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David Nadig: The Complexities of Modern Markets - [Making Markets, EP.43]
Making Markets
Navigating the Challenges of Passive Investing in Modern Markets
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The passive investment strategy faces inherent challenges that can distort market dynamics. One major issue is the passivity that leads to flow susceptibility, where significant market changes occur due to large capital flows. Additionally, passive investing often overlooks nascent risks, which may arise unexpectedly from lesser-known market players, such as those in the Options Clearing Corporation. This lack of oversight can create conditions for market distortion. Furthermore, not all returns from passive strategies benefit shareholders directly; intermediaries within the investment ecosystem, such as market makers, often capitalize on these passive flows, leading to a redistribution of gains outside of shareholder returns. Investors should recognize that being a passive investor may forfeit opportunities, as evidenced by research demonstrating that stocks removed from major indices can perform exceptionally well post-exclusion. This suggests a fundamental flaw in current indexing methodologies, which prioritize maintaining a fixed number of components over evaluating intrinsic value. The broken nature of indexing extends to fixed income, where the structure hampers potential returns, creating disparities between accessible and non-accessible investment avenues. While it's essential for investors to seek out these discrepancies caused by passive strategies, caution is warranted against overgeneralizing the necessity of alternative investments like private equity, given the risks involved.
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