Head­ing pas­sively to the poor­house

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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