The Bear’s Lair: Markets won’t work in an indexed world

Active stock investing is going increasingly out of fashion, as managers underperform their respective indexes and fiduciaries recommend indexed investment. I understand the rationale for this, but it leaves one massive question hanging: if the vast majority of investment becomes indexed, who is going to do the necessary work of capital allocation? Without that being done rationally, the capitalist system cannot function.

In the autumn of 1972, Professor Jay Light revealed to our Investment Management class the then new statistic that, while the average return on U.S. stocks in the period 1926-71 was 9.1%, the return on institutionally managed money in the same period was only 8.3%. My immediate response, mocked by the professor, was that somewhere there must be little old ladies cleaning up in the market. The anomaly remains true to this day; somewhere there are people beating the market, and it’s not professional investment managers.

Since that time, new participants have sprung up, notably hedge funds and fast traders. Hedge funds for a number of years showed an ability to beat the market averages, principally by finding hitherto neglected arbitrages and taking advantage of them. As for fast traders, they have essentially replaced the New York Stock Exchange specialists in their apparently essential function of trading based on insider knowledge of money flows. More recently, hedge funds have showed far less ability to outperform the markets, and an institutional rebellion is arising against their excessive fees and mediocre performance. This is healthy.

I am not a believer in the Efficient Markets Hypothesis, which states it is impossible to beat the market. I believe that it is indeed possible to beat the market, just very difficult, and that each new technique that becomes popularized for beating the market tends to get arbitraged away rather quickly, so becoming a loser. For example, “value investing” on the basis of the techniques outlined in Graham and Dodd’s 1940 classic “Security Analysis” failed miserably between 2011 and 2015, underperforming the market by more than 50%. Most likely, this was not a failure of Graham and Dodd’s classic techniques, but a failure of our economic management, which through ultra-foolish monetary policies have resulted in capital being hugely misallocated, causing a productivity crisis in all countries where “funny money” has reigned.

Thus great investors tend to be truly successful only while they are rather obscure, and that famous ones, like Warren Buffett since 1990 and Ray Dalio more recently, have great difficulty maintaining their track record.

We have here a “tragedy of the commons” applied to the most important market of all, the market for capital. For any individual investor, it makes more sense to buy indexed investment products. The fees are lower and the performance is generally better than that of actively managed money. Nevertheless, the market as a whole requires that a substantial body of investors devote a great deal of time and attention to analyzing stocks, attempting to determine which are undervalued and may benefit from a revaluation. It is becoming increasingly clear that the demand for those analytical investors in either investment banks or conventional fund management operations is dwindling, although hedge funds may for the moment provide an alternate source of employment.

Without those analytical investors, it is difficult to see how capital can be allocated. If everyone is trying to index, or relying on “momentum” or rumors to determine how to invest, then there is no rational process by which capital is allocated to the optimal investments. Without such intelligent allocation, it is difficult to see how capitalism can work. Even if you have an efficient price mechanism in the trading of goods and services, you have no price mechanism to determine which goods and services will be created.

This is essentially what seems to have happened over the last several years. The public market no longer contains the most exciting growth opportunities; instead these are traded between venture capital investors in the “unicorns” market for private companies valued at more than $1 billion.

This in itself is not necessarily disastrous. In the nineteenth century, the capital market was very illiquid for all but the smallest investments and few people bought stocks directly. Capital raising was thus undertaken by J.P. Morgan and other less scrupulous stock promoters, who undertook hard sell campaigns to move the shares. This was not especially rational either, and it resulted in a great deal of capital being wasted in fly-by-night promotions. Still at the top end of capitalism, where the big money was made and allocated, you could be confident that a grownup was in charge – Morgan himself.

There is no equivalent grownup in today’s venture capital sector. Companies like Uber can suck in round after round of venture capital without ever generating profitability or even a plausible business model that would justify their outrageous valuations. Theoretically, deep analysis is undertaken by venture capital companies, of the sort that would traditionally be undertaken by Wall Street analysts. In practice, since there is no way of measuring the work of venture capital analysts until years after the event, they can become caught up in fads, allowing valuations in bull markets to lose all contact with reality. The pressure on analysts to deliver what their top managements want is just as intense as it was in the corrupt bubble-era Wall Street of 1996-99.

It is possible to envisage a future in which all novel investment is carried out through venture capital companies, while Wall Street exists only for the established and dying companies. Investment on Wall Street would then be primarily indexed, and the only sorting effect would be through incessant takeover bids, on which occasions the index funds would have to decide which way to vote their shares (they would of course be advised by specialist proxy advisory firms, as now.) This bifurcated market might work, but it would be highly illiquid and the cost of capital would soar towards infinity every time the venture capital business entered one of its periodic busts.

Hedge funds cannot fill the gap; they are too short term oriented and their fees are too high. Given that their returns have now declined below that of the S&P 500 index, it is likely that institutional money will cease flowing into them, and they will shrink as a percentage of the capital employed.

An alternative locus for proper analysis of market forces, as the world becomes indexed, is that of university endowments. Pension funds are too regulated; if the rest of the market demands low-fee indexed investment products, they will be forced to comply. But university endowments, whether or not they actually employ the best and brightest analysts, certainly think they do. Accordingly, over time they may become research shops, doing high-level fundamental analysis on publicly listed companies and achieving modestly superior returns thereby.

That is a capital market that can make some sense. Instead of a universe of funds and institutions, all employing standard quality analysts and all therefore achieving slightly sub-par returns, you will have a world of indexed investment vehicles for the masses, whose returns deviate only marginally from those of the indices themselves. Then there will be a relatively few large university endowments, employing analysts who are truly the best in their field, and which are able to achieve the modestly superior returns that first principles suggest ought to be achievable with truly superior analysis.

In addition, there will be individual investors, some of them very rich and very intelligent, some of whom will also achieve modestly superior returns.

To balance these few investors with superior returns, there will be a mass of investors with committees and politically driven mandates, who will divest from sectors that have become unfashionable and make investment decisions either on a political basis or on the basis of bureaucratic infighting. These institutions (some of which will be university endowments who politicize their work) will form the necessary lumpen mass of sub-par investment returns necessary to balance the truly superior ones.

We who live in this capitalist economy will have cause to thank the university endowments and other few superior investors. Because only on the basis of their work is capital allocated intelligently, and not on the basis of randomness or political whim. Without them, the U.S. economy will become like that of Soviet Russia, ruled by Gosplan.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)