August 31, 2016

Market Serfdom

Last week a stock strategist said passive investment is worse than Marxism.

That’s a way to get attention at risk of offending Marxists. It did (get attention). CNBC covered it. Jason Zweig did too in the Wall Street Journal weekend edition.

It’s relevant to investor relations because passive investment is sweeping the planet. We call it “the elephant in the room” because public companies sometimes seem paralyzed as mass capital inured to the sellside and results and road shows floods stocks.

The shift is huge. Mr. Zweig noted that in the past year $300 billion left active stock-picking portfolios as $400 billion flowed to indexes and exchange-traded funds.  Over the trailing decade, data from the Investment Company Institute show it’s trillion of dollars routing from active funds to passive vehicles.

You’ve seen the Betterment ads?  This “robo advisor” let’s investors precisely tailor exposure to various assets the same way architects use CAD systems to design structures.

At Sanford Bernstein in London, senior analyst Inigo Fraser-Jenkins released a report borrowing economist Friedrich Hayek’s phrasing called “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” I thought immediately of “The Princess Bride” as I’d never encountered anyone named Inigo save Montoya (Mandy Patinkin) in that film pursuing the six-fingered man.

Mr. Fraser-Jenkins, erstwhile head of quantitative strategy at Nomura, thinks the six-fingered threat from passive investment is its lack of judgment for committing capital.

Brilliant point. The equity capital market formed so people with money could take risks on businesses that might improve the human lot.  The brokers pooling capital then supported these endeavors with research so investors could make informed decisions.

Enter Blackrock and Vanguard. No, they’re not Trotsky and Lenin papered in currency. But they’re massive through efficiency, market rules, monetary policy (a system, not good judgment, makes it work), not prowess or wisdom.

Mr. Zweig says Vanguard reported owning 6% of all US shares. Assume Blackrock is about 7%. Combined, they’re 10-15% holders of everything. Dictators.

“What happens when everybody indexes?” John Bogle, Vanguard founder, said to Mr. Zweig.  “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.”

Mr. Bogle adds that we’re a long way from there.  Indexes would have to grow to 90% of the market from between 5-10% now. Oh? We’ll come back to this point to conclude.

When money is directed by a model to equities, there’s a shift in purpose from giving to taking.  How? Models take a piece. Investors commit.

The market first formed so entrepreneurs needing risk-taking capital could find it. A market priced around the willingness of investors to accept risks combined with the capacity of businesses to deliver results is the heartbeat of efficient capital-allocation.

Models don’t care about that relationship. They take, then leave. So invention happens on private equity, which removes from the American capital model its defining egalitarianism for the masses and instead concentrates it in ever fewer hands.

Your job just took on added importance, IR pros. You alone can track the impact and evolution of asset-allocation. Move beyond telling the story to measuring quantitative investment. It’s the job of IR to apprise executives and boards of important facts about the equity market.  It’s our market. No index will tell you something is amiss.

So The Elephant slouches toward serfdom.

In that shadow, any company considering itself a yield investment has Big Data looming tomorrow after the close. Most REITS will separate into a new industry classification from Financials.  That’s like a massive index-rebalance playing out over coming weeks.

Concluding, Mr. Bogle is wrong about how much bigger indexing can get before markets are paralyzed.  We’re now pushing limits. Indexes and ETFS are currently 32-33% of daily volume, combined (our measures). At 40% there will be no room for anything but machines. Stocks are needed to satisfy stock-pickers, fast traders, counterparties for derivatives and trading leverage. It’s already so finely balanced that most stocks don’t trade more than 200 shares at once.

You’re the frontline, IR. This is your fight. Report on it (we can help). Solution? Remove rules making averages the goal. Stock-picking would soar anew.  Else? Serfdom.

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