotic relationship where everyone acts rationally and is compensated fairly. Of course, you do have the problem of massive flows in or out distorting stock prices, but that will happen even if they’re investing actively - what actually matters there is not active vs passive, but whether the buyers come in care about valuation.
A thoughtful and thought-provoking piece. I thought that index funds were sometimes or often synthetic instruments without the actual stocks being bought. If not, there's a crisis ahead. The Klarman book is easily found online or in some public library collections as an e-book. Finally, quant investing was so profitable in 2024: "passive" in the sense that with minimal intervention it's done by the numbers perhaps with AI and at least this year with impressive returns. I suppose that as a fund or ETF that would count as "factor-based". Vanguard warns that such funds are "risky", but advisory services claim years of back-testing show the contrary. How will they fare in a downturn compared to the Index?
John Bogle would respectfully disagree there! Too bad the two can't talk anymore, would be a fun listen. I think ETF indexing has a space im the portfolio, but only in periods where markets rise in general. If the markets wouldn't have gone anywhere for 10 years it would not be nearly as popular. Timing is important too. I can vividly recall that I was sitting on some cash in March 2020 in the depth of the Covid drawdown thinking what is the most antifragile thing I can put my money into. In the end I did the exact opposite and risked it all by buying lots of OOM call options. Worked marvels for me obviously, but it was a one-off. Had I dumped everything into an S&P ETF and stayed invested, I would have probably been better off risk/reward-wise, with less stress along the way.
You're right about the success of ETF investing. The bull market has helped. I do believe there is a place in a portfolio for both ETFs and individual stocks. I'm curious how full-time indexers react when the market goes south for several years. The index is only a means. Will they stay calm and sit it out?
I say this nearly every day to my 2 sons and my wife. ETF investing especially IWDA is investing in the biggest companies without any clue about the value (nor the fundamentals)
But they have a return ytd of 30% without doing anything...
The reply of the ETF investor is that the active investor will make the market efficient again forcing the stocks to their intrinsic value. But what if there are no active investors left...
There will always be active investors though. Even within the ETF space, the finance wizards have created new products like thematic ETFs at higher costs. I think it's human nature, you will always have people that want to gain an edge or beat the index. I do think that index investors might want to temper expectations for the future. A 30% passive return is not normal
Worth noting that modern factor-based ETFs actually blend the best of both worlds - they maintain the low-cost efficiency of index funds while incorporating fundamental analysis through value, quality and momentum screens, potentially addressing some of his key concerns about blind price-agnostic buying.
With higher annual cost, bit I see it could be a compromise. Thanks!
There are other problems with index funds. Since index funds are passive, they generally do not participate in active shareholder actions. They are very likely to vote with the management on issues requiring shareholder votes, including on the question of executive compensation. It is also very likely that in most larger companies, index funds control majority of the votes. It is easy to see how management's accountability to the shareholders is materially diminished as index funds have grown.
Specific persons like Vanguard will actively vote on the companies within the index. But as you say, I'm not share on what level that will keep management accountable..
I guess the situation is even worse, because a lot of actively managed funds and institutional investors are following investment strategies that are close to passive investing.
I am wondering if that Bloomberg article classifies sovereign wealth funds as actively or passively managed
Good question, but the article does not provide that amount of detail in sourcing data
They may be following the market with the bulk of the portfolio and try to achieve some alpha just with a part of it. A pension fund may be happy by just replicating the market performance and do some hedging to reduce the risk.
That I understand. But I just hope the pension fund doesn’t charge too much of a cost for that hedging if it’s just following the benchmark…
In that case, it becomes ridiculous to pay the fees. I would only invest in an actively managed fund if it steers away from an index. A manager that does something in between might get stuck in the middle.
I’ve always found the somewhat moralistic objections to indexing voiced by Klarman and Marks to be a little strange. At the end of the day, you’re buying a fixed percentage of every business beyond a certain size in a certain country, and while you may not know the valuation you’re paying for each individual component, you know what multiple you’re paying overall (or at least you definitely should!). It doesn’t actually particularly matter how things in that index are valued relative to one another if you’re happy with the overall multiple. Then those who put in the effort to buy actively can reap the reward of figuring out mistakes in the relative valuations. That seems to me like a healthy symbiotic relationship where everyone acts rationally and is compensated fairly. Of course, you do have the problem of massive flows in or out distorting stock prices, but that will happen even if they’re investing actively - what actually matters there is not active vs passive, but whether the buyers come in care about valuation.
You make a great point! And both methods are not mutually exclusive. You can choose to do both.
A thoughtful and thought-provoking piece. I thought that index funds were sometimes or often synthetic instruments without the actual stocks being bought. If not, there's a crisis ahead. The Klarman book is easily found online or in some public library collections as an e-book. Finally, quant investing was so profitable in 2024: "passive" in the sense that with minimal intervention it's done by the numbers perhaps with AI and at least this year with impressive returns. I suppose that as a fund or ETF that would count as "factor-based". Vanguard warns that such funds are "risky", but advisory services claim years of back-testing show the contrary. How will they fare in a downturn compared to the Index?
Some of them are, and others are fully replicating, buying the underlying asset. The next downturn might prove interesting...
John Bogle would respectfully disagree there! Too bad the two can't talk anymore, would be a fun listen. I think ETF indexing has a space im the portfolio, but only in periods where markets rise in general. If the markets wouldn't have gone anywhere for 10 years it would not be nearly as popular. Timing is important too. I can vividly recall that I was sitting on some cash in March 2020 in the depth of the Covid drawdown thinking what is the most antifragile thing I can put my money into. In the end I did the exact opposite and risked it all by buying lots of OOM call options. Worked marvels for me obviously, but it was a one-off. Had I dumped everything into an S&P ETF and stayed invested, I would have probably been better off risk/reward-wise, with less stress along the way.
You're right about the success of ETF investing. The bull market has helped. I do believe there is a place in a portfolio for both ETFs and individual stocks. I'm curious how full-time indexers react when the market goes south for several years. The index is only a means. Will they stay calm and sit it out?
Joh Bogle was alarmed at the rise of index funds and had sounded warning just before he died https://www.wsj.com/articles/bogle-sounds-a-warning-on-index-funds-1543504551
I say this nearly every day to my 2 sons and my wife. ETF investing especially IWDA is investing in the biggest companies without any clue about the value (nor the fundamentals)
But they have a return ytd of 30% without doing anything...
The reply of the ETF investor is that the active investor will make the market efficient again forcing the stocks to their intrinsic value. But what if there are no active investors left...
There will always be active investors though. Even within the ETF space, the finance wizards have created new products like thematic ETFs at higher costs. I think it's human nature, you will always have people that want to gain an edge or beat the index. I do think that index investors might want to temper expectations for the future. A 30% passive return is not normal