Around a third of U.S. equities are now owned by index funds or by institutions mimicking index funds and the percentage so owned is steadily rising – passively owned institutional equities recently overtook those actively managed. This is a negation of capitalism; if investors are not making rational decisions about their investments, the market’s sorting mechanism becomes broken. Furthermore, if individual investors buy not directly but through irresponsible institutions, the sorting mechanism is almost equally damaged. We need to return to an 18th century capitalism, in which capital allocation required and received deep thought on the part of the country gentleman allocator.
We were assured in the 1960s and 1970s, when the shift from individual capitalism to institutional capitalism was taking place, that it would all be for the best. Responsible well-trained institutional investors would take the place of individual investors who had neither the time nor the skills to monitor their investments properly. Through institutional investment managers, corporate top managers would be held to account and compelled to act in the best interests of shareholders, who would be represented by institutional investors with the voting power and specialist skills to monitor management’s policies and activities and propose changes where they were needed.
Like many such theories, this turned out to be bunkum. The bureaucrats managing the institutional money had far more in common with the bureaucrats managing large corporations than they did with the individuals whose money they were managing. Naturally, a confluence of sympathy rapidly became a confluence of interest. Institutional investors consistently underperformed the stock market indices, because the focus on institutional investor performance only resulted in the ousting of a bureaucrat-investor when he grossly underperformed the broad mass of investors. Hence sheep-like behavior, in which institutional investors buy what is fashionable and follow the herd, became almost universal, resulting in the over-funding of the popular (for example, electric automobiles) and the underfunding of the unfashionable (for example, emerging markets).
This market pathology became worse with the emergence of index funds, in which no investing intelligence was required, beyond the simple mimicking of an index that had been constructed by somebody else. (The construction of the indices required decisions to be made; the motivations for decisions on which companies are included in a given index have always been murky and may in some cases represent corruption and malfeasance.) Such funds can be guaranteed to match the market, subject only to a generally small tracking error – which since institutional investors and investment advisors consistently underperform the market, makes them attractive to retail investors seeking a decent return, ideally combined with sleep at night.
The problem is that, to the extent they become a substantial part of the market, indexed funds remove any pressure at all from the companies in which they invest, allowing the bloating of bonuses and the grotesque proliferation of stock options that increase investors’ costs, reduce their returns, and make corporate management not merely bureaucrats but overstuffed bureaucrats following leftist political fads without regard to their effect on their shareholders.
You may well ask how I exercise my rights of corporate governance as an individual shareholder with time to manage my modest portfolio. Well, I freely admit I do less than I possibly should (but then my holding is never more than about 0.001% of the outstanding shares, if that). I don’t check the criminal records of those put up for Directors but vote them all through indiscriminately. I never care a scrap which one of the Big Four auditors is selected to audit the accounts, and I am positively pleased if one of the next tier of substantial and perfectly respectable firms is chosen instead; it may be a sign of intelligence in management, and it at least takes us beyond the auditing oligopoly. Only if an auditor is chosen of whom I have never heard, or who was responsible for an auditing disaster in one of my other companies, may I vote against adopting them and at least dig a bit to find further information.
As an investor I become the scourge of management in several areas. One is woke DEI and environmental initiatives, which I vote against without fail, since I assume they are a sign that management is putting their left-wing views ahead of shareholder returns. I also always vote against share repurchase plans, if I am given the option; they are a ripoff of shareholders, and managements worldwide have shown themselves unfit to be trusted with them – they always buy at excessive prices, then are forced to issue shares at much lower prices in the next downturn. Finally, while I look at management compensation and vote in favor if it looks reasonable, I always without exception vote against stock option schemes, which I regard as rewarding management to dilute and destroy the interests of long-term shareholders.
I also watch the company news closely, and if I think management are cheating the shareholders or doing something stupid, I sell immediately. In that sense, I am an active shareholder, though generally if management appear sensible and honest, I do not panic in the inevitable share price downturns, because I recognize that things can go wrong without it being management’s fault, and they should be given time to come right again. I am probably more likely to sell if the market for the shares goes mad and drives their price up to ridiculous heights, because too expensive is too expensive, however good the company and its management.
A society in which almost all money is institutionally managed, or worse still not managed at all, is akin to the EU, in which essentially all opportunities for survival require working either for the government or for a behemoth corporation in which management is remote and employees have no control simply because of the laws of large numbers. When the EU says it wishes to be a “regulatory superpower” it is demanding the removal of agency from all private sector entities, except those that obey the ruling bureaucracy’s bidding.
Index funds and ownership through institutions that are in the pocket of behemoth companies has the same effect; there are almost no mechanisms by which the free market’s price signals can be brought to bear to improve economic decision making. If this corporatist, institutional, over-regulated capitalism is our future, we will in the long run be very little better off than dwellers in the old Soviet Union, with no President Reagan to show us the way out of eternal economic and political decline.
The solution is structural. As far as possible, we must revert to a society in which capital is controlled by leisured country gentlemen, only some of them genuinely wealthy, who hold shareholdings directly, not through institutions, and who have the time and inclination to inquire properly into the investments they hold. In this respect we have one enormous new help: AI models, which can be used to search through all available information on a company, report back on what is salient to our investment decision and, if we wish, recommend a course of action — sell, buy more, vote against the Directors, vote down the woke initiative or stock option scheme, etc. Naturally, each “country gentleman” investor will need to instruct the AI of their general views on such matters, their investment priorities, etc. but as a new generation arises for whom AI is a well-known tool, this should become no problem.
With AI’s assistance, individual investors with modest portfolios will have time to take their own investment decisions and vote their shares according to their investment and political preferences. AI will elevate the abilities of ordinary laymen at least to the level of the average institutional investor, without the conflicts of interest and pressures from corporate lobbyists from which such institutional investors inevitably suffer. It will no longer be necessary for the individual to buy an index fund or to entrust his affairs to a pernicious and expensive “advisor” – with the assistance of AI he will be able to make his own investment decisions, as did his ancestors. And if on occasion he wishes to attend a shareholders’ meeting and harass management, he will be able to do so remotely, without having to travel to rural Idaho, or wherever the company has arranged to hold the AGM to avoid its shareholders.
With people saving for their own retirements, they generally accumulate a substantial “pot” of investment capital by the time they are 55 or 60. By managing that pot themselves, they will bring the performance pressure on managers that is needed to make the capitalist system function properly. And over time, the dozy, often corrupt corporate behemoths with their overpaid managements will be out-competed by smaller and more intelligent companies, who no longer have to rely on their connections with government and the big institutions, but can attract capital directly from “country gentlemen” investors.
Eighteenth century capitalism was true capitalism, just as eighteenth-century country gentlemen were truly independent gentlemen, rendered so by their capital and fully equipped to play an active role in politics and society. With fewer people and greater wealth, we will all be able to approach the country gentleman ideal. We must structure our policies and lives to do so!
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(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.)