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Think of it this way: if there are too many "free riders" in the form of passive investors, then ... it will become easier for active investors to make money, and beat the market, and more people will actively invest their money (or invest in actively managed funds).

Yep, there will usually be opportunities for arbitrage for active traders if there are too many passive investors. I suspect there will be some sort of equilibrium between active and passive at some point.

The thing is that I'd rather be doing other things with my time, so I'm a passive investing kind of guy. Imagine getting the market return for doing nearly nothing for dirt cheap. That's a high growth rate to level of effort ratio!

An equilibrium exists but expected returns of active and passive are unknown. Would it reach equilibrium or could there be a crisis due to passive allocating funds poorly.

I mean, I don't know, I'm a random guy on the internet saying stuff, not an analyst.

But I think a key point is that active investing already exists and dominates the market -- it's still like 85% active. People choosing to invest in passively managed funds are doing so because they see a higher return. Maybe the choice is sticky and people won't switch back if the returns begin to fall, but people still have to switch in.

So building up a surplus of passive investors requires people to continue to switch to a passive strategy after the returns between passive and active level out and reverse. And not just a little -- profits from investing are returned to investors, and reinvested. So if the equilibrium between active and passive investing is X% of the market passive, and we get up to passive investors at X+10% of the market, then the X+10% of passive investors will see a lower rate of return than the 90-X% of active investors. Which means -- unless those active investors take their surplus profits and dump them into then-less-profitable passive funds, before long the active investors will have 91-X% of the market and the passive investors will have 9+X%. Absent continued switching, the feedback of profit re-investment will push the balance back to equilibrium.

You got some good replies to your question (which is a very good one!) but I'll take a stab at it like this:

A market is "too passive" when it becomes exploitable due to perfect predictability. But - that is the very thing that will keep it from ever reaching that level of passivity. Exploiting it is an active step, then someone else bets against the exploiter, etc.

>the companies who use debt to buyback their shares are whats driving the market. Every dollar they spend on their stock is then magnified 100x by the big passive funds, and both 1 & 2 have no agency other than to try to get swept up in the winds.

I've always found stock buybacks intriguing and confusing. Here's a hypothetical scenario that seems to go against what you're saying:

Company A buys back $1 work of stock. Since there is now $1 less in Company A's bank account, that company is now worth $1 less. So the market cap should in theory be $1 less. Since the market cap should be $1 less, and $1 of stock disappeared, those perfectly balance out and mean the stock price should stay the same.

Now the index investors take a look at the situation. Company A's market cap has shrunk, whereas other companies' market caps haven't. So Company A has a smaller share of the index than other companies than it had before. But the index investors still have the old ratio of Company A to other companies, so they are overinvested in Company A. They all sell a bit of Company A in order to get the correct balance according to the index. Company A goes down in value.

So a stock buyback caused the price to go down.

market cap = book value + discounted future cash flows = share price * number of outstanding shares

When you do a buyback, the book value drops (company loses cash), but the discounted future cash flows remains unchanged. The number of outstanding shares also drops.

The net result is the stock price increases as a company accumulates cash and uses it for buybacks because the number of outstanding shares drops.

Another way of thinking about it is that it's the same as dividends, but the dividend only goes to the sellers of the stock during a buyback.

Market cap = whatever the market decided at that time, and is determined by offer and demand.

The whole book value + discounted future cash flow does not reflect the real stock exchange at all. If that was the case no investor would want share buybacks because as you say it would only reward the ones who sell...

When taking into account offer and demand stock buybacks make more sense: the buyback increase the demand for the stock. The offer will increase a bit (a few might sell) but not in the same proportion because the offer is not very elastic (most of your investors are in for a long ride and are not going to sell), so the price goes up, you get rid of some short term investors, and the long term investors see their share increasing in value. Everybody's happy and the dividend ratios do not mean anything anymore.

Buyback increases the value of the outstanding shares, which is great for those in the company with stock options.

I don't understand your reasoning for why the price increases. To use your equation with my original example:

Initially:

market cap = $100

book value = $20

discounted future cash flows = $80

share price = $1

number of outstanding shares = 100

After the buyback:

market cap = $99

book value = $19

discounted future cash flows = $80

share price = $1

number of outstanding shares = 99

So the market cap didn't change.

I agree it's effectively the same as dividends (although I think buybacks are slightly better for the taxes of stockholders).

You'd probably be interested in listening to this talk by Michael Green: https://www.youtube.com/watch?v=x-rJciYZmi0

He goes into a lot of data around the idea that the market is "too passive", and he believes that we were already at that point last year before the pandemic.

I really enjoyed and learned a lot watching this, thanks.

> 2. Highly skilled Hedgefunds like Medallion who do great on average, but they are small

Medallion usually does well, but hedge funds underperformed in the 2010's.

> Medallion usually does well

That's a bit of an understatement. The lowest yearly return since 1990 after fees and expenses has been 20%. Since 2005 their lowest yearly return has been 29%.

They practically print their own money. Their strategies appear to have low capacity, I'll give you that.

If you consider #3 and don’t limit it to only debt-driven buybacks, then the price increase can be absolutely insane.

The best example is Berkshire Hathaway stock (BRK A share) which currently trades at $402,620 per share.