Michael Green and Hari P. Krishnan Tweeted about a paper they are working on that explores, oh boy here we go, whether index investing can grow so big as to trigger something called the Feller Condition that could cause the indexes to go to zero. 

This is dense stuff and I certainly don't have it dialed in but the simplest way that I can break this down is that if passive funds grow to too large versus the market capitalization of the stocks in the index, the resulting loss of price discovery associated with markets would create an instability that would take the index down to zero. The number is 83%. If index funds account for 83% of the market cap, all of this could happen and currently we're a little over 50% (if I am reading correctly) with an estimate of hitting 83% in 5-7 years. 

Again this is very theoretical so not all the dots will connect right away, not for me anyway. 

Jack Bogle used to get asked about whether index funds could grow too large. Obviously he was a huge believer, supporter, founding father of indexing but even he acknowledged there's something to this idea. From Google AI, "he warned that if everyone indexed, markets could become chaotic, though he believed this was unlikely to happen." Green and Krishnan are quantifying this chaos starting at 83%.

This doesn't mean companies fail although some would have to I think, they would still sell products and services, this is about horrible consequences to stock prices if there is no price discovery possible. 

My first question is whether the use of passive funds in active strategies is a mitigating factor. No reply from Green on Twitter but Copilot seemed to think that was relevant. It estimated that between 30-70% of index fund AUM was used for active strategies. Yes that is a very wide range but intuitively that it could be more than half doesn't seem correct. 

If you read the thread, you will see a lot of assumptions that I would simplistically equate to building a model that assumes linear returns. Testfol.io says the S&P 500 (simulated) has compounded at 9.61% over the last 140 years but in only two of those 140 was the S&P 500 up actually nine point something percent. 

The path to recovery or at least partial recovery, or slow recovery might be thought of as how markets snapped back from the flash crash in 2011 or the other one in 2016. Capital/bids came in the market eventually stabilized. Those were more about mechanical glitches though not a fundamental tenet of capitalism being removed from the equation so maybe it would take more than a couple of hours. 

In trying to figure out what to do and what would work in a prolonged crisis, trying to buy a couple hundred thousand shares of a few different stocks at a penny or two might end up paying off but be prepared to lose that money too. Commodity markets and managed futures could likely carry on, certain managed futures programs might short stocks all the way to zero depending on how it plays out. I would also look at relative value (BTAL would probably go up a lot), arbitrage and volatility harvesting. Currency is also relative value. Foreign equity markets don't have index saturation to the extent the US does but I could see where they go down a lot, not as much as US indexes, but be slower to recover because of a smaller correction mechanism. 

This might also morph into a credit event so I'd be careful with esoteric strategies like bank loans and as much as I love cat bonds, that market could unravel if insurance companies investment portfolios go to zero. 

What about real estate? Would this cause a deflationary spiral leading home prices to crater or would capital seek real estate as an alternative? I don't know.

Don't shoot the messenger. And I am sure my understanding up to this point is very incomplete. If you're a student of markets then this theory might fascinate you, it does me. It is just a theory that I think is worth understanding as far out there as it may be. 

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