Compromising my values every day, for you.

Right now active investors and speculators are about as popular as genital herpes. This is unfortunate because I, Baruch, am one of them.

Examples of this anti-speculator animus are everywhere. Paul Krugman has long had in mind the creation of a special level of hell for “Masters of the Universe”, as he calls us, not kindly, in his excellent Return of Depression Economics. He thinks I’m “socially useless”, if not dangerous, and wants to have a special tax levied on me. Alice Schroeder, author of the latest Warren Buffett biography (how clever of her to realise that another biography of Warren Buffet was what the world needed!), has a very maximalist interpretation of securities law. She believes it’s impossible “to make a living on Wall Street without compromising your values,” and goes so far to suggest that when it comes to investing, “It’s hard to make a living legally.” Felix Salmon, sworn enemy of active investing, links to a largely incomprehensible blogpost from profs Fama and French which suggests investing in mutual funds is like buying an index fund but you pay more fees, ie it is a bad idea and thus “alpha-peddlers,” people like me, are snake oil salesmen. AllAboutAlpha (HT Abnormal) put it best last month in an apposite post about the emergence “of a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.”

Summing it all up, the charge sheet goes as follows: 

  • institutional investors like me are unable to deliver things we claim we are able to deliver, viz outperformance, alpha, whatever you want to call it.
  • As such my activities make no contribution to society and perform no useful function. In fact we are positively dangerous, and our widespread use of illegal information makes us unethical to boot.
  • Society would benefit much more if retirement savings were invested in index funds, which contain all the upside of equity investing but at lower cost, and meanwhile the rest of us who foolishly insist on trading for a living should be taxed. 

A lot of this stems from the traditional malice and envy of those who “review”  for those who “do”. We can’t do much about that. But there are intellectual assumptions behind some of it which are worthwhile tackling. In my opinion it all boils down to the hoary chestnut of the strength, or weakness, of the Efficient Market Hypothesis. The critics above share a belief in a strong form of EMH, which precludes investors from making returns which persist, and drives the less scrupulous to cheat in order to fulful their promises. Alice Schroeder puts it like this:

There is only so much alpha — that excess return above a baseline average — to be had in an efficient market. The incentive to create some artificial alpha one way or another is very high. Those who bend the rules successfully post good numbers, which adds to pressure on other Wall Streeters to push the gray boundaries of legal information flow.

What I do NOT propose to do here is get into the statistical nitty gritty of whether a strong or weak EMH is provable or improvable by positive hedge- or mutual fund returns, or their absence. I don’t quite know how to do it, and it’s deathly boring anyway. What we can do instead is weigh the intellectual coherence of the charge sheet. Is a financial system re-engineered to discourage speculation a good thing? Would it work? What would it be like?

This is what Baruch thinks: these objections to active investing are not at all coherent: firstly, we really don’t want a truly efficient market — it would be a disaster. Secondly, any restraint on speculation would endanger proper investment. The two are inextricably intertwined. Thirdly, index investing is not a truly scaleable strategy; if all of us do it, it will stop working. Let’s go through each of these points in turn.

To start, let’s do a thought experiment, and posit a maximally (impossibly) efficient market. Everyone knows everything; as soon as new information is available it is instantly disseminated and assimilated. Investors have near-perfect foresight, not in the sense of being able to tell the future, rather they know what things mean when they happen; what the emergence of a new competitor signifies for the earnings of a company, or the impact of new regulation, or an earthquake in Japan. Instant agreement! None of this debate between bulls and bears, no rumour-mongering, no publication of rival research biased by the interests of management or powerful shorts. No friction, either. No trading costs associated with exiting massive positions; any stake can be exited at will. Sounds great, huh?

No. It would be horrible. Stretches of utter boredom and then, suddenly, patches of incredible volatility. Previously healthy companies, and their ecosystems, would disappear overnight, as new technologies that invalidated their business model were invented and discounted. New multi-billion capitalisations would instantly appear in their place. Stocks wouldn’t actually go up any more, as even inflation rates would most likely be properly discounted too. So there wouldn’t be any point in actually investing.

