It has become difficult to keep track of all the articles
being written about market capitalism’s tendencies to work its way into some
sort of calamity or dead end. One of the
latest involves the evolution of stock investment funds and their
management. An article by Charles Stein
in Bloomberg Businessweek provides
some necessary background. The paper
edition of the magazine used the title The Prof
Who Made a Monkey of Wall Street.
For some reason, the online version was titled The Professor Who Was Right About Index Funds All Along.
Stein introduces us to Burton Malkiel.
“In 1973, Malkiel, a Princeton
professor, published the first version of his investment guide, A Random walk
Down Wall Street. He wrote that “a blindfolded monkey throwing darts at the
stock listings could select a portfolio that would do just as well as one
selected by the experts.” Since most investors can’t beat the market average
over time, he argued, they’d be better off in some kind of low-fee fund that
simply held all of the stocks on a widely followed index. Problem was, no such
retail fund existed.”
It took only a few years for Vangard to step in and
create such an investment option. Money
managers were generally dubious at the time.
“….Ned Johnson, then the head of
Fidelity Investments, spoke for most money managers when he told the Boston
Globe, ‘I can’t believe that the great mass of investors are going to be
satisfied with an ultimate goal of just achieving average returns’.”
Apparently, investors ultimately decided that “average”
returns were better than casino type investing where the house’s take, money
managers’ fees, insures the return is generally less than average.
“Things changed ... slowly, and
then all at once. That first fund, the S&P 500-mimicking Vanguard 500 Index
grew to a respectable $3 billion in assets in its first 20 years. But when it
turned 40 years old on Aug. 31, it had more than $200 billion in assets, making
it the third largest mutual fund, behind two other Vanguard index funds. From
the end of 2007 through 2015—that is, since the financial crisis—domestic
equity index funds saw a net inflow of investor money as active stockpickers
grappled with outflows. About 34 percent of all fund assets are now in index
trackers. Fidelity, though still a believer in the idea that managers can beat
the markets, now advertises how inexpensive its own index funds are.”
As more money flows into index funds, a qualitative shift
in desired investment outcomes occurs.
An “active” investor might feed money to a particular company in hopes
that that firm will outdo all of its competitors, take away their business, and
produce a dramatic increase in profit for itself. Index funds, however, are “passive”
investors. They can charge low fees
because they simply invest in the portfolio of companies that make up whatever
index they are following. This leads to
a given fund having investments in many, if not all competitors in a given
arena. It is in the best interest of
passive investors, therefore, for all companies to have stable, growing
profits. This is not the way capitalism
is supposed to work.
The writer of the Free
Exchange column in The Economist
provided some thoughts on this issue in an article titled Stealth Socialism.
“There is a contradiction at the
heart of financial capitalism. The creative destruction that drives long-run
growth depends on the picking of winners by bold, risk-taking capitalists. Yet
the impressive (if not perfect) efficiency of markets means that trying to
out-bet other investors is almost inevitably a losing proposition. Algorithmic
punters trade away the tiniest of arbitrage opportunities near-instantaneously.
Active investment strategies therefore amount to little more than a guessing
game: one in which, over time, the losses from bad guesses eventually top the
gains from good ones. Betting with the market—through broad index funds, for
instance—is therefore a good way to maximise returns. Yet where does that leave
capitalism, red in tooth and claw, and its need for bloody-minded
nonconformists?”
“In America, since 2008, about
$600 billion in holdings of actively managed mutual funds (which pick
investments strategically) have been sold off, while $1 trillion has flowed
into passive funds. So the passive funds now hold gargantuan ownership stakes
in large, public firms. That makes for some awkward economics.”
“Research by Jan Fichtner, Eelke
Heemskerk and Javier Garcia-Bernardo from the University of Amsterdam tracks
the holdings of the “Big Three” asset managers: BlackRock, Vanguard and State
Street. Treated as a single entity, they would now be the largest shareholder
in just over 40% of listed American firms, which, adjusting for market
capitalisation, account for nearly 80% of the market.”
If one believes that stock ownership provides at least
the potential for determining corporate decisions, then these funds could have
tremendous power over the national economy.
Such a level of influence by government would be considered socialism,
thus the reference in the title.
“The revolution is here, but it
was not the workers who seized ownership of the means of production; it was the
asset managers.”
The author uses the airline industry to illustrate the danger
of such a concentration of ownership by big investors.
“Institutional investors hold
77% of the shares of the companies providing services along the average airline
route, for instance, and 44% of shares are controlled by just the top five
investors. Adjusting measures of market concentration to take account of the
control exercised by big asset managers suggests the industry is some ten times
more concentrated than the level America’s Department of Justice considers
indicative of market power. Fares are perhaps 3-5% higher than they would be if
ownership of airlines were truly diffuse. In theory large asset-management
firms might be quietly instructing the firms they own not to undercut rivals.”
If one is concerned by these developments, the options available
are to limit investors’ access to the best mode of return on investment, or to
limit major shareholders power to influence corporate decisions. Neither of these is consistent with what
market capitalism is supposed to be about.
The author holds out hope that the market will eventually
recover on its own.
“Passive investment pays because
active investors rush to price in new information. If passive investors took
over the market entirely, unexploited opportunities would abound, active
strategies would thrive and the passive-fund march would stall.”
However, it is best to hedge one’s confidence in the
markets and consider some good-old-fashioned government intervention.
“As evidence of the side-effects
of growth in passive funds accumulates, the best remedy might be for Washington
to take its antitrust responsibilities more seriously.”
As for Malkiel, Stein tells us he still has money
managers in his sights.
“Malkiel, 84, is now chief
investment officer at Wealthfront, a Silicon Valley startup that’s become one
of the leading robo-advisers—firms that use index funds to build automated
investment plans for a fraction of the fees charged by traditional advisers.
Just as index funds brought down the cost of investing, robo-advisers will
bring down the cost of advice, says Malkiel, who spent 27 years on the Vanguard
board. ‘The one thing I know is that the less I pay the purveyor, the more
there will be left for me,’ he said.”
Capitalism isn’t what it was, nor is it yet what it will
become.
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