One Cause of Market Turbulence: Computer-Driven Index Funds

In many ways, this stampede toward passive investing — in which people put their money into funds that track indexes and broader market themes as opposed to relying on human stock pickers — is uncharted territory.

.. the key question is how this transformed market holds up during a financial storm that lasts more than a few days.

.. Cheaply priced exchange-traded and index funds .. They now own close to 40 percent of stocks in the United States

.. BlackRock..  is the leading issuer of exchange-traded funds, with $1.3 trillion under management

.. The popularity of E.T.F.s has concentrated unparalleled financial power in BlackRock and Vanguard, the two biggest providers of index funds and E.T.F.s. Together, they sit on $10.5 trillion in assets and control 65 percent of the 1,700 exchange-traded funds that exist.

.. As the flows have grown in volume, much of these funds have gone toward index heavyweights like Amazon, Apple and Facebook, pushing their valuations ever higher.

.. Active fund managers — human stock pickers  .. because they are the ones who buy when others sell.

Buffett Assails Money-Manager Fees as Berkshire Reports Profit Rise

Billionaire also declares victory in his $1 million bet with another asset manager that low-cost index funds would out earn hedge funds over a decade

 Warren Buffett intensified his attacks on Wall Street money managers Saturday, saying that investors wasted more than $100 billion over the last decade on expensive advice.
.. “The bottom line,” Mr. Buffett wrote, is that “when trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
.. Book value, a measure of assets minus liabilities that is Mr. Buffett’s preferred yardstick for measuring net worth, rose 10.7% in 2016, compared with a 12% total return in the S&P 500, including dividends.

.. Berkshire’s BNSF railroad subsidiary. Net earnings at Berkshire’s railroad fell 16% in 2016 due largely to a drop in coal demand.
.. Ajit Jain, widely considered to be one of the leading candidates to take the Berkshire CEO job when Mr. Buffett is no longer on the scene
.. Berkshire, he said, is still willing to buy back its shares if prices fall below 120% of book value.
.. Mr. Buffett praised some companies, including Bank of America Corp., for buying back shares. “Some people have come close to calling [buybacks] un-American—characterizing them as corporate misdeeds that divert funds needed for productive endeavors,” Mr. Buffett said. “That simply isn’t the case.”
.. Berkshire has warrants to buy 700 million shares of Bank of America at $7.14 apiece. The stock closed Friday at $24.23, so Mr. Buffett is looking at a paper gain of about $12 billion.
.. He attributed America’s “miraculous” economic growth to “human ingenuity, a market system, a tide of talented and ambitious immigrants, and the rule of law.”
.. He instead saved his sharpest comments for pricey money managers who pledge to beat the market, saying that in his lifetime he has identified “ten or so professionals” who can do so successfully.
.. “If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years,” he wrote.
.. In 2007 Mr. Buffett bet $1 million that his chosen index fund, the Vanguard 500 Index Fund Admiral Shares, would outperform hedge funds over the next decade.
.. Mr. Buffett in his letter Saturday praised Vanguard founder Jack Bogle as a “hero.”
.. “If a statue is ever erected to honor the person who has done the most for American investors, the handsdown choice should be Jack Bogle.”

How the Internet Hurt Actively Managed Mutual Funds

Yet given that the ETF is over 20 years old, and Vanguard is more than 40 years old, the question arises…why  just in the past 5-10 years has the explosive growth finally shown up?

 The answer, in a word (or two): The internet. It was the internet that did it.
 To understand why, reflect back on what it was like 20 years ago to evaluate an actively managed mutual fund. The average consumer only knew how they were doing by getting a once-per-quarter statement showing account balances, or by pulling out The Wall Street Journal stock pages to see the prior day’s closing NAVs. While this approach was fine to monitor that the portfolio was growing–which it was, almost continuously, throughout the 1980s and 1990s–it did nothing to tell investors whether the funds were actually good, or whether the rising tide of a booming stock market was lifting all boats together (even the laggards).
But with the internet, for the first time, it was possible to look up not just the closing prices of the funds, but to benchmark them, with actual performance data.
.. And the lesson brought about by that transparency: It turned out that a lot of actively managed mutual funds weren’t beating a simple, passive index fund. And it didn’t require complex calculations and reading a 172-page prospectus to figure it out. A straightforward website could easily collect all the performance data automatically, and calculate the results instantly.

.. And the ability to buy investments directly on platforms like Schwab and E*Trade meant that a large swath of investors no longer had to pay an “adviser” (who was really a mutual-fund salesperson intermediary) to invest their dollars.
.. The coming Department of Labor fiduciary rule in 2017 will likely drive the trend even further, as advisers who hold out as such will actually be held accountable as advisers (at least with respect to retirement accounts). Which means the adviser has to justify that the actively managed fund really is worth the additional management fee over a lower-cost passive index ETF instead.