Capital Ideas

Yves Choueifaty has some interesting views. In Active managers can’t beat a benchmark, they are the benchmark today, he writes,

One aspect of this perception is true: the average active manager cannot beat a cap-weighted market benchmark. But that is where the truth ends.

The reason for that lack of outperformance does not stem from a lack of skill. This perception problem haunting active managers is rooted in a very simple, yet profound, misunderstanding of market benchmarks and how the market works.

The belief that active managers do not represent value is fuelled by misguided arguments made by passive managers, including pioneers of index investing who have been known to call active management “a loser’s game” and have argued most investors should favour passive investment and avoid active management.

He claims that this argument confuses the role of benchmarks,

By definition the average active manager cannot outperform the benchmark because the benchmark is determined by the sum of activity carried out by both active and passive managers. And because passive managers have no impact on the direction of the benchmark — they merely follow rather than drive its direction — it is, in fact, the sum of all the bets taken by active managers that define the benchmark.

It is obvious that it is impossible for the average active manager to outperform (or underperform) the average active manager. The benchmark is, after all, the output of all the activities carried out by active managers.

He adds the warning,

To assume a benchmark is an input to the investment process is a dangerous mistake. Yet this is exactly what passive management does. If investors decided to allocate all their capital to passive management, as advocates of the index-tracking world would recommend, the global economy would implode.

There is much more from him here, and an FT interview of him in May 2015.

In the interview, he proposed that passive portfolios are not neutral but in fact, dynamic asset allocators which place more money with overvalued stocks. To solve this problem, he set up an ‘anti-benchmark’ fund that tracks proprietary anti-benchmark indices. The idea behind the fund is that there is no universally agreed and formal measure of diversification, and hence, to create one such measure and use it to create an index of maximum diversification. According to the interview, it is an idea that takes no bets on style or valuation.

(At this point, I have no opinion on his maximum diversification idea, merely a wait and see position, although I have a suspicion that long term it might not fare so well because of the divergence in asset class performance and other factors – but I may be wrong. Having said that, I don’t know the engine under the bonnet of the fund.)

The main idea I wanted to bring to the forefront though, is how little we value good allocation of capital for the safety and prosperity of the markets as a whole. In fact, in one of my earliest posts in August 2014, Radioactive Cold Cream and Rational VolatilityI wrote,

Someday, we will look back at the way capital was allocated, the crude way we invested and estimated risk and thought, how naïve we were, how reckless. Just like in the early days when radioactive materials were discovered and used for cosmetics and novelty items.

The lack of understanding of flow, risk modeling, behavioural fallacies, decision making, information asymmetries and political interference contributed to inefficient capital allocation by all agents.

And quoted,

Underestimated risks contribute to financial bubbles with eventual crashes while overestimation of risks might cause inefficiency of financial resource allocations and a slowdown in economic growth, giving rise to periods of stagnation.

This was my conclusion in the post, Found and Lost, A Different Order of Magnitude for A Money Manager,

My view here, is that no doubt we will save costs if en masse we invest all our money in passive funds. However, if in the future, we have too few active managers in the game, we would all have to endure the consequences of inefficient businesses being granted capital and hence, we can only look forward to lower average returns. So this avenue also comes at a cost in the long run, a potentially much higher cost.

As important as it is to debate between the management costs of passive versus active, perhaps more focus should be on the bigger issue: how do we allocate capital efficiently to achieve long term quality returns on our investments for the benefit of all?

In What’s an Anti-Shepherd To Do, The Defense Against Herding, I pondered the antidote to herding behaviour in relation to information dispersion,

There are truly very limited cures once informational cascades have begun as the actions of the market agents are driven by information, both public and private, as well as individual incentives. Perhaps it is not so blasphemous after all to suggest that market prices might be in need of an externally induced chaos, but in a controlled manner. An agitation if you will, a strong enough incentive that a critical number would break ranks and reach individually unique valuations of the market. That however, is easier said than done.

A reminder in Marking the Markets, of when a market ceases to be a market,

Ultimately, the market should be a place for price discovery and value seeking…

The main asset of modern markets is the trust of the participants. For trust to build, the market participants must be able to believe that

  1. with enough effort, the truth can be discovered through the information obtained, and
  2. that once it is obtained, that information can impact prices through buying and (short-) selling.

It is when the information is available and the truth is known, but the avenues for action are closed off, that the market ceases to be a market, but rather, a capital trap. Once a market is viewed as a potential trap, the confidence in the market will be gone…

Finally, in the post Filters and the Financial System, a plea to evolve the market well,

In essence, there are many kinds of filters, but the idea is to let some things through and some things out. A filter does not even have to be in the form of market regulations, but also in the form of a good market that gets rid of bad ideas. A well-functioning financial system not only depends on the efficiency of flows, but also on an Efficient Market Selection, a set of filtering mechanisms used by both the markets and policy makers to guide the evolution of the markets towards efficiency.




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