There would be no time to react, for alternative strategies to take effect. Unforseen events would have incredible implications far beyond government and management’s ability to plan, and cascading logical implications, tearing through valuations and asset prices, would be bewildering to the general public, who would not be blessed with the intellectual gifts bestowed by fortune on financial market participants. They’d live in terror of losing their jobs and savings. There’d only be the need for a few actual investors anyway, as all of of them would be in agreement at every point; there’d just be a couple of of them. In fact it would be those investors who would appear like gods, who would seem to have the power of prosperity or poverty over the rest of us. A most unpleasant prospect.

OK, strong EMH-ers would say. This is a ridiculous reduction to absurdity. But stressing a proposition to its maximum does reveal uncomfortable truths about it. Let’s try another tack, take the strength of the hypothesis down another notch; even a strong but imperfect EMH would still be undesirable. There would be less incentive to provide liquidity, which would weaken markets’ ability to allocate resources. This would make them more, not less, volatile. It’s here where we dispose of the trading tax.

We won’t go into whether such a tax is workable or not, but rather ask whether would do what it is supposed to do: encourage investment, raise money, and discourage speculation. It would not. The first and last goals are in conflict, due to a commonplace misunderstanding of  how portfolio management works.  it is widely believed that “investment”, ie buying for the long term, is A Good Thing. Selling is normally associated with “speculation”. Both of these are Bad Things. Where this comes unstuck is that if the cost of capital in a society is more than zero, portfolios will be limited in size. If so, buying anything will entail selling something else. If I can’t sell it, or must take a haircut in doing so, I am less likely to buy. Think also in the context of a rational market, the underpinning of strong EMH; when a long term “investor” exits something to allocate resources to the New Thing and somehow benefit society by doing so, what bloody fool is going to take the other side? Not someone with a long term view, that’s for sure. No, it’ll be a (boo hiss) top-hatted mustache twirling “Speculator”, eager to make a scalp, no doubt from the removal of the overhang on the stock.

I don’t think enough people have thought this one through. A trading tax is not consistent with strong EMH. It would have the opposite effect of what its proponents desire, and create less stable markets less safe for investment. If a government needs to raise money, much better to tax profits, which is in fact exactly what we do right now.

Finally, what about the indexers? Don’t they have a point? Fees and stuff kill returns. Isn’t index fund investing a more sustainable and cheaper strategy for the rest of mankind to follow?

Well, yes and no. Index investing is by its nature parasitical; it is a free-rider strategy that piggybacks on the ability of active market participants to allocate resources, effectively index points, to companies that produce more benefit to society. As such it is not a sustainable strategy, for if too many people do it, passive movements would start to crowd out the signals from active participants. Let’s reduce to absurdity again and assume indexing becomes the predominant and eventually only investment style: markets would slow down, freeze, and ultimately cease to function. Underneath the major index weights, new startups would only be able to capitalise on their innovation by being bought by larger ones (why the big ones would bother if it meant nothing to their share prices is another mattter). Eventually innovation would slow down too; the world would be duller, lifeless, the opposite of the distopia of the extreme EMH above, but probably equally horrible.

In the real world, however, what would be more likely to happen is that active investing strategies would become less and less crowded and as such able to make more and more positive return,  to indeed, earn their fees. Of course, then Fama and French would write another equally opaque piece of statistical jibber-jabber to prove active investing was great and Felix would suggest we all pile into mutual funds. Wouldn’t they? In either case, indexing is probably a less scaleable strategy and can only prosper if sufficiently small numbers of investors do it.

Summing up, the charge sheet against Baruch and his colleagues is NOT intellectually coherent. It’s proponents would deliver an unstable system, prone to breakdown, that fails to allocate resources efficiently. It’s clear we are not in fact “socially useless”; on the contrary, results of thought experiments where we are absent show our value, and dare I say, partially justify our inflated salaries.

