Stairway to Heaven, or Highway to Hell?

I read an article in The Economist a few weeks ago about a concept called the Nash equilibrium, named after John Nash who won the Nobel Prize in Economic Sciences for his contribution to game theory. The article highlighted that the Nash equilibrium helped economists better understand how self-improving individuals could lead to self-harming crowds.

The first thing I thought of was the massive rise in “low-volatility” funds and ETF products. If the Nash Equilibrium was applied to these trends it would likely explain that as more and more investors rush into them, the more the promise of low volatility and peace of mind is a fairy tale.

The second thing I thought of was how index funds will eventually find themselves out of synch with the value of their underlying holdings all due to self-improving investors who appear to be acting in their best interest. That is, investing in the lowest fee products possible while often outperforming the majority of investors – otherwise known as an index fund. Why wouldn’t all self-improving investors use this as their solution to build their wealth?

This commentary will help explain why we believe index investing will work (until it doesn’t) and why it will stop working. To explain, here’s a quick story.
It’s all about insight

Let’s go back to the 1980s when index investing was an insignificant part of the market. Every time you bought or sold shares there was another investor on the other side of the transaction with an opinion on that same stock. Your ability to outperform was based on having insight about that stock that the other person didn’t. This was capitalism at its finest – two well-informed investors determining the price of each security.

Luckily for you, there were investors who weren’t always as well informed as you. Or if they were, their information was different:

  • Some would have good insight into the nextquarter, but not the next three years
  • Others were technical investors which meant they waited for a couple of squiggly lines to intersect before buying. As time passed you realized that not many of these guys became rich so assumed they were exploited by you and others like you
  • Some were momentum investors who tried to chase performance by buying when stocks were on the rise and selling on the decline. They always gave you a chance to sell your stocks for a higher price than you thought possible and buy at prices so low it seemed unfair
  • There were those who bought stocks based on a tip from a friend or co-worker without really knowing much about the business. More often than not they’d become donors to your financial health
  • Closet indexers started trending during the 90s. Buying stocks from them was kind of like
    stepping into a ring with a one-legged kick boxer. They’d try their best but there were unmistakable constraints imposed on them that prevented them from succeeding

Everyone described above was trying, but their approaches often caused a dislocation between the stock price and the value of the business. The last 30 years were hard but there were a lot of opportunities to exploit those investors who treated a stock as a piece of paper and not a business. Even if that only happened with 3% to 5% of the universe, it was all you needed to outperform the market.

A friendly animal with no teeth emerges

Over the last 10 years you noticed a new class of investor in the marketplace – the passive index investor. They didn’t care what stock they owned, as long as it was in the index. They were an odd bunch. It was all about exposure to the market for a low fee. They wanted to own every stock in the index which included the good, the bad and the not so pretty ones. That was the only criteria for purchase!

Effortless mediocrity

At first glimpse, it looked like passive investors were putting their faith in no one. They believed the markets were efficient. That there were enough smart people trying to determine the right price for
investments that there were few, if any, mispriced securities. You realized passive investors put their faith in people like you, those who still tried! This allowed them to buy and sell their stocks at fair value without lifting a finger for analysis, trusting in the homework of others. Not necessarily the qualities we want to teach our kids, but for those who chose to follow the path to effortless mediocrity it’s been a free lunch for a few decades.

The group with no questions

The inescapable reality of index investing is that these investors have decided there’s no point trying. That’s why it’s called “passive” investing. Passive investors no longer believe in the importance of
asking questions about the businesses they own.

Questions like:

  • Is it a good company?
  • Is it facing steady decline?
  • Is the accounting clean?
  • Are the earnings overstated?
  • Is management competent?
  • Am I buying it at a dumb price?

None of these questions mattered anymore!

Initially this group flew under the radar, but lately more and more of your transactions are with people who decided it isn’t worth trying! You notice the dislocation between price and value has become a more common occurrence, likely because you’re trading with people who are ignorant to price and value.

Many of your friends become index investors. It’s tempting to follow the herd into this passive investing utopia with low fees and market returns with zero effort. You recognize it would diminish your soul to simply aim for average, so you drive on. You realize that investors buy into the fallacy of the dumb money experiment because they take comfort in assuming that since they own the market, they’ll earn the same return as the market.

