The Irony and Internal Contradiction of Passive Investment Management
My relatively snarky post on hedge fund fees and passive management got a lot of response, including a few of challenging emails from friends and acquaintances. So I wanted to cover a few followups here.
One of the interesting features of passive investment management is that it doesn't work if everyone does it. I vaguely remember there is some name for this in the game theory world but I can't for the life of me remember. Anyway, passive investment is based on the theory that the market for financial products is relatively transparent and efficient. While one stock will certainly perform better than another, it is almost impossible (or at least really expensive) in a mostly-efficient market for a regular investor, or even an average fund manager, to parse this out. As a result, high fees or expenses one might incur to find these opportunities generally don't pay for themselves, and it is better to just invest in a broad basket of securities and accept the average market return.
But note that this is predicated on the assumption that someone, somewhere is actively managing. Someone must be looking for good stocks and bad stocks and buying the former and selling the latter. Without these folks actively managing, it would not be an efficient market. [I am reminded at this point of the old joke about a man walking down the street with an economist. The economist steps right over a $100 bill on the sidewalk without stopping. The man asks the economist, "why didn't you stop and pick up that money?" and the economist answers, "in an efficient market it can't really be there."]
I remember a while back reading economic research about shopping. What percentage of customers have to be active price-shoppers to make a market efficient? I personally don't price shop for the small stuff. If I need a bunch of cheap bulk stuff, I just run to Wal-Mart or Costco and buy it with confidence I am getting a pretty good price. But why can I do that? Because I trust these large corporations to honor their promise for low prices? Hah! No way. What I trust is that there are people who clip coupons and price every dang item to the penny, and it is these folks who keep Costco and Walmart honest. Government interventionists like to talk about the free rider problem all the time, but most all of us are free riders on these hard core shoppers.
The same is true with us passive investors. I like to get snarky about the fees certain active investors charge, but I am still dependent on their work. And I don't particularly doubt that there are hedge funds and private equity firms that make consistently above market returns, but I do think they are a minority. I would equate it to max-contract players in the NBA. No one doubts Lebron James merits a max contract -- any of the teams in the NBA would sign that deal in five seconds. But a max deal for, say, Chandler Parsons? Joakim Noah? The problem with hedge funds is that the few of these folks who merit the two and twenty max contract have very likely been closed to new investors for years, in the same way it is impossible to get LeBron James to play for Memphis. It is frustrating for me to see public and private institutions chasing yield and continuing to pay 2 and 20 to folks with an unproven algorithm and a marketing plan. If I am going to pay 2 and 20, its more likely to be to someone in private equity or an LBO fund who is doing more than stock picking. That's because I do think that stocks are generally well-valued on the market based on their current management, investment plans, culture, etc. But they may contain opportunities for smart people who can come in and, for example, apply different management and culture and strategy to the people and assets. A box that is half Kale and half candy corns might not sell for a good price because no one wants the combination, so value can be created splitting it up.
A couple of other thoughts that came up in discussions since yesterday:
- I am willing to believe that passive investing looks so good vis a vis active investing because central banks have inflated assets and compressed volatility. If all the boats are rising with the tide of state actions that are raising the tide, then one is less likely to be fussy about which boat he is on. What's the point of value investing when the market treats stocks as commodities? But I can certainly see that in markets like the late 70's or pre-market-boom early 80's that stock pickers might have had more room to differentiate themselves.
- I am also willing to concede that passive investing may turn out to be a terrible trend for corporate governance. If all your shareholders are just holding your stock as part of a basket of 500 stocks, who is going to hold you accountable? It is very awkward for a Vanguard agitate for changes in a company, even when they might be the largest single shareholder. Also, ironically, passive investing may be opening the door for single lone wolf activist investors to impose their will on companies, sometimes to the other shareholders' detriment. If one person with 5% cares a lot and the other 95% are passive, that one person might be able to raise a lot of hell.
As a final note, I am a screaming hypocrite on the whole passive investing thing, since with most of my net worth I am the ultimate in active investors. I have most of my savings in one company, the one I run.