I’ve made this point before and I’ll make it again: financial markets have mostly evolved. No-one designed them. They are typical spontaneous orders. If we want to retain their price setting mechanisms for the good of society we can only meddle in their workings so far. Otherwise we may be in danger of breaking them. It’s no accident we’ve ended up like this: the most, liquid, sustainable and scaleable market model is what we have now: millions of active investors vehemently disagreeing with each other, trading off a myriad of time frames. It’s not pretty. Very often it produces results we find unpleasant and unjust, and Baruch would be the first to admit that many of its most successful practitioners are highly unattractive people. But it is very likely that if we were to stop them from doing what they do, or try to restrain them inappropriately, in many cases you’ll be doing more harm to a functioning economy than good.


11 thoughts on “Compromising my values every day, for you.”

  1. “It’s clear we are not in fact “socially useless”; on the contrary, results of thought experiments where we are absent show our value, and dare I say, partially justify our inflated salaries.”

    I’m not a hater, I’m a professional money manager too and I completely agree with your argument as far as it goes, – but the problem that everyone outside finance has with us is right there in the word ‘partially’.

  2. This is well put indeed, but it suffers the same problem of Krugman/Schroeder/Salmon et al., it fights a narrative with another. What we need to go further is simple models to study what to salvage from EMH, what to do about indexing, how to value properly companies and the market. Efforts are made, but we remain in a world of darkness, chiefly guided by intuition (quants notwithstanding).

  3. Among my fellow plebs, EMH seems to resonate greatly with just world adherents and those of a more religious bent. Perhaps professional gangsters and atheists make for better investors?

  4. I don’t really think you understand where the proponents of a trading tax are coming from. I think most of them would agree with the following points:

    – The financial sector has gotten bigger than it needs to be. The economy would function just as well with fewer traders, freeing up valuable talent to more useful pursuits.
    – Banking is a boring business, or it ought to be.
    – Innovation in finance is almost always wrong. It’s usually either a new way to hide losses (barely distinguishable from theft) or a new way to transfer risk (which is how statisticians steal).
    – Despite what is claimed in your post, there’s nothing wrong with selling; every sale is also a purchase. The objection is to constant, meaningless churn that produces fees for bankers and nothing else.
    – Too much liquidity in a market is problematic. In less liquid markets, shareholders act more like owners. In more liquid markets, shareholders act more like gamblers.

    1. Point by point response:

      1. While I don’t necessarily disagree with the larger point, the financial sector is not just traders and investment bankers; on the contrary, most employees in the financial sector are neither, and are paid mere fractions thereof.

      2. Not even worth responding to.

      3. I 100% disagree. Innovation in finance is usually good, but just like any other tool, when it is misused, abused, misunderstood, misappropriated, etc, the results can be catastrophic. In properly trained hands, for a job requiring it, a Jackhammer is a fantastic innovation, however, in the hands of a child for a task more suited to a regular hammer, the results could be catastrophic.

      4. I don’t think the post said there was anything wrong with selling – but many people associate selling (i.e. profit taking) with speculation – and thus its perceived as bad, when it actually is necessary, as you’ve acknowledged.

      5. Liquidity is necessary as investors lives are not static, and a financial plan established at Tzero may evolve/devolve in an infinite number of pathways over the course of that investor’s lifetime. Also, most investors don’t have the time, knowledge, inclination, etc to act like owners; they want all the economic exposure of owning shares (or whatever asset) of what they expect to be a growing firm without any of the responsibility. No one should expect to have their cake and eat it too, especially without astounding effort/knowledge.

  5. Baruch

    Coupla’ points –

    First, while all specs are active investors, not all active investors are ‘specs’ per-se. Sure, one could claim that in extremis everyone is a spec for Popperian lack of certainty (except perhaps in Raj’s world, and even there deals fall through, numbers change as some of a co’s “beat” is put into the kitty at the last second for a rainy day), though I reckon that is too literal, and those active and informed investors bearing reasonable risks for reasonable returns are distinct from the latter.

