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.