Sunday, October 2, 2016

Yet Another Contradiction Emerges In Market Capitalism: Investment Fund Management

It has become difficult to keep track of all the articles being written about market capitalism’s tendencies to work its way into some sort of calamity or dead end.  One of the latest involves the evolution of stock investment funds and their management.  An article by Charles Stein in Bloomberg Businessweek provides some necessary background.  The paper edition of the magazine used the title The Prof Who Made a Monkey of Wall Street.  For some reason, the online version was titled The Professor Who Was Right About Index Funds All Along

Stein introduces us to Burton Malkiel.

“In 1973, Malkiel, a Princeton professor, published the first version of his investment guide, A Random walk Down Wall Street. He wrote that “a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do just as well as one selected by the experts.” Since most investors can’t beat the market average over time, he argued, they’d be better off in some kind of low-fee fund that simply held all of the stocks on a widely followed index. Problem was, no such retail fund existed.”

It took only a few years for Vangard to step in and create such an investment option.  Money managers were generally dubious at the time.

“….Ned Johnson, then the head of Fidelity Investments, spoke for most money managers when he told the Boston Globe, ‘I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns’.”

Apparently, investors ultimately decided that “average” returns were better than casino type investing where the house’s take, money managers’ fees, insures the return is generally less than average.

“Things changed ... slowly, and then all at once. That first fund, the S&P 500-mimicking Vanguard 500 Index grew to a respectable $3 billion in assets in its first 20 years. But when it turned 40 years old on Aug. 31, it had more than $200 billion in assets, making it the third largest mutual fund, behind two other Vanguard index funds. From the end of 2007 through 2015—that is, since the financial crisis—domestic equity index funds saw a net inflow of investor money as active stockpickers grappled with outflows. About 34 percent of all fund assets are now in index trackers. Fidelity, though still a believer in the idea that managers can beat the markets, now advertises how inexpensive its own index funds are.”

As more money flows into index funds, a qualitative shift in desired investment outcomes occurs.  An “active” investor might feed money to a particular company in hopes that that firm will outdo all of its competitors, take away their business, and produce a dramatic increase in profit for itself.  Index funds, however, are “passive” investors.  They can charge low fees because they simply invest in the portfolio of companies that make up whatever index they are following.  This leads to a given fund having investments in many, if not all competitors in a given arena.  It is in the best interest of passive investors, therefore, for all companies to have stable, growing profits.  This is not the way capitalism is supposed to work.

The writer of the Free Exchange column in The Economist provided some thoughts on this issue in an article titled Stealth Socialism

“There is a contradiction at the heart of financial capitalism. The creative destruction that drives long-run growth depends on the picking of winners by bold, risk-taking capitalists. Yet the impressive (if not perfect) efficiency of markets means that trying to out-bet other investors is almost inevitably a losing proposition. Algorithmic punters trade away the tiniest of arbitrage opportunities near-instantaneously. Active investment strategies therefore amount to little more than a guessing game: one in which, over time, the losses from bad guesses eventually top the gains from good ones. Betting with the market—through broad index funds, for instance—is therefore a good way to maximise returns. Yet where does that leave capitalism, red in tooth and claw, and its need for bloody-minded nonconformists?”

“In America, since 2008, about $600 billion in holdings of actively managed mutual funds (which pick investments strategically) have been sold off, while $1 trillion has flowed into passive funds. So the passive funds now hold gargantuan ownership stakes in large, public firms. That makes for some awkward economics.”

“Research by Jan Fichtner, Eelke Heemskerk and Javier Garcia-Bernardo from the University of Amsterdam tracks the holdings of the “Big Three” asset managers: BlackRock, Vanguard and State Street. Treated as a single entity, they would now be the largest shareholder in just over 40% of listed American firms, which, adjusting for market capitalisation, account for nearly 80% of the market.”

If one believes that stock ownership provides at least the potential for determining corporate decisions, then these funds could have tremendous power over the national economy.  Such a level of influence by government would be considered socialism, thus the reference in the title.

“The revolution is here, but it was not the workers who seized ownership of the means of production; it was the asset managers.”

The author uses the airline industry to illustrate the danger of such a concentration of ownership by big investors.

“Institutional investors hold 77% of the shares of the companies providing services along the average airline route, for instance, and 44% of shares are controlled by just the top five investors. Adjusting measures of market concentration to take account of the control exercised by big asset managers suggests the industry is some ten times more concentrated than the level America’s Department of Justice considers indicative of market power. Fares are perhaps 3-5% higher than they would be if ownership of airlines were truly diffuse. In theory large asset-management firms might be quietly instructing the firms they own not to undercut rivals.”

If one is concerned by these developments, the options available are to limit investors’ access to the best mode of return on investment, or to limit major shareholders power to influence corporate decisions.  Neither of these is consistent with what market capitalism is supposed to be about.

The author holds out hope that the market will eventually recover on its own.

“Passive investment pays because active investors rush to price in new information. If passive investors took over the market entirely, unexploited opportunities would abound, active strategies would thrive and the passive-fund march would stall.”

However, it is best to hedge one’s confidence in the markets and consider some good-old-fashioned government intervention.

“As evidence of the side-effects of growth in passive funds accumulates, the best remedy might be for Washington to take its antitrust responsibilities more seriously.”

As for Malkiel, Stein tells us he still has money managers in his sights.

“Malkiel, 84, is now chief investment officer at Wealthfront, a Silicon Valley startup that’s become one of the leading robo-advisers—firms that use index funds to build automated investment plans for a fraction of the fees charged by traditional advisers. Just as index funds brought down the cost of investing, robo-advisers will bring down the cost of advice, says Malkiel, who spent 27 years on the Vanguard board. ‘The one thing I know is that the less I pay the purveyor, the more there will be left for me,’ he said.”

Capitalism isn’t what it was, nor is it yet what it will become.

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