"Outside the Box" is a newsletter by John Maudlin that provides reprints from various financial sources that give particularly useful insight or non-obvious thinking. This week's is a particularly good example from GaveKal's Brave New World investment book.
There is little doubt that indexation is the cheapest way of capturing the attractive long-term returns offered by the capitalistic system. From there, it would be easy to deduce that one should have part, if not all, of one's portfolio indexed. But this conclusion would be wrong, as indexation works on three basic premises, legitimate at the micro-economic level, but chaos inducing on a macro scale....
Indeed, the system can work only as long as active money managers attempt to do the job for which they are paid i.e. allocating capital according to what they perceive to be the future ROIC in the different investments which they consider at any given point in time. Most of them will fail, but the process of screening for future ROIC is vital for the well being of the capitalistic system. Winners emerge, losers collapse. In this creative destruction (or is it destructive creation?), capital is allocated efficiently through a constant system of trial and error.
To put it in another way: the active money managers (and their clients) support most of the costs; the indexers get most of the rewards. Without a doubt, this is what happened in the 1980's and 1990's. So why did it stop working? Easy. The active money managers, chastised by years of underperformance, were forced to become 'closet indexers'. In January 2000, some of our clients in the City got fired from their fund management job for refusing to own France Telecom or Nokia.
And this behavior brought the entire system down. The business of money management had become so big after a decade long bull market that it had been taken over by 'professional people', advised by consultants. Often, these management teams wanted to conserve, and not create. They were accountants, not entrepreneurs. The management of the firms (not money managers themselves anymore) attempted to reduce the unpredictability of the results of their money management teams by preventing them from taking risks. And risk was defined as a deviation from the index against which the money managers were measured (hence the introduction of 'risk controls', 'tracking errors' etc.).
...To put it succinctly, indexation became a victim of its own success for two reasons.
The first consequence of the move towards closet indexing was that money management evolved from being an exciting and intellectually stimulating business to a boring and mind-numbing number-crunching game...
The second, most harmful consequence is that capital started to be allocated according to size, rather than future returns on invested capital. Indeed, relevant indices are all, for the most part market weighted. In simple English - which we don't always understand but profess to speak - this means that investments get allocated to companies according to their stock market size. This allocation of capital according to size was tried out before, and, the last time we checked, the Soviet Union was not doing that well.
Indeed, in an ironic twist of history, in its hour of triumph over communism, capitalism devised a socialist way of allocating capital. All of a sudden, investors across the capitalist markets decided that it was better to invest in companies according to their size than according to their marginal returns on invested capital.
Read the whole thing, it isn't too much longer and fills out the argument nicely. I may have to get this book, it is a really nice idea. Suddenly I understand the reservations I've had about the growth in the ETF sector. If everyone is in indexes, forget about efficient market theories -- we've taken the zero-sum nature of trading to its logical conclusion.
And this is why mutual funds seem to be fairly dry and dying, and everyone is a hedge fund -- there is a lot of money to be made if everyone else is ignoring reality for the safety of an index. Indices mean consistent buying patterns to be exploited.
But how does Managed Money For The Rest of Us (ie, those without the networth to get into hedge funds) pull out of this trend? As covered, a mutual fund manager has lost the incentive system to deviate too far from conventional wisdom. The market has been trained to punish them when they do, if it isn't all positive. Can it be corrected, or are we setting up the end of managed money for savvy but not rich investors?
