Maths and the facts debunk the myth of parasitic index investors
• Active investors as a group also replicate the market, at a price that exceeds the likely reward
Chris Veegh of 10X Investments took exception to last Tuesday’s Bottom Line column, which accused passive investors of piggy-backing on active investors. He wasn’t the only one. But Veegh wrote a piece that ought to be read by all sides of the debate.
“If you have the facts on your side, pound the facts. If you have the law on your side, pound the law. If neither are on your side, pound the table.” It’s a dictum that the active lobby has taken to heart, says Veegh, before asking: “Why invest passively?”
His answer: this inconvenient question highlights the flaws in the fund manager model. It has to do with the zero-sum nature of active investing, the less-than-even chance of delivering a market-beating return after fees. It also speaks to our inability to reliably predict future winners and the corrosive impact of the high fees charged by fund managers.
This is the stuff of the “active versus passive” debate. But how much debate can there be if both the arithmetic (the “law”) and empirical evidence (the “facts”) overwhelmingly support indexing? Hence the appeal to emotions rather than logic.
Invariably, this appeal subjects index investors to fear and shame. Fear because market calamity awaits (always!) and they will be caught like deer in the headlights, while their active peers daintily avoid the impending carnage; shame because they are deemed free riders.
Much is made of the “social purpose” of active management and the noble pursuit of price discovery. There is no argument that it is a valuable good. Markets require an element of active trading and fundamental research to retain their informational efficiency.
But how many people seeking social purpose choose to be investment managers? This field largely attracts those at the other end of the altruism spectrum, those driven by self-interest. They are not following a higher purpose to deliver efficient markets, but a desire to maximise assets, revenues, remuneration and owner wealth.
Price discovery is just a byproduct. In any event, noting how markets react instantly to news, there is more instinct than intellect in the process. Prices are primarily set by traders, not fundamental analysis.
The oft-expressed concern — how would markets function if everyone indexed? — refers to an unrealistic scenario. As soon as the market’s pricing efficiency was impaired, it would demand active investing. And even in efficient markets there will always be those who think they can beat the collective insight of all other investors.
The more relevant issues are: what level of indexing can the market sustain before price discovery is impaired? And who should pay for price discovery?
Charles Ellis, writing in the Financial Analyst Journal in 2014, addressed the first issue. Based on the New York Stock Exchange’s daily market turnover (more than 100% of listed shares) and the average 5% annual turnover of index funds, he calculated that even if 80% of assets were indexed, active managers would still account for 90% of trading volume. The point is that, even with a lot less active management, markets will be informationally efficient.
Given that indexing is essentially a “buy and hold” strategy, with minimal trading, the second question answers itself.
The contention that the starting valuation is the most important characteristic of any investment perpetuates the myth that active fund managers build their clients’ wealth through astute trading. That may be so in the short term, but short-term investing is an oxymoron or a euphemism for speculating.
For real investing – which “on thorough analysis, promises safety of principal and a satisfactory return”, says Ben Graham – we must talk long term.
And in the long term, the market’s return depends almost entirely on dividends paid and growth in earnings. Over a 40year savings life, this will provide more than 95% of total gain. Graham’s other famous quote that the market is a voting machine in the short term and a weighing machine in the long term refers.
It is senseless for investors to pay for daily pricing of companies’ future prospects if returns depend almost entirely on the actual performance delivered by those companies. They should pay only to access those gains, and index funds facilitate this at low cost. If they held the underlying shares privately, no one would think to impose a moral obligation to support the market’s daily price-setting either.
Then there is fear. Index funds are supposedly more at risk of poor returns because they have higher allocation to expensive shares. The intimation is that active managers sell “expensive” shares, buy “cheap” ones and, once their value is realised, deliver an above-average return while index investors remain at the market’s mercy.
If such obvious mispricing exists, it hardly endorses the industry’s price discovery. But this claim also ignores a fundamental truth: there is a fund manager on the other side of every trade doing the opposite.
If active and passive investors together own the market (as they must), and passive investors replicate the market, it follows that active investors as a group also replicate the market. Both styles are thus equally exposed to cheap and expensive shares. There is no way around this logic. And as active managers do most trading, they are swapping the cheap and expensive shares among themselves.
Trading shuffles the deck. It is the same set of shares, just in different hands. This shuffling of ownership adds no value in aggregate, yet costs investors billions of rand a year in excess fees, for the odd chance of a winning hand.
This cost should be borne by those who rely on daily price discovery for their return — that is, speculators. Paying active management fees should be their ante in the gamble for outsized profits.
Everyone else should be reminded that the price of active management exceeds the likely reward. And that the high fees do not reflect the cost of price discovery, but rather the industry’s refusal to share scale benefits with investors, and instead excessively reward employees and owners.
In truth, it is active managers who neglect their social obligation to give investors their fair share of return. It is they who live parasitically, feeding ravenously off others’ savings, even after poor performance.
That voracity will not be suppressed, so there is no chance that indexing will ever kill the active management “host”. But cutting it down to size, as it is likely to do, will go a long way towards curtailing this gratuitous transfer of wealth.
IT IS ACTIVE MANAGERS WHO LIVE PARASITICALLY, FEEDING OFF OTHERS’ SAVINGS, EVEN AFTER POOR PERFORMANCE