Wednesday, March 30, 2016
Finance's Battle of the Somme
When I think of senseless waste, I think of the Battle of the Somme. Whole generations lost in
order to move a trench line forward by a metre or two. Zoom forward in time to the modern finance industry which, for many decades, has been marshaling starry-eyed recruits in search of excess returns. I worry that all their effort has been wasted because, like the Somme's trenches, the integrity of prices can't be advanced any further once large amounts of effort are already being expended in beating the market.
Fund managers who want to beat the market must find unique information in order to get a leg up on their competitors. But the supply of such information is limited so that at some point, prices include pretty much everything there is to know about a company. Any additional effort to hunt down information is wasteful from a society-wide perspective.
The recent-ish phenomena of indexing gives us a feel for how far beyond the 'waste point' we've gone. Rather than trying to beat the market, indexers randomly throw darts at stocks in order to harvest the average market return. Throwing darts is far cheaper than hiring Harvard grads to hunt down information. An indexer is betting that information has already had most of its value wrung out of it, so any effort to search for more doesn't justify the cost.
Say that the finance industry had only progressed a step beyond the waste point. If so, then as investors begin to adopt indexing, the bits of information they stop analyzing become unique again. The marginal return to hunting for information will rise above zero and those engaged in the activity should perform better. The popularity of indexing would quickly stall as money moves back into the beat-the-market game, pushing the value of information back to down to nil. We'd expect the size of the information hunting and indexing ecosystems to stay steady over time as shifts in the marginal value of information are quickly ironed out by movement from one group to the other.
The numbers show the opposite. Index investing has been growing for three decades and shows no sign of slowing. Managed funds have been shrinking since the mid-2000s. And rather than benefiting from the unparsed information that these indexers have left on the table, fund managers continue to lag the average market return. This suggests that we went FAR beyond the 'waste point.' After all, if the brain power that indexing is releasing from the information hunting process has not made information hunting more profitable, then there was way too many people engaged in the activity to begin with.
If markets are supposed to efficiently allocate resources, why did we go so far past the waste point? I suppose we can chalk it up to a combination of greed, hubris, cynicism, and naivete. Whatever the reason, the long trek beyond the waste point has been the financial equivalent of the Somme. For decades, all those investors who thought they could beat the market would have been better off allocating their resources elsewhere. And generations of young Wall Street whizzes could have been making useful things for the rest of us rather than engaging in the equivalent of converting a scorched desert into a scorched desert.
The good news is that the rise of indexed investing is steadily undoing this misallocation. Fund managers, traders, analysts, and advisers are currently being let go so that they can move into different sectors of finance or entirely different industries, a trend that could continue given the fact that non-indexers continue to underperform the market. And this will proceed down the line to financial journalists, financial economists, and all other workers who provide support to the information hunters. These people are alert, ambitious, mobile, and intelligent so the real world should become a more productive place.
As I was writing this, I thought of this post from David Glasner.