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Is Robert Shiller Right?

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I’d like to think Shiller is wrong, but that idea makes me nervous. You say that: “when an index fund is purchased its price will necessarily change relative to the underlying basket of assets. If the price of the index rises above the asset value of the underlying basket then a market maker will sell the index and buy the underlying basket.” I think the question that many people have (including me) is how much of the market has to be actively making this comparison in order for the prices to not get too wacky. For example, if only 20% of the market is exploiting these value differentials (the pyramid is inverted), is that enough to avoid prices getting crazy high and then crashing? I think that’s the “chaotic system” that Shiller is referring to. (Note, I realize 20% active is not the current situation. I am pushing the example to an extreme to make my point.) Given that Shiller says markets are often irrational, and relatively passive investors ignore rationality (at least when it comes to pricing), isn’t there a potential hazard with the relatively passive approach when it becomes a substantial part of the market?

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Posted by (Questions: 2, Responses: 0)
Posted on 11/14/2017 4:00 PM
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Hi Karl,

Yes, I hesitate to say that Shiller is wrong as well, but as I said, I raise chickens so who are you going to believe????

I think the error some people might be making here is the idea that liquidity necessarily means efficiency. A market can be highly illiquid and still operate correctly. For instance, what if we opened the stock market for one day at the end of the month each year? Prices would settle at a monthly level and the market would look less liquid, but would it really be less efficient? The prices should still be the same at month end even if the markets were open every day. Or take housing markets. They’re way less liquid than a stock market, but are they less efficient? You could make this comparison across a lot of different markets. Liquidity doesn't necessarily mean efficiency.

But I am making a simpler point here. The act of buying and selling an index fund necessitates the underlying more active market making. So, millions of people are buying and selling index funds every day. A whole bunch of these people are relatively inactive. They are just rebalancing, reinvesting dividends, etc. But this activity creates the need for more underlying activity. The market maker has to rebalance the underlying index every time one of these purchases/sales happens and that creates a market for a more active underlying market.

I guess the point I am actually making is that if you took the actions of “passive” investors and calculated them they would certainly be less active than something like day traders, but they would be more than active enough to necessitate sufficient underlying activity and price discovery. But again, don’t confuse liquidity with the need for price discovery. A market can be illiquid and still have perfectly sufficient price discovery.

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Cullen Roche Posted by (Questions: 10, Responses: 1771)
Answered on 11/14/2017 4:17 PM
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A point I’ve made in such discussions elsewhere is that Shiller’s POV presumes that active investing (as he defines it) has advantages over passive investing (as he defines it). If that is so, then as more money moves from passive to active, presumably even more advantage shifts to the active investor. Like a kind of arbitrage. At some point, an equilibrium will be reached where the passive investors are leaving enough money on the table to draw out enough active investors to set prices.

That said, IMHO it would be quite reasonable to have Vanguard and other big providers not be allowed to vote their shares, because their interests are not necessarily aligned with my interests, and they could contrive to suppress necessary market signals.

Alternately, we could use computing to separate aggregation of assets from aggregation of voting. For instance, I could subscribe to a service which gives me a selection of voting styles which are then applied to the component shares held on my behalf by VTI. I doubt anyone would pay enough to make that worthwhile, though.

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Posted by (Questions: 0, Responses: 1)
Answered on 11/14/2017 11:37 PM