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Weekend reading: Welcome to Indexville – please invest passively

Weekend reading

Good reads from around the Web.

The question of how many active investors and financial intermediaries are needed to make the market go around is becoming less theoretical as passive investing’s popularity grows each year.

This week the blog Philosophical Economics made a great – if theory-heavy – stab at answering it.

The article introduces us to the economy of Indexville – a land where everyone is a passive investor (and Monevator is an even more popular site than Buzzfeed).

The first hurdle for successful equity investing in Indexville is company valuation – in our world a free ride enjoyed by passive investors as a consequence of active investors competing for bargains.

The author’s conclusion is that perhaps 20,000 analysts would be sufficient in a passive-only world to value the equivalent of the entire US stock market.

That’s a cheap wage bill, the piece suggests, compared to the total cost of today’s actively managed funds, where the equivalent fees might be 25-100 times higher.

A bigger problem comes with providing liquidity to investors who want to buy or sell their passive funds, instead of just receiving dividends.

I’ll leave you to read the article for that long discussion.

The author concludes that even in the fantasy-land of Indexville, some percentage of investors would need to be active – but maybe as few as 5%.

Those active investors would be playing a zero-sum game in any speculation.

But by providing liquidity to passive investors, they would also in aggregate earn a small additional return over passives – effectively a fee charged for providing liquidity, and for taking on the risks of doing so.

Axe-wielding passive investing maniacs

Like me you probably won’t agree with every assumption made in the piece, but it’s a fascinating discussion – albeit one for finance nerds, really – and it strips back our bloated financial markets to their bare bones.

It will be fascinating to look back in 20-30 years to see whether the financial services industry did get significantly cut down to size.

Or – surely more likely – to see how it managed to avoid that fate.

From the blogs

Making good use of the things that we find…

Passive investing

  • Are active investors addicted to gambling? – The Evidence-Based Investor
  • On over-confidence [I call this the “ageing engineer effect”]Josh Brown
  • Is the robo-advisor movement already dying? [US but relevant]Kitces

Active investing

  • Jeremy Grantham on that commodity bubble: “Mea culpa” – GMO
  • What it means to be an original investor – Latticework
  • 3 things you should know about market valuation, but don’t – Dash of Insight
  • A dozen things learned from Bernard Baruch about investing – 25iq
  • Does growth justify the share price of Domino’s Pizza? – UK Value Investor
  • Margin of safety: Tool for action, or inaction? – Musings on Markets

Other articles

Product of the week: You can now get a table-topping 1.7% from Shawbrook Bank’s 120-day notice period savings account, reports The Telegraph. Don’t spend it all at once!

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

Active investing

  • Why ‘closet benchmarking’ has to end [Search result]FT
  • Crude soothsayers should remember tale of ‘peak oil’ [Search result]FT
  • Investors trade stocks alphabetically – Wall Street Journal
  • Beaten-up hedge funds reminisce about the golden age – Bloomberg
  • Open-ended property funds are a bad idea [My verdict!]CityWire
  • The highest earning hedge fund managers – Institutional Investor

A word from a broker

Other stuff worth reading

  • Merryn S-W: Active funds in search of a future [Search result]FT
  • A new way forward for the welfare state – The Guardian
  • How to answer the question: Is it worth it? – New York Times
  • P2P firm Lending Club is in trouble [US but…]FT Alphaville & Bloomberg
  • Our peer-to-peer is “safe”, insist UK lenders [Search result]FT
  • Pound could dive 20% on Brexit, says NIESR – ThisIsMoney
  • Why the £200,000 gap between two annuity quotes? – Telegraph
  • It’s millionaires versus billionaires in Hawaii – Bloomberg
  • How breakfast became a thing – Pricenomics

Book of the week: Simon Jenkins in The Guardian sounds like a desperate man in claiming that physical books have seen off the challenge of digital books – not just grasping at straws, but onto the ankles of his own straw man. But there’s no doubt some physical books will survive as things of beauty, just like I suppose a few people will always wear old-fashioned analogue watches while the rest of us will be using our wristbands to be beamed up to a Premier Inn orbiting the moon. One of my favourite purchases in the beautiful books category in the past couple of years has been Death & Co: Modern Classic Cocktails, which is now £5 cheaper than when I bought it. The Kindle edition is £2 cheaper still, and I thoroughly do not recommend you save the money.

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  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []

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{ 13 comments… add one }
  • 1 Moongrazer May 14, 2016, 2:47 pm

    Honestly, what are the chances we’d ever end up even remotely close to some purely passive plateau? There’s just too much human greed in the equation for me to believe we’re headed that way.

  • 2 Greg May 14, 2016, 3:45 pm

    I prefer to call it the ageing physicist effect…
    http://www.smbc-comics.com/index.php?db=comics&id=2556

  • 3 dearieme May 14, 2016, 4:05 pm

    “Open-ended property funds are a bad idea”: I cannot conceive why anyone would invest in one.

  • 4 John from UK Value Investor May 14, 2016, 4:57 pm

    “there’s no doubt some physical books will survive as things of beauty, just like I suppose a few people will always wear old-fashioned analogue watches”

    Me-thinks you are too pessimistic about the future of analogue technology. I prefer paper books, not because they are beautiful, but because for me they are functionally superior to digital books. The reading surface is not shiny or backlit, they can be bent into all sorts of shapes and scribbled in (with that old analogue technology called a pen), and if it’s a good book worth keeping, they become associated with various memories from decades ago, much like a favourite coffee mug, or a wife (I’m joking of course).