Since passive investors don’t ask questions and put their faith in other people to do their work for them, they don’t even bother to think about what the world would look like if passive investors dominated
the investing universe. For example, what will become of market returns if this indexing trend continues and dumb money represents over half the market?

Blind leading the blind

Let’s fast forward to a world where everyone but you has become an index investor. The calamity that
ensues would obviously occur well before only one active manager remains but sometimes it takes going
to an extreme to prove a point.

If there are no other active managers and the passive investors buy and hold, you’d have no trading partners. Passive investors would earn the market return because they aren’t trading. The market return would be determined by no one as there isn’t anybody reliable to set the price. There’s an old idiom about the blind leading the blind that comes to mind in this example.

Awash in dumb money

Luckily, this isn’t how things would pan out for you. Passive investors are rarely ever truly passive so they’d still trade because they won’t be able to escape feelings of fear and greed. And they’d probably reinvest their dividends, continue to save each year for retirement and put that savings into the market. Others would need money and have to sell their stocks. There would also be changes to the composition of the index which would force them to trade. Really only those who hold the index and never trade are truly passive. Each time a passive investor trades is an opportunity that can be exploited.

Let’s assume you know one stock really well. It’s called ABC Company, held in the index and you’ve determined the fair value is $20 per share.

When “investors” decide to add to their retirement savings through their low-fee index fund, they blindly
buy each representative holding in the index. Who determines the price if everyone but you is a passive investor? You’d be the price setter of ABC, but the prices of the remaining stocks in the index will be a crapshoot.

Initially you find it hard to believe that otherwise sophisticated people could be so careless with their money. They don’t ask about the value of a business so you get to determine the buy and sell price. Being the savvy active investor that you are, you’re going to set a price well above $20 when there is more
demand of ABC Company than supply. When there are more passive index sellers of ABC, you can set
your buy price all the way down to $1 if you’d like. The passive indexers have relied on you, and people
like you, for decades to set the fair price. They trust you implicitly! After all, it’s all about getting the proper “exposure” so they can get their “market return” even if it’s not good value.

Though they don’t think for themselves, they still have feelings and will feel the volatility. The proprietors of the index funds would make excuses for the volatility that would sound perfectly logical for most of the non-thinkers.

The profitable facilitator

The herd would look to you to set the price. You’re legally allowed to exploit them. The index manager’s
job is to match the composition of the index for a promised low fee. You’d be the happy facilitator.
Given the example above, the notion that increased index investing shrinks the opportunities for active
managers is absurd.

The fun part of exploitation

If you became well-educated in other names in the index, you’d be able to take advantage of passive investors more often. When they trade, you’d profit solely at their expense. You’d decide how much of their money to take on each trade. The growth of your wealth will be directly proportional to the volume of their trades. If they trade enough, they’d eventually have no money and you’d own the entire market capitalization of the stock market. At that point, would the returns of index funds match the return of the market?

This is what would happen if you were the last active manager. It probably wouldn’t get to that point though because as soon as passive investors started to get heavily exploited, some would start thinking for themselves. They’d cut and run well before this utopian exploitation point.

More dumb money = more opportunity

The example above assumed you were the only active manager. Even if there were two active managers left would you spend your time trying to profit at the expense of the other one? Of course not, you’d both exploit the dumb money. Same scenario if there were three or four active managers in a sea of indexers. With passive index funds purportedly representing 40% of some markets, the supply of dumb money is beginning to reach critical levels for exploitation.

This brings us back to how self-improving individuals can cause self-harming crowds. Each passive investor
thinks they’re doing what’s best for them – investing in a product with low fees while effortlessly achieving market returns. It works if only a minority uses this strategy because they can rely on the majority for proper price discovery. With fewer and fewer active managers determining fair prices, passive investors would increasingly be left having to buy and sell at something other than a fair price. The very people they relied upon when they were a minority would exploit them when they become a majority.

This commentary is intended for our investment partners. We’d appreciate if you’d refrain from forwarding it, as we’d like the momentum behind the dumb money movement to continue.

Geoff MacDonald
Portfolio Manager

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