In a recent article, “The Ethics of Indexing Redux,” Nadig explored the idea of the growth of passive investing and the potential ramifications. These insightful takeaways were well worth exploring since Nadig and Geraci are proponents of passive investing overall. Looking at the impact of passive flows and how price discovery is really working in indexes, Nadig has been keeping an eye on the progress of this line of thinking, which motivated the previously mentioned article. There were three key questions to explore – 1) Is the current dominance of passive strategy in flows impacting how markets function? 2) If so, is it possible to determine how in a way that might influence the decisions we make as investors? 3) Does pooled ownership create any winners or losers in a way that isn’t representative of that ownership? Digging into where these questions come from, Nadig believes that while the logic being suggested by experts (and the math to back it up) concerning the efficient markets hypothesis is freaking some people out, many rational people already know this hypothesis has remained unproven for a while. Looking at why there’s a higher multiplier concerning the money going into an index fund, Nadig notes that multiple explanations begin to set an understanding. Simply put, “If you are a market maker,” Nadig states, “And you have to sell somebody your Tesla that you have in inventory to make a trade happen, that is an easier thing to do in terms of your inventory management and liquidity across your book than to do that with 500 stocks all at once.” So, it’s coming down to understanding that there are many ways to substitute for one big company within a series of stock holdings to find similar exposure, while it’s very difficult to find a substitute for the top 1000 stocks in the U.S. As far as what to expect, if everything Nadig is saying ends up completely checking out (which is not to say something is necessarily wrong), it would mean the characteristics of markets are different than what to expect. “That means there’s a reason to expect that long term flows will continue to support markets regardless of short term volatility…until it doesn’t.” “We need to be careful of those tipping points,” Nadig adds. Getting to either side of it would mean markets will move more than otherwise expected.
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