Comment by JamilD | Hacker News Reader

Comment by JamilD | Hacker News Reader

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> In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns.

This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return.

Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes.

[0] http://longbets.org/362/

[1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...

Keep in mind that both have the same disadvantage. It is certainly possible (and getting much easier in the last decade) to pick times when passive investing was essentially a worthless proposition (e.g. Sep 2000 up to now yielded <2% per year. Doing better would have been easy, even if you got bitten by the crash. Buying and holding almost any asset would have beaten it (a house, gold, ...). By contrast, starting in March 2003 would have yielded 7.5% per year, which would be pretty hard to beat over that time period).

Truth is that the starting time of an investment determines your results far more than whether you pick active or passive investing.

Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.

> Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.

Could you expand on what you mean here? Do you mean, that for every day, "today does not look like a good time to start", or do you mean that on this May 4th, 2016, you expect that investments made today, will seem like a bad investment on May 4th 2066? (Or whatever is considered a "long term graph")?

I mean nothing more than that if you were to put the S&P 500 graph over the last 15 years and extremely naively look at it, you'd conclude it was very high at the moment. Naively it would seem that it will see 1600 before it sees, say 2500.

Also if you look at long term history you'd conclude something similar : the US has had a very long (if somewhat disappointing) economic recovery since 2008. We're due a bust.

And finally, the playbook from earlier recessions does appear to be unfolding : manufacturing production has dropped by a lot, and services has flatlined. This is very much like the start of previous recessions. Next up is bad loans to commodity producers (ie. miners) and manufacturers actually going bad (meaning banks declaring losses), then a few defaults, then panic, then recovery.

I would expect index investments made today will seem like bad investments in 10 years. I would never dream of predicting 50 years out. To be fair, I would have told you the same a year ago (not about the recession playbook, but probably everything else listed in this post).

I mean nothing more than that if you were to put the S&P 500 graph over the last 15 years and extremely naively look at it, you'd conclude it was very high at the moment.

High based on what metric? When I look at this graph, it looks like it's been relatively flat for the last half decade: http://i.imgur.com/3gIwjbh.png

What? This looks flat to you?! :

http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#{"ran...

It's up 53% over that 5 year period, for a CAGR of 8.9% (excluding dividends).

Yeah, you're right, it's more like flat over the last three years

How do you look at that chart, say "it's flat the last 3 years" and ignore the three boom bust cycles before it?

I'm not trying to give investment advice, just explaining why you should be somewhat credulous about any sales pitch from a guy with vested interests in where you should put your money. It's not as simple as Buffett makes it seem.

> It's not as simple as Buffett makes it seem.

Yes, actually, it is. That's the whole point.

No, it isn't. If everyone in the room were passive investors, and a company like GM starts losing money quarter after quarter, the passive investors will not sell GM. The company will continue to maintain the same stock price. They will continue to issue stock to cover their losses. Issuing stock increases market capitalisation, passive investors will buy in, and keep giving the company cash. On the other hand, new companies will have no active investors looking at them. No active investors to issue IPO's to.

The economy will stagnate. Eventually the entire portfolio the room holds will be money losing companies, burning up the country's capital.

The half of the room who are active investors contribute greatly to the economy's long term growth. They could either have negative long run returns as passive investors, or positive long run returns that are less than passive investors.

This analysis is dead-wrong. Passive investors will sell GM, not buy in.

Index funds are weighted by capitalization. So whether GM's capitalization goes up or not is actually irrelevant: what's relevant is the ratio of its capitalization to the size of the total capitalization of all companies in the market, and how that changes.

Setting that point aside, here's some basic math that shows why this analysis is completely wrong and why GM's market cap will go down. Let's say today, I am the CEO of GM, and I issued 1 million new shares, bringing the total up to 1 Billion outstanding shares. I dump them on the market, when the price was $50. The price drops some amount, because shares are being sold.

How much money did I, as CEO of GM, raise? At most $50 million

How much could market cap possibly have gone up? Exactly the amount that was raised: at most $50 million

How much could market cap possibly have gone down? Drop in stock price * 1 Billion

So market cap increase is precisely equal to the amount of capital provided by investors, which is finite and won't run away into a vicious cycle as suggested by the poster. Market cap decrease can be... well... 100%, all the way to zero. And the more shares issued, the more downward pressure on market cap... as the effect of crossing the bid-ask spread on market capitalization gets amplified.

>> I dump them on the market,

I'm sorry, that's an invalid assumption. Especially in a world with only passive investors.

GM has been losing $1 billion a quarter for 10 quarters. GM's stock price is $30 as it has been since 10 quarters ago, market capitalisation $40B. It is running out of cash building unprofitable products. The underwriter calls various index funds, telling them there will be a capital raising of $10B, at $28 per share, representing a ~5% discount, and as a result of that, GM's weighting in the index is going to be re-weighted upwards at the next index balance in three weeks, so they might as well sell other (more productive) stocks, which will be weighted downwards, and buy GM at a discount. The capital raising is "oversubscribed" because of this arbitrage opportunity. As a result of the discount, the stock price of GM falls from $30 to $29.50 ($2 times by roughly 25%). GM's stock price falls 0.16% per quarter, and can sustain this rate indefinitely because of passive investors.

In a stock market with active investors, GM's fall in stock price would be a lot more than 50 cents.

Passive investors represent inertia that will keep the current ratios of market capitalisation between companies listed on the stock exchange constant, even if those ratios are suboptimal economically. As a result of the stunted capital allocation, the economy will begin to shrink, over the long run, as it continues to support unprofitable companies by depressing the share prices of the more productive companies, since, ironically, those more productive companies raise much less money than the unprofitable ones, and those capital raisings funded by selling the other companies that aren't raising money.

Buffets position is also backed by reality. On average, managed money will do worse because of the fees. The people making outsized returns are the minority.

It's like going into a casino and arguing that the casino is losing because you see one guy hit a jackpot on the slot machine.

Again, I'm not advocating for one strategy over another, just pointing out that Buffett's explanation is simplistic and that it is worth considering metrics other than average returns.

I mentioned this above, but I think you're missing the point. For what you suggest to be worth considering, you have to believe you're something other than an average investor.

But you aren't. That's who he was speaking to and speaking about. Average investors.

Hes not arguing managed makes more money, just that within hedge funds there is variation, where there is no variation within index. The both have the same avg, but wildly different max/min/etc

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