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.


  1. We went far past the waste point due to a missing market. We should be able to trade financial indices directly (as described in Robert Shiller 1993) without investing in the underlying stocks, as we do now. Investment companies who think that they can generate alpha should be expected to fund themselves by shorting the index i.e. by selling macro securities. Those who consistently fail to generate alpha will burn up their capital.

    Index funds do help us approximate the missing market, and that is good, but they create the free-riding problem that you noted in your previous post on slow and fast money.

    1. Do you have a link for Shiller 1993?

    2. Here is the Google Books page for Shiller's 1993 book on Macro Markets

      Shiller focuses on the technical details of producing these securities, but his advocacy for them doesn't really spell out the potential benefits of such markets. We can do that here in posts like this on the bloated investment management industry, or your previous one that points out undesirable side effects of passive investing in stocks by indexers.

    3. Thanks, will check it out. I've always liked Shiller, he's had some wild & great ideas for novel investment products.

  2. Surely there was a great deal waste in the Somme, but war is full of coerced agents, and coerced agents tend not to act in their best interest. Stock Analysts and Fund Advisors are (I believe) acting in their best interest, so the idea that they'd be doing wasteful work seems strange.

    You say: "As investors begin to adopt indexing, the bits of information they stop analyzing become unique again." "Unique" seems like a strange word choice here, but I'm not sure what is better. Maybe we could describe bits of information that are known to few as "asymmetric."

    1. Yep, all analogies break down at some point. I think this one works best if we think of the waste that is being created from the perspective of society.

      Asymmetric works for me.

  3. JP, you've got it all wrong. *The smart guys are there to create inefficient markets*. Don't for a second think that smart guys are there to create fair markets. You think that pays?!

    A lot of smart guys have been working and persuading very hard in all avenues of government, finance and industry to create inefficiencies: massive bubbles everywhere -- LBOs, fiber, internet, housing, all the way to hamburgers and burritos. These bubbles have employed people, expanded the surveillance-and-debt state's power faster than legal constraints, and created world-spanning technologies and industries. The consequences will live on for decades. Massive bubbles created massive waste, but formed real power and capital investment with few legal constraints and little inflation. They're that smart, JP.

    In short, it takes a lot of smart guys to keep your "first-world" no-inflation high-leverage bubble-blowing markets blessedly inefficient.

    Nobody wants EMH. We want cake, and lots of it. Dumb markets are fair and efficient. Nobody in the US wants that.

    (From Margin Call, a good movie.)

    Jesus, Seth. Listen, if you really wanna do this with your life you have to believe you're necessary and you are.

    People wanna live like this in their cars and big fuckin' houses they can't even pay for, then you're necessary. The only reason that they all get to continue living like kings is cause we got our fingers on the scales in their favor.

    I take my hand off and then the whole world gets really fuckin' fair really fuckin' quickly and nobody actually wants that. They say they do but they don't.

    They want what we have to give them but they also wanna, you know, play innocent and pretend they have no idea where it came from. Well, thats more hypocrisy than I'm willing to swallow, so fuck em. Fuck normal people.

    1. So a small group of conniving individuals have created something called the burrito bubble? Sorry, I don't see it.

    2. But I do agree on one thing, Margin Call was a great movie.

    3. It was, wasn't it? And, yes, there is a hamburger and burrito bubble - CMG, SHAK - good thing, too, or all those former manufacturing and real estate workers couldn't become waiters and bartenders!

      And yes, a small group of conniving individuals created the burrito bubble. (Psst, c'mere. Don't tell anybody I told you this. They are called the "Federal Open Market Committee". This rabbit hole goes deep. Don't get in over your head. Follow the money, JP.)

      Or do you think that $3 trillion in base money was efficient allocation? Things were about to get really efficient and fair, really fast. They didn't, because of these "smart guys". In fact, they continue to work overtime in their struggle against the EMH. We should pay them more!

  4. in the past 30 years I've never read a study that strongly supports the "information" advantage of fund managers, definitely not when fees are factored in. So you may want to visit your premise.

    Funds became the de-facto saving vehicle from the great disinter-mediation from savings accounts to tech heavy funds (before discount brokers made direct stock ownership possible. In short, fund managers hung on the coattails of the information revolution from 1985 to 2000 (and beyond). People aren't going into index funds because manager's can't beat the market (though that's some of it). They're going into index funds because it doesn't make sense to pay for the "risk" anymore.

    Also, you ignore a trend towards active management's focus more on sector trends (though ETFs mostly) than old Graham and Dodd company accounting analysis. Today's active managers don't play stocks, they play markets (currencies, international trade, M&As, etc.) Hedge funds are doing well. Leverage ETF/ETNs are doing well.

    All in all, the problem that fund managers are up against isn't investment "information", it's high debt, low-growth global economies. That's why I came to this blog and look forward to reading more of your posts. How long can the stock market keep going up when technology is more about playing Call of Duty on your PC, than better productivity at your company?