Price Discovery, But Now With Fewer “Patsies”
“If you’re playing poker for half an hour, and you don’t know who the patsy at the table is . . . it’s you.”
As super-cheap exchange traded funds (“ETF’s”) proliferate, Wall Street is fighting back.
The latest salvo: a new academic paper suggesting that ETF’s raise trading costs and dry up research on individual stocks — effectively making the overall market dumber and less efficient. See, “The Downside of ETF’s”; The Wall Street Journal (Aug. 9, 2015).
As one of the study’s authors puts it: “You are more likely to converge on the truth if you have more people searching for it.”
Maybe (it depends on who the people are; see below).
But that hardly means individual investors should instead try to beat the market — or seek out expensive advisors who try to.
Active vs. Passive Investing
The overwhelming evidence is that, after subtracting fees, active investing lags passive investing — that is, stock-picking underperforms simply owning broad swaths of the overall market at the lowest possible cost, as ETF’s now allow investors to do.
Meanwhile, a tiny bump in trading costs is irrelevant for anyone subscribing to a long-term, “buy-and-hold” strategy, which is what most investors should be pursuing, anyways.
Finally, I’d argue that, while ETF’s may in fact shrink the number of actors setting prices, the “dropouts” switching to ETF’s are overwhelmingly drawn from the ranks of retail or individual investors.
Or what Wall Street famously refers to as the “dumb money.”
As the remaining, active investors become increasingly large and sophisticated, over time the market should be becoming smarter, not dumber.
Call it the “quality over quantity” efficient market theory.
Stock Price “Tug of Rope”
Which is not to say there are no drawbacks to ETF’s, at least for the market as a whole (vs. individual investors).
The main negative I see: greater volatility.
To understand why, imagine price discovery as a 24/7, global tug of rope between buyers and sellers.
The “rope” is more stable when there are millions of investors pulling on either side than when there are just a handful of especially brawny players.
P.S.: or if you prefer, imagine the lurches and momentum shifts when just two sumo wrestlers battle.