Heading passively to the poorhouse
When I was a student at the University of Toulouse some 50 years ago, I took a number of classes on something that bothered my professor a great deal: that an action which is perfectly rational at the level of the individual can lead to catastrophe at the macro level. This is what logicians call the ‘fallacy of composition’.
The classic example is what happens when depositors take their cash out of a bank because they are worried it will fail. At the level of each individual, the decision makes perfect sense. But if everyone does it, the result is calamitous.
The same applies to indexing, but almost no one seems to understand what is going on. Capitalism fosters economic growth through the process of creative destruction. Businesses which have a high return on invested capital get access to capital; those that do not, starve and die in a ruthlessly Darwinian process. For active money managers, the name of the game is to buy the first lot and to sell the rest.
Getting this right is an extraordinarily difficult job, which leads to a wide range of results — just as in the real world of production. However, this process of trial and error allows the market to determine who is talented at choosing between good and bad investments.
In time, these talented types will grow too big and become less efficient, and new contenders will emerge to challenge the bloated old Tyrannosaurus rex.
So, in a normal competitive world, the wide dispersion of results in the active money management industry is a sign that capital is being allocated efficiently, because the goal is to allocate it according to the ROIC, and not in line with what the competition is doing.
But a world in which risk is defined as the divergence in investment returns relative to an index looks very different. As a money manager in such a world, your only goal will be to minimise your deviation from the benchmark. You will pay no attention to the ROIC of the underlying companies in your portfolio, and you will allocate capital solely according to the size of companies’ market capitalisation.
In this world, the dispersion of results will be very small. What’s more, since the allocation of new capital will be determined by what amounts to a socialist measure of risk, the growth rate of the economy will go down, and therefore so will returns in the stock market. As a result, over the long run even the laggards among active managers in a competitive world will tend to generate higher absolute returns than the best passive managers under the socialist system of indexation.
Why do I call passive investment a form of socialism? Quite simply because the target is equality of outcome, without any consideration of what effect this goal will have on growth. Sadly, even at the core of the capitalist system, ideas that favour equality of outcome over equality of opportunity increasingly prevail. It is not just the capital markets which are so afflicted. Our schools and colleges too are moving more and more towards equality of outcome.
As a result, our educational system has become what one well-known teacher in France described a few years ago in a best-selling book as “La Fabrique Du Cretin”. Just as standards of education collapse if all students are awarded AAA grades, so if all money managers get the same results, economic growth collapses. As Aristotle observed: the same cause produces the same effect.
So, when people ask me how to assess a manager, I always give the same answer. There are three levels of profitability in the capitalist system: • 1% real return if you take no risk (three-month T-bills); • 3% real return if you take only duration risk (government bonds);
• 6% real return if you are prepared to risk complete loss of capital (equities).
Choose your level of risk and assess your manager over five years.
When I used to manage money myself, I more or less aimed for a return of 4.5% with a 3% risk (not that I succeeded all the time). And when anyone asked me which index I wanted to be measured against, I always answered, “You choose. I will pay no attention”. The consultants did not like me one little bit.
If we want capitalism to return to its roots, we should decide once and for all that risk is defined as losing money, not deviation from a benchmark. Indexation will take us all to the poorhouse.
