Skip to main content

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.

Comments

Popular posts from this blog

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out. In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers. To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as f...

The bond-stock conundrum

Here's a conundrum. Many commentators have been trying to puzzle out why stocks have been continually hitting new highs at the same time that bond yields have been hitting new lows. See here , here , here , and here . On the surface, equity markets and bond markets seem to be saying two different things about the future. Stronger equities indicate a bright future while rising bond prices (and falling yields) portend a bleak one. Since these two predictions can't both be right, either the bond market or the stock market is terribly wrong. It's the I'm with stupid theory of the bond and equity bull markets. I hope to show in this post that investor stupidity isn't the only way to explain today's concurrent bull market pattern. Improvements in financial market liquidity and declining expectations surrounding the pace of consumer price inflation can both account for why stocks and equities are moving higher together. More on these two factors later. 1. I'm with...

Does QE actually reduce inflation?

There's a counterintuitive meme floating around in the blogosphere that quantitative easing doesn't do what we commonly suppose. Somehow QE reduces inflation or causes deflation, rather than increasing inflation. Among others, here are Nick Rowe , Bob Murphy , David Glasner , Stephen Williamson , David Andolfatto , Frances Coppola , and Bill Woolsey discussing the subject. Over the holidays I've been trying to wrap my head around this idea. Here are my rough thoughts, many of which may have been cribbed from the above sources, though I've lost track from which ones. Let's be clear at the outset. Inflation is a rise in the general price level, deflation is a fall in prices. QE is when a central bank purchases assets at market prices with newly issued reserves. In equilibrium, the expected returns on all goods and assets must be equal. If they aren't equal then people will rebalance towards superior yielding assets until the prices of these assets have risen high...