    And don’t get me started on digital watches (too late!). The Apple Watch 1 (or whatever it’s called) will be laughed at by everybody in a few years as a technological dinosaur, so you’ll be forced to upgrade ad infinitum, as Apple would so dearly love you to do. However my old analogue watch will just keep on ticking, probably for far longer than I can manage.

    I suppose you even have one of those newfangled “mobile phone” things as well…

  • 5 The Investor May 14, 2016, 4:58 pm

    @Moongrazer — I’m not so sure. Pure, probably not, but this thought piece isn’t really about “how will we make a pure passive world work?” but rather “how much active do we need for passive to still be effective”

    Most people will say they invest in active funds (if they even know the difference) because they want ‘decent returns’ or ‘a good retirement’ or something like that.

    They don’t say “I am investing in active funds because it is important to me to do better than other investors.”

    A few maybe, and more who are seeking returns well above the market’s historical average who see in the active fund literature a way to achieve that.

    But I believe they’re greatly outnumbered by the people who use active funds because they either still don’t know passive funds exist, or because they believe things that aren’t true about active investing (like that a majority will do better with ‘smart and clever’ active management than passive, rather than the opposite being true.)

    Where the real greed comes in is with financial services (or where the profit motive comes in, if you prefer) who can only make the sort of fortunes discussed in the hedge fund article I link to above with massive amounts of assets under active management.

    I think the scope for actively managed assets to be radically cut down to size is high, however greedy the managers are.

    You could be right, but passive is already far from the tiny minority movement it once was in the US. And if I recall correctly, Vanguard is effectively eating up most to all of the outflows of from active funds each year…

    Time will tell! 🙂

  • 6 Passive Investor May 14, 2016, 10:01 pm

    @investor. Thanks for the link to the article about passive vs active share of the market. I thought it was excellent. It confirmed what I have long thought which is that the proportion of passive investing can be way over 50% provided there is just enough active to provide liquidity. It is also reassuring as it means there is no danger from having too much passive. Even everyone behaved rationally (ie invests passively) once the share of the market gets towards 90-95% there will be enough profit margin in active market making / trading to mean that firms will do it. In fact I believe there will always be a healthy number of investors who are lured towards active funds (Unless there is a very rapid evolution of human psychology / human nature!)

  • 7 grislybear May 15, 2016, 12:57 pm

    Enjoyed reading your site very informative. Im retiring next year aged 62 and have a simple passive portfolio 70stock 30bonds which suits me. Im looking for a method of deacumulating , dont really fancy the investment trust route. I had a look on your site and found a link to a 4 bucket system a bit complex and too fidly for me. What i need is a simple system with the emphasis on very simple. Anyone on here have any ideas or better still using a very simple method. By the way my portfolio is valued at 300k. All the best to everyone and keep up the good work.

  • 8 thinker May 16, 2016, 10:09 am

    Hi
    If open-ended property passive funds are not good for investor then what are the suitable alternatives.

  • 9 magneto May 16, 2016, 11:56 am

    @grislybear

    As have suggested in previous threads, a good starting point about investing in retirement is :-
    Frank Armstrong’s book ‘The Informed Investor’ chapter 18.
    My copy cost £0.01 on Amazon (plus postage!).
    Best penny’s worth ever spent!

    The book covers much more than just the retirement investment issues. The whole investment process for all investors is covered in a straightforward and easy to understand manner.

    It is also (I believe) Monevator compliant!

  • 10 grislybear May 16, 2016, 8:51 pm

    @magneto !bingo, Frank Armstrong has company called investor solutions which has a free copy of a book called Investment Strategies for the 21 Century. Some very nice ideas about diy variable annuities etc are talked about in the book. I have ordered my copy of The Informed Investor from amazon (all the 1p copies have been sold haha). Thanks for the info. on Frank Armstrong, a new name for me to add to the great and the good.

  • 11 magneto May 17, 2016, 11:17 am

    Thanks grislybear for drawing attention to the on-line book. Particularly liked the last two sentences of this para :-

    “I assumed that the investor would re-balance the portfolio so that in good years he would replenish his hoard of short-term bonds, and in bad years he would draw it down. This idea isn’t entirely new. A similar technique was used by Pharaoh about 3,000 years ago with some notable success.”

    Have noted also that Frank Armstrong in the next section, highlights an area which we talk about here from time to time; how the Rich can invest, by living off the stocks yield, never selling; rather like The Greybeard!

    Perhaps sometimes overlooked in discussions about portfolio construction for retirement, is this very important distinction between those who can live off the ‘natural yield’ of their portfolio; and those who need to drawdown capital from their investments, to make ends meet!

    Thanks for the info

  • 12 The Investor May 18, 2016, 9:41 am

    @thinker — I prefer closed-ended funds for property (i.e. investment trusts) as these are not required to sell assets to meet redemptions in a downturn (because there are no redemptions — they are effectively listed companies, just like any other).

    You can still lose a lot of capital in terms of both NAV and the share price falling (as the discount widens) but at least the manager is not a forced seller near the low points of the cycle. Dividends may prove more sustainable. They also don’t need to hold a vast wad of cash to manage redemptions, like an open-ended fund.

    Just my feeling, not personal advice. 🙂

  • 13 thinker May 24, 2016, 1:39 pm

    @The Investor – Thanks for reply .I have looked into the property IT listed on the aic website.The Schroder global property trust has stopped trading I have decided to invest some amount in the TR property investment trust which deals in securities in the Europe including UK looks diversified with acceptable gearing.
    The F&C commercial property trust yield looks good but i feel risk in a trust which has geared so heavily.For USA,i believe it is better to buy some etf in the sipp account like Vanguard real estate or London listed ishares.

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