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Stumbled upon this blog post a few days ago and was wondering what’s this community’s view to this particular critique of index investing? Spoilers:

What’s more, the price becomes a lot more driven by cash flows than fundamentals. If the two guys are doing active research and decide the stock is terrible, but the other 8 have incoming cash that they must invest in this stock because its part of the index and there was an inflow of say retirement investments, guess what - there’s more buying than selling! So even though fundamental research says the stock should go down, the stock goes up driven by blind demand.

and

While everyone’s more interested in how much they can sell the stock to someone else for, at the end of the chain somewhere someone must be getting revenue from the business, not the ‘greater fool’ to whom they can sell their shares. As investors, we don’t think about dividends much because we think about capital gains and the stock price is driven today by tons of factors not related to fundamentals - the fact that a brainless passive strategy is something we even consider talks about how crazy we’ve gotten with valuations and trading.

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    Yes and no. Wouldn’t a distorted market create more alpha for the active investors? Assuming 99% of the investors move to passive, this would create high inefficiencies in the market, and this would attract investors (e.g. hedge funds) who would be able to exploit them. A high alpha would then convince some investors to switch from passive to active again.

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      Agree. My test to re-evaluate my passive investment strategy is when active managers of mutual funds outperform the indexes 50% the time. According to the SPIVA scorecard, active fund managers outperform their respective indexes only 20% of the time. If the pros can’t find easy alpha, I don’t believe that I have a realistic chance.

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        In a hypothetical scenario where 99% of the investors become passive, the remaining 1% wouldn’t have enough oomph to move the market and correct the inefficiencies - price discovery would essentially be dead at that point. Or am I missing something?

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          I doubt the price can bubble up much past the theoretical threshold at which indexing becomes less efficient than active strategies, so that remains, indeed, a hypothetical scenario.

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        …guess what - there’s more buying than selling!

        Facepalm. There is exactly as much buying as there is selling, the price won’t move otherwise.