Why Index Funds Are Like Subprime CDOs

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steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

iopsi wrote:
Tue Sep 17, 2019 6:25 am
Obviously i'm not advocating for zero financial education, but becoming as skilled as a professional financial analyst might be excessive.
I think the point of your post is that a decent financial education leads to you being an over performer compared to the professionals. The problem is articles like the one that this thread is based on provide poor information.

So educate yourself but do it smartly:-

1. Asset allocation
2. Index funds
3. Withdrawal rates

These concepts are really important whereas complex unsubstantiated ideas like this thread or any of the articles about the 4% rule now not being valid or how active investing in options and warrants or whatever push you down the path of trying to manage extreme outlier events. If you are concerned about outliers your best bet is saving up a bigger stash. The problem that I see is people worry about outliers and then head down the rabbit hole of active investing. So they are so worried about outliers that they will probably (highly likely) under perform compared to the person who has a simple equity/bond asset allocation and utilises broad index funds.

Maybe a better way to view financial education is education for DIY'ers who will outperform professionals most of the time is pretty simple and can be obtained by most people. Apart from that you are better off learning other skills that will impact your life in different ways. Gaining the education of a financial professional will probably (highly probable) lead to under performance compare to the DIY'er who chooses the simple path to wealth (ala JL Collins).
Last edited by steveo73 on Wed Sep 18, 2019 12:47 am, edited 1 time in total.

steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

IlliniDave wrote:
Tue Sep 17, 2019 7:35 am
As just a guy who invests I don't think of risk as a monolith. In the broadest sense it's just a category heading for what can go wrong. I've always sort of bristled against the standard definition of investment risk (std dev of investment return), but I guess the MPT folks needed something for one of the axes. Some people (led by Bernstein, I believe, but maybe it was Pfau) call risk defined by measures of moderate-term volatility "shallow" risk. For someone with a longer time frame (increasingly not me) this risk is mainly a risk because it can, and does, often trigger counterproductive investor behavior. Deep risks are the sorts of things that can wipe you out. Milder ones might be sustained surges of inflation, stronger might be long term economic collapse. For many there's a window where shallow and deep risk co-mingle in the form of sequence of return risk.

I don't concern myself too much with the shallow risks. Knowing I'm at the juncture I'm most sensitive to them I've just incrementally shifted a larger share of my at-risk money into assets I reasonably expect to be less volatile. I expect to lose potential return based on that approach, but it could potentially a better jumping off point by blunting downside potential.

When it comes to deep risk I don't really have enough $$ to simultaneously guard against much when compared to all the deep risk scenarios that could be posited. So being unable to control it (i.e., control how the event/aftermath affect me), I don't let myself worry about it.
Good post. I first learned of those risk concepts (shallow and deep) from Bernstein. Shallow risk is typically mitigated against via having some bonds or cash and assuming that you don't panic in this situation (this may be easier said than done). These asset classes though aren't good in mitigating against the most likely deep risk which is inflation. Cash and Bonds are going to slowly lose value in relation to inflation. Equities though are the asset class to mitigate against this risk.

I think Bernstein has 4 categories of deep risk:-

1. Inflation - equities mitigate against this problem.
2. Devastation - war or something like that. I don't know how easy this is to mitigate against. I think the cost of for instance having a safe and diamonds isn't worth the cost of mitigating this risk.
3. Confiscation - this is similar to devastation but more about governments taking all your assets. This is another risk that I personally won't manage.
4. Deflation - cash is really helpful here. The likelihood of this happening is really low so again I don't intend to mitigate against this risk however a broadly diversified world equity index may help and this is a financial asset that works for point 1 as well.

One point I'd make about all of this is that a diversified world index tracker is a great way to manage your risk. I cannot think of a better single asset class than this. When you add in a simple bond fund you are doing really really well. You are going to have a portfolio that will be freaken awesome and out perform the vast majority of investors out there.

This guy provides in my opinion the best advice on how to invest for the average person:- https://kroijer.com/. Note the average person doesn't mean that a smart person will beat the average person. That isn't how investing works. The smart person who uses the average person approach will beat the vast majority of smart people who think they can beat the average approach.