    Second, I wonder whether you’ve overemphasized the assault on active investing. for as the previous comment suggests, the ire is upon justifying absolute and relative compensation structures and the quite legitimate philosophical questions regarding how an essentially fixed-pie is divided outside the prevailing letter of the rules of the game that allows for asymmetrical risk taking and reward. The ire naturally extends to executive comp, where our ilk are again accused of culpability (somewhat accurately) from reasonable critics suggesting our collective short-termism (highlighted by A. Rappaport) fosters crony capitalism than encourages and reinforces most of the absurdities of executive comp in both absolute and relative terms.

    Third, (and related), is that the ire not so much directed at the disabused spec generally (who arguably is a chump by most historical accounts and a welcome player at the table), nor the thoughtful active investor, but at the leveraged spec in particular. “Is there any other kind?” , one might ask (like Col Jessop did in “A Few Good Men”)? Of course there are as one needn’t lever to spec, but the systemic issues that have caught he attention of more saintly critics are real and therefore it is right to examine the wisdom of such liberties since as a society we throttle freedoms for far smaller civic transgressions.

    Fourth, the systemic consequences of leveraged spec are/were meaningfully large and almost blew it (and us) all up. I would would call this – i.e. the negative externalities that result from herding combined with leverage, a toxic combination particularly in divergent markets and so the cocktail IS a matter of public concern – less so at your micro-level than the macro level.

    Fifth, with regards to a transaction tax, I personally do not think it wrong to view the very very short term transaction in the pejorative – either as an economist, or as an armchair philosopher, or social critic – particularly in relation to the long-term risk-taker-bearer. The shorter the frame, the less bearing on longer-term efficiency. It seems to me that if short term predators eat the long-term risk-bearers lunch, the long-term risk bearers will starve (and this I believe is bad). At least in a zero-sum game between ultimate risk-bearers, the fittest (or luckiest) survives, but in a highly intermediated market (say by HFT) both long and short risk bearers can be killed and then your precious allocative effciency goes the way of the headless chicken (if its not already running amok as such).

    Finally, you suggest financial markets evolved and I read into your words (perhaps mistakenly) that you imbue this happenstance with virtue. Indeed the NYSE is a great example of how simple incremental evolution yields monstrous results since it evolved within a flawed quasi-monopoly structure bent upon serving certain interests. You couldn’t design a more inefficient, less transparent, more self-serving system than the NYSE. By extensions, cancer and viruses evolved too. And we spend much time and effort battling against them – and we’ve some success to speak of. I take your point we don’t want to kill the patient, but few would argue conceptually for trying to battle it. Perhaps it is a useful to better-define the body from the cancer ?

    1. Jay, Cassandra, all good points (actually that’s only mostly true, you’re both wrong) and the reason I won’t reply more here is that your objections deserve the fuller rebuttal of a proper post, which I am working on now.

      As a taster, however, I would say that evolved complex have a tendency to more virtue than designed ones, and liquid markets — in the sense of depth, not necessarily in terms of money being free — are mostly a good.

  6. um, that was “evolved complex SYSTEMS” being better than designed complex systems.


  7. Baruch, I would suggest you neglected to add Nassim Taleb through his seemingly long forgotten “Fooled by Randomness” as one of the critics.

    My personal point of view based on Taleb’s point is that any fund manager that “comfortably” beats the market over the 10 year period 2008-2018 will probably deserve every penny of their bonus, assuming its done legally.

    I do remain highly sceptical that many will be able to do this without the flood of credit fueled growth experienced over the past 30 years.

    I’m sure you would agree that we are entering into very different era and yesterday’s investing “heroes” are unlikely to be adapatable to what lies ahead. Good luck to those that are proven to be better than the rest, but the measure cannot be of short duration.

    A few years ago I predicted that the bottom of the market will be when Warren Buffet is truly humbled by “the market” and I still believe its coming.

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