Post by realisedurgency on Mar 30, 2017 13:51:34 GMT 7
Fun article recommended to me when I asked "What is the problem with index funds?".
www.bloomberg.com/view/articles/2016-08-24/are-index-funds-communist
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Are Index Funds Communist?
Aug 24, 2016 2:05 PM EST
By
Matt Levine
I have been half-joking for a year and a half that maybe index funds should be illegal, but here is an almost entirely serious claim from Sanford C. Bernstein & Co. that they are worse than communism:
In a note titled "The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism," a team led by Head of Global Quantitative and European Equity Strategy Inigo Fraser-Jenkins, says that politicians and regulators need to be cognizant of the social case for active management in the investment industry.
"A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management," they write.
The basic idea is straightforward. The function of the capital markets is to allocate capital. Good companies' stock prices should go up, so they can raise money and expand. Bad companies should go bankrupt, so that their resources can be re-allocated to more productive purposes. Analysts should be constantly thinking about whether companies are over- or underpriced, so that they can buy the underpriced ones and sell the overpriced ones and keep capital flowing to its best possible uses.
But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function. Whatever the biggest company is today will remain the biggest company tomorrow, and capital will never be allocated from bad uses to good ones. Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
There is a lot of debate over whether this is actually how it works. For one thing, public stock markets are not really a mechanism for raising capital any more. But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation, because bad active investors will be driven out but good ones will remain. The passive investors can't influence relative prices, since they just buy the market portfolio, meaning that the fewer but better active investors will continue to make the capital allocation decisions. On this view, lower returns to active management are a sign that prices are more efficient and capital allocation is getting better.
Fraser-Jenkins et al. don't buy it. Their worry is that the growth in passive and quasi-passive products -- not just true index funds but "smart beta" funds that invest based on historically predictive factors -- has caused markets to become more correlated, as all the passive funds buy all the same stocks for the same reasons. They are not alone here; I like to quote Nevsky Capital's final investor letter:
In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical.
"By definition," write Fraser-Jenkins et al., "passive flows of capital, given that they seek to emulate or replicate what has already occurred must be backward looking." And a market that is more correlated, they argue, will do a worse job of allocating capital.
Anyway it is a fascinating and delightful note but now let's talk about something slightly different.
[...]
www.bloomberg.com/view/articles/2016-08-24/are-index-funds-communist
====
www.bloomberg.com/view/articles/2016-08-24/are-index-funds-communist
====
Are Index Funds Communist?
Aug 24, 2016 2:05 PM EST
By
Matt Levine
I have been half-joking for a year and a half that maybe index funds should be illegal, but here is an almost entirely serious claim from Sanford C. Bernstein & Co. that they are worse than communism:
In a note titled "The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism," a team led by Head of Global Quantitative and European Equity Strategy Inigo Fraser-Jenkins, says that politicians and regulators need to be cognizant of the social case for active management in the investment industry.
"A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management," they write.
The basic idea is straightforward. The function of the capital markets is to allocate capital. Good companies' stock prices should go up, so they can raise money and expand. Bad companies should go bankrupt, so that their resources can be re-allocated to more productive purposes. Analysts should be constantly thinking about whether companies are over- or underpriced, so that they can buy the underpriced ones and sell the overpriced ones and keep capital flowing to its best possible uses.
But when those thoughtful active analysts are replaced with passive index funds, the market stops serving that function. Whatever the biggest company is today will remain the biggest company tomorrow, and capital will never be allocated from bad uses to good ones. Indexing is cheaper, yes, but that's because active management has positive externalities, and if no one will pay for it, those benefits will disappear.
There is a lot of debate over whether this is actually how it works. For one thing, public stock markets are not really a mechanism for raising capital any more. But more fundamentally, there is an alternative view that the rise of passive investing will improve capital allocation, because bad active investors will be driven out but good ones will remain. The passive investors can't influence relative prices, since they just buy the market portfolio, meaning that the fewer but better active investors will continue to make the capital allocation decisions. On this view, lower returns to active management are a sign that prices are more efficient and capital allocation is getting better.
Fraser-Jenkins et al. don't buy it. Their worry is that the growth in passive and quasi-passive products -- not just true index funds but "smart beta" funds that invest based on historically predictive factors -- has caused markets to become more correlated, as all the passive funds buy all the same stocks for the same reasons. They are not alone here; I like to quote Nevsky Capital's final investor letter:
In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical.
"By definition," write Fraser-Jenkins et al., "passive flows of capital, given that they seek to emulate or replicate what has already occurred must be backward looking." And a market that is more correlated, they argue, will do a worse job of allocating capital.
Anyway it is a fascinating and delightful note but now let's talk about something slightly different.
[...]
www.bloomberg.com/view/articles/2016-08-24/are-index-funds-communist
====