I don't think that you can really beat a simple portfolio (international equity fund and domestic bond fund) via tweaking your asset allocation from an expected future returns perspective. No one knows what markets will out perform in the future so of course some asset allocation or some form of active investing will beat this approach. The problem is we don't know today which approach will beat the simple approach.

You can do other things to improve your chance of success such as obtaining a pension or saving more money but that sort of defeats the purpose.

The Old Man
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Re: Why Index Funds Are Like Subprime CDOs

Post by The Old Man »

steveo73 wrote:
Wed Sep 18, 2019 12:46 am
1. Inflation - equities mitigate against this problem.
Equities do not mitigate inflation. If they did, then they would have performed far better in the 1960s-70s then they actually did. Personally, I think that real estate with a fixed rate mortgage would do great in an inflationary environment.
steveo73 wrote:
Wed Sep 18, 2019 12:46 am
2. Devastation - war or something like that. I don't know how easy this is to mitigate against. I think the cost of for instance having a safe and diamonds isn't worth the cost of mitigating this risk.
For little people this is about survival. This is about living and having enough capital to start over. Hidden and mobile assets work, human capital is important, and social capital is especially important. This risk can also be about natural disasters and crime. These can be mitigated with insurance and basic security/protective measures.
steveo73 wrote:
Wed Sep 18, 2019 12:46 am
3. Confiscation - this is similar to devastation but more about governments taking all your assets. This is another risk that I personally won't manage.
At the personal level this risk is most likely to be realized through divorce and lawsuits. Insurance, asset protection, trusts, and lawyers help here.
steveo73 wrote:
Wed Sep 18, 2019 12:46 am
4. Deflation - cash is really helpful here. The likelihood of this happening is really low so again I don't intend to mitigate against this risk however a broadly diversified world equity index may help and this is a financial asset that works for point 1 as well.
How is it really low? We are currently experiencing unprecedented negative interest rates in much of the world. That means deflation. It is only a matter of time until negative rates arrive in the USA. There has been a lot of interest in governments on how to deal with the cash problem (zero lower bound), so that deep negative interest rates can be implemented. If successful, then cash will provide no help against deflation.

steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

The Old Man wrote:
Wed Sep 18, 2019 11:54 pm
Equities do not mitigate inflation. If they did, then they would have performed far better in the 1960s-70s then they actually did. Personally, I think that real estate with a fixed rate mortgage would do great in an inflationary environment.
They actually do. This is just a factual comment. The data backs this up. Equities are the asset class that will enable your portfolio to survive over the long term. They provide the best returns. Inflation slowly but surely eats away at most other asset classes. Real estate is a potential winner but personally I don't like it and I don't think the data is there to prove this point.
The Old Man wrote:
Wed Sep 18, 2019 11:54 pm
At the personal level this risk is most likely to be realized through divorce and lawsuits. Insurance, asset protection, trusts, and lawyers help here.
I agree with the likely risk but I don't see how you can protect against this. Divorce is my no 1 concern. I can't protect myself with lawyers etc here. I deserve to lose half because my wife deserves half.
The Old Man wrote:
Wed Sep 18, 2019 11:54 pm
How is it really low? We are currently experiencing unprecedented negative interest rates in much of the world. That means deflation. It is only a matter of time until negative rates arrive in the USA. There has been a lot of interest in governments on how to deal with the cash problem (zero lower bound), so that deep negative interest rates can be implemented. If successful, then cash will provide no help against deflation.
Deflation very rarely occurs. Cash works great against deflation. If everything is dropping in price your cash is going up in relative value. You might be right in your premise. I give you a .00000001% chance of being right though. There is way too much that would have to happen for deflation to occur and then cash not to help protect you. We would have to be in really dire circumstances.

Personally I just worry about long term inflation as the deep risk that I am going to manage. I do worry about shallow risk. I do this via bonds and cash.

None of these points though refute the concept that equity index funds are the no 1 bullet in your arsenal when it comes to FIRE. If you don't want to use that bullet you better have a freaken good alternative option. The second best bullet is probably a bond index fund.

