Confusion: Is there some (incredibly weak) sense in which every person who makes a trade is bringing unique information to market?
Uncle George’s opinion of the new iPhone is reflected in sales figures and aggregate reviews. But technically, he is in possession of a unique piece of private information: ‘what does this one guy called Uncle George think about AAPL stock?’
This information is vanishingly close to being worthless, and a million miles way from a tradable edge, but it’s not quite worthless—it still collectively helps to generate a signal. What does this mean, if anything?
Is there some (incredibly weak) sense in which every person who makes a trade is bringing unique information to market?
Seems like the answer to this question is straightforwardly yes. People’s desires to hold various assets will be super correlated with each other. But there’s non-zero information in each person’s preferences.
I’m pretty sure there is an entire literature (but cannot know think of the term) regarding the problem if everyone were to be index investors. Basically, if no one is investing in the underlying assets, in the extreme, we don’t get pricing for those assets and ultimately cannot even price the indexes well. In short, the market implodes on itself without all those individual market interactions.
Yeah, active investors are providing a valuable service to everyone else, both by exploiting genuine asymmetries, and by collectively generating a signal in the Uncle George sense. People sometimes worry about the passive revolution for this reason, but the vast majority of funds under management are still active, and human nature being what it is, there will presumably always be plenty of people willing to have a crack.
the vast majority of funds under management are still active
Is this true? A quick search suggests not:
With actively managed U.S. stock funds posting outflows in 11 out of the last 12 years, and an unbroken streak of inflows for passively managed U.S. stock funds, assets in index-tracking strategies have caught up with those in active funds.
Our latest U.S. fund flows report shows that at the end of April [2019], both passive and active U.S. equity funds had a total of about $4.3 trillion in assets, essentially reaching asset parity.
Huh, I got that from a recent Bloomberg article which says 15:1...not sure who’s right or why the numbers are so different.
Active management in the equity market, both in the U.S. and abroad, is dominant. And not by a little: Active management in the U.S. trounces passive by a ratio of 8-to-1 in dollar investments. Expand that to include the entire world, and the ratio is closer to 15-to-1. If we include fixed income in our calculations, the ratio balloons to 60-to-1.
I think the reason not to worry too much about the passive revolution is that as long as there are money-making opportunities from active trading—people will be incentivized to do it. The end state “everyone is passive—there is no price signal” is not one we can reach from where we are, and it is not a stable equilibrium. If we ever did cross over into “too few hedge funds”, there would such a strong incentive for more, that I don’t think it would last long. But perhaps I misunderstand this critique.
We do get a price for those assets but that price is inefficient. That means that there’s an opportunity for market participants to make money of the inefficiency.
The question is whether or not Uncle George is worse or better informed then the professional investors. In situation like this I think:
“Would I be the sucker in a poker game if I would sit down at a poker table with the institutional investors who’s day jobs it’s to trade this investment?”
In early February I could have reasonably said:
For most people a pandemic like this is a black swan and that includes the retail investors but it isn’t for me and thus I don’t think I’m going to be the sucker when I go to the poker table.
I think that should be your mental model when doing most trades that aren’t index based.
Confusion: Is there some (incredibly weak) sense in which every person who makes a trade is bringing unique information to market?
Uncle George’s opinion of the new iPhone is reflected in sales figures and aggregate reviews. But technically, he is in possession of a unique piece of private information: ‘what does this one guy called Uncle George think about AAPL stock?’
This information is vanishingly close to being worthless, and a million miles way from a tradable edge, but it’s not quite worthless—it still collectively helps to generate a signal. What does this mean, if anything?
Seems like the answer to this question is straightforwardly yes. People’s desires to hold various assets will be super correlated with each other. But there’s non-zero information in each person’s preferences.
I’m pretty sure there is an entire literature (but cannot know think of the term) regarding the problem if everyone were to be index investors. Basically, if no one is investing in the underlying assets, in the extreme, we don’t get pricing for those assets and ultimately cannot even price the indexes well. In short, the market implodes on itself without all those individual market interactions.
Yeah, active investors are providing a valuable service to everyone else, both by exploiting genuine asymmetries, and by collectively generating a signal in the Uncle George sense. People sometimes worry about the passive revolution for this reason, but the vast majority of funds under management are still active, and human nature being what it is, there will presumably always be plenty of people willing to have a crack.
Is this true? A quick search suggests not:
https://www.morningstar.com/insights/2019/06/12/asset-parity
Huh, I got that from a recent Bloomberg article which says 15:1...not sure who’s right or why the numbers are so different.
I think the reason not to worry too much about the passive revolution is that as long as there are money-making opportunities from active trading—people will be incentivized to do it. The end state “everyone is passive—there is no price signal” is not one we can reach from where we are, and it is not a stable equilibrium. If we ever did cross over into “too few hedge funds”, there would such a strong incentive for more, that I don’t think it would last long. But perhaps I misunderstand this critique.
We do get a price for those assets but that price is inefficient. That means that there’s an opportunity for market participants to make money of the inefficiency.
The question is whether or not Uncle George is worse or better informed then the professional investors. In situation like this I think:
In early February I could have reasonably said:
I think that should be your mental model when doing most trades that aren’t index based.