Jason

Re: Why Index Funds Are Like Subprime CDOs

Post by Jason »


Campitor
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Re: Why Index Funds Are Like Subprime CDOs

Post by Campitor »

When I started looking into stocks, bonds, and mutual funds, it seemed that the fund managers who consistently beat the market were managing private funds that had a minimum buy-in of 50 million or more. Sadly for most Americans who don’t want to side-hustle or read financial reports, indexing is the best lowest hanging fruit they can stomach.

And I’m glad that fund managers are losing business as a result of bad business practices. If Washington doesn’t want stop incentivizing bad financial policies, then let the consumers of financial instruments do it via their investment choices.

steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

These are great.
Jason wrote:
Thu Sep 19, 2019 6:11 am
It's official.

https://www.bloomberg.com/news/articles ... stry-shift

Edit: I found this Peter Lynch interview interesting.

https://www.fidelity.com/viewpoints/inv ... t-strategy
This is a great quote but there are others in that article.
Lynch: Long term, the stock market's a very good place to be. But I could toss a coin now. Is it going to be lower 2 years from now? Higher? I don't know.

But more people have lost money waiting for corrections and anticipating corrections than in the actual corrections. I mean, trying to predict market highs and lows is not productive

Nuuka
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Re: Why Index Funds Are Like Subprime CDOs

Post by Nuuka »


steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

https://www.whitecoatinvestor.com/indiv ... ocks-dumb/

This is interesting. If you don't like the heading the statistics are great.

steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 »

Nuuka wrote:
Wed Oct 02, 2019 11:31 am
Jim Rickards on index-funds

https://dailyreckoning.com/free-riding- ... ollapse-2/
This is absolute nonsense. Compare this to the article I just posted. To me it shows the exact difference between a passive investor and an active investor. The active investor has all sorts of reasons on their side but no facts. It's all subjective nonsense. The passive investor has invested rationally with the odds in their favor.

Nuuka
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Re: Why Index Funds Are Like Subprime CDOs

Post by Nuuka »

I am adding here extracts from my journal since I think they may be relevant. This is my private thinking and I have absolutely no reference to where I base my text, nor do I have any evidence that there is any truth in them.

“i don’t believe in index funds. I think they are too risky for my appetite.The risk I see is that they are kind of tracking stock with the money not actually being 100% invested to underlying shares but the middle-man actually pocketing part of the money. It must be so because they charge almost nothing. So they have to “eat from the payload”. Otherwise It doesn’t make sense to offer index funds to public. I see the risk that some of the index funds blow up if there is a counter-party failure in derivatives, such a megabank failure.”

“I could see the middle management in an index fund thinking: for those stocks that there exists derivatives, I don’t need to buy the underlying stock. Since I can get gearing with derivatives, I don’t need to put so much money to get the same effect. Rest of the money I can invest into some interesting play.”

Latter quote involves two risks
- derivative counterparty risk
- risk that index-fund money is used for other investment purposes which may blow up

The first risk is real and serious because if a major derivative player fails, chains of derivatives will fail, some of them hitting the index-fund, so they cause first freeze for derivative-dependent parts of index-fund (withdrawals temporarily disabled) and later lead to stepwise revalue lower of the fund (after couple of months lower value will be announced and withdrawals re-enabled)

The second risk is typical Ponzi-risk that it will only be detected if there is a depositor run on the index-fund.
Last edited by Nuuka on Fri Oct 04, 2019 10:32 am, edited 8 times in total.

IlliniDave
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Re: Why Index Funds Are Like Subprime CDOs

Post by IlliniDave »

Nuuka, I think you are correct that a middle man pockets part of the clients' money. That is always the case in any mutual fund, index or otherwise. However, I think the reason index funds cost less is that the middle man is pocketing less of the clients' money. That philosophy (lower cost -> higher return) was part of the impetus for the creation of retail index funds.

Nuuka
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Re: Why Index Funds Are Like Subprime CDOs

Post by Nuuka »


7Wannabe5
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Re: Why Index Funds Are Like Subprime CDOs

Post by 7Wannabe5 »

@Nuuka:

Yeah, this becomes really obvious if you spend more than a few years dealing in something inherently not liquid like rare books. Every seller needs a buyer. It's not the case that a book on the topic of the electrification of the first skyscrapers in NYC is only worth what you could get today from another dealer, because that's not your customer. The problem with index funds, in my only semi-informed opinion, is that eventually you are assuming the availability of a customer who is simultaneously more skilled professional AND greater sucker than you.

It's always misleading to think you have money when what you really have is stuff, although, of course, money is just stuff too. Other problem is "Then what...?" If you sell off your tools and/or inventories then you need to make some new plans.

tonyedgecombe
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Re: Why Index Funds Are Like Subprime CDOs

Post by tonyedgecombe »

7Wannabe5 wrote:
Tue Oct 15, 2019 6:14 am
The problem with index funds, in my only semi-informed opinion, is that eventually you are assuming the availability of a customer who is simultaneously more skilled professional AND greater sucker than you.
That's often a general complaint about equities but seems somewhat invalid in terms of index funds as you are only getting growth and dividends on a par with the whole market. The person who sells during retirement might not be any different to the person who buys at the start of their career. Neither needs to be a sucker nor rely on the expenses of a professional.

Redbird
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Re: Why Index Funds Are Like Subprime CDOs

Post by Redbird »

I'm not sure if this is the right thread, and I'm not taking a position. Just offering this as food for thought:

https://global-macro-monitor.com/2019/1 ... arket-run/

7Wannabe5
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Re: Why Index Funds Are Like Subprime CDOs

Post by 7Wannabe5 »

@tonyedgecombe:

I suppose I was thinking more in terms of a rapid sell-off. Also, it seems to me that the system you are describing requires at least one thrifty industrious orphan for each spendthrift scion of prior generation AND vice-versa.

@Redbird:

Maybe Picketty was wrong and we will soon see the rubber band snap on elasticity of capital. Kind of like when water stops clinging to itself. But, I would place my chips on one more generation of overall slow growth.

lumps
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Re: Why Index Funds Are Like Subprime CDOs

Post by lumps »

I feel like there's a lot of people defending index funds as being the rational choice for an individual, but not wanting to accept that everyone making the rational choice does not guarantee the best outcome for the group e.g. prisoner's dilemma.

_______Active Passive
Active 5,5 5,7
Passive 7,5 3,3


Could this be an accurate payoff matrix? The numbers presented above are the annual ROI. In the long term, mispriced securities would lead to an underperforming economy (passive/passive strategies adopted by all actors).



No one is arguing that it's a bad choice on an individual level. Just like amassing nuclear weapons is a good choice for the individual state actor who finds itself in a cold war, they'd be better off having to expend zero resources on making and maintaining (and dismantling) their arsenals.

On a similar note, are solutions at an individual level really going to change anything? The idea of active investing being incentivized due to mispriced securities only makes sense when there are enough people interested in accurately priced securities. Should the conclusion be pushing for regulation of the size/number of index funds? Seems implausible here in the states, but if the alternative is to push individual investors to choose actively managed funds or to learn enough to actively invest, it seems like a losing cause.

WFJ
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Re: Why Index Funds Are Like Subprime CDOs

Post by WFJ »

Almost all of these "Indexing is dead and they are the next CDO, we're all going to die" articles are using horrible/dishonest data. Almost all use a comparison between Index funds vs retail funds, which is ignoring most of the investors in equities. The US stock market is roughly worth $49 trillion and AUM of passive index funds is difficult to estimate but below provided a number at $4.3 trillion in 2019, meaning passive index funds accounted for a whopping 10% of all equity holdings, "Indexing will cause market crash, we're all going to die (subscribe to my newsletter for "premium insider tips" that THEY don't want you to know!!!
https://www.morningstar.com/articles/92 ... uity-funds

For comparison, the market cap for all index funds is less than AAPL, MSFT and AMZN, market cap of top 10 US companies dwarf the AUM of all index funds.

Nobody knows if the individuals proclaiming "Indexing will destroy Western Civilization" are stupid, dishonest or just picking something to write another gloom and doom article about as silver is roughly what is was worth in the 1920's. When (passive/total market) approaches 50%, there might be some issues, but more likely the ratio would needs to rise to 75% or even 90% before any issues would present themselves. Beware of denominator manipulation in Finance or any science.

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