Is indexing the answer?
John Mauldin's Outside the Box

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Introduction

Investment managers around the world have become closet indexers, suggest my friends at GaveKal, which is messing around with the normal forces of the capitalistic marketplace. Today's Outside the Box is a Chapter from GaveKal's important new book, Our Brave New World. You can get a copy at www.gavekal.com or now from Amazon at www.amazon.com. It is a definite must read for any serious investor. (The book is the work of Charles and Louis-Vincent Gave and Anatole Kaletsky.)

At the end of this article, I am going to make a few comments. So put on your thinking caps and enjoy this essay, which is truly an example of outside the box thinking.

John Mauldin

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Is indexing the answer?

In the previous pages we have asked a lot of questions, and tried to provide concise and clear answers. Yet of all the questions we asked, this last one is possibly the only one of most interest to our reader; how do we invest in this brave new world of ours? Is the answer, as some argue, to throw our hands up, admit that the world is too complicated for us to understand, and entrust our capital to computers? In other words, go out and put all of our money in index funds? We do not think so.

There is little doubt that indexation is the cheapest way of capturing the attractive long-term returns offered by the capitalistic system. From there, it would be easy to deduce that one should have part, if not all, of one's portfolio indexed. But this conclusion would be wrong, as indexation works on three basic premises, legitimate at the micro-economic level, but chaos inducing on a macro scale. They are:
  1. Active money managers allocate capital according to what they perceive to be the future marginal returns on invested capital (ROIC).

  2. Few active (stock selection) money managers will outperform the indices over the long term.

  3. Very few active money managers will add value through asset allocation. Massively diverging from indices does not work.
These three founding principles are fine on their own but internally contradictory. Indeed, the system can work only as long as active money managers attempt to do the job for which they are paid i.e. allocating capital according to what they perceive to be the future ROIC in the different investments which they consider at any given point in time. Most of them will fail, but the process of screening for future ROIC is vital for the well being of the capitalistic system. Winners emerge, losers collapse. In this creative destruction (or is it destructive creation?), capital is allocated efficiently through a constant system of trial and error.

To put it in another way: the active money managers (and their clients) support most of the costs; the indexers get most of the rewards. Without a doubt, this is what happened in the 1980's and 1990's. So why did it stop working? Easy. The active money managers, chastised by years of underperformance, were forced to become 'closet indexers'. In January 2000, some of our clients in the City got fired from their fund management job for refusing to own France Telecom or Nokia.

And this behavior brought the entire system down. The business of money management had become so big after a decade long bull market that it had been taken over by 'professional people', advised by consultants. Often, these management teams wanted to conserve, and not create. They were accountants, not entrepreneurs. The management of the firms (not money managers themselves anymore) attempted to reduce the unpredictability of the results of their money management teams by preventing them from taking risks. And risk was defined as a deviation from the index against which the money managers were measured (hence the introduction of 'risk controls', 'tracking errors' etc.).

What were the results of these changes? Initially, important changes in the industry. Later, a massive bear market. To put it succinctly, indexation became a victim of its own success for two reasons.

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The first consequence of the move towards closet indexing was that money management evolved from being an exciting and intellectually stimulating business to a boring and mind-numbing number-crunching game. This was a blow to a number of individuals who had spent their lives in the industry; it also meant that money management started to attract a different type of character than it did a decade ago (i.e. originals, free-thinkers, crazy people).

The second, most harmful consequence is that capital started to be allocated according to size, rather than future returns on invested capital. Indeed, relevant indices are all, for the most part market weighted. In simple English - which we don't always understand but profess to speak – this means that investments get allocated to companies according to their stock market size. This allocation of capital according to size was tried out before, and, the last time we checked, the Soviet Union was not doing that well.

Indeed, in an ironic twist of history, in its hour of triumph over communism, capitalism devised a socialist way of allocating capital. All of a sudden, investors across the capitalist markets decided that it was better to invest in companies according to their size than according to their marginal returns on invested capital. The capital allocators did this, supposedly, for the benefit of workers (the future retirees). Unfortunately, if this system were pushed to its logical conclusion, the workers would be left holding the bag. As the Holy Catholic Church states, and history shows, the road to hell is paved with good intentions.

Behind this switch of allocating capital according to size, one finds hundreds of studies, published by thousands of scholars and consultants (and financed by Wall Street dollars) justifying indexation. But what the studies do not acknowledge is that the data on which conclusions are drawn represent a period where active management was both truly active and dominant. In other words, indexing represents a form of black box investing; but black box investing can only work if:
  1. volumes are kept fairly low,

  2. nobody knows that a black box is operating (see the disaster behind the portfolio insurance of 1987) and,

  3. nobody knows how the black box works.
Clearly, none of these three rules apply to indexing.

The more money flows into indexation strategies, the more capital gets invested according to size, and the more capital is misallocated. This can only lead to a lower return on invested capital, which, in turn, can only lead to a lower growth rate and, more often than not, to huge disturbances in price levels. As the late 1990s craze showed, indexation is a guarantee for capital to be wasted, which automatically leads to lower growth and lower long-term returns on the stock markets. So we could have a very paradoxical result: indexers might keep outperforming but the long term returns of the stock markets will fall, as a sign that the economy's structural growth rate is falling.

Once again, we need to remember Bastiat's law: 'there is always what you see and what you do not see'. We shall see the underperformance of active money managers. We shall not understand the result of them being forced to index: the long term declines in the rates of returns in the stock markets. A study of the1998-2003 bull and bear market illustrates perfectly what we are trying to prove. In 1999, we had the perfect case of a stock market going up strongly in index because a few big stocks were bought massively, first by the indexers (which is fine), and then by the closet indexers (which is suicidal).

Being both natural optimists and fervent believers in an efficient free-market, we cannot believe that the system is bent on self-destruction. We do not want to admit that, because the money management industry has become too sophisticated and too risk averse for the good of the economic system it is supposed to serve, we will have to face years of bear markets and sub-par growth. The market will find a way to triumph.

And maybe it has. Indeed, as we all know, experienced money managers have been leaving the bigger firms in hordes over the past few years to set up their own hedge funds. Interestingly, the main characteristic of a hedge fund is that it aims to allocate capital efficiently, and that it put its neck on the block.

Capital is flowing in huge amounts to this new breed of managers. By creating a class of absolute return oriented money managers, the system has effectively recreated the cautious money managers of yesteryear, bent on delivering steady and understandable returns. One hopes that these fellows, willing to do their jobs (i.e. incur a high tracking error) will take the indexers and closet indexers to the cleaners. The more (and quicker) they do it, the better for the long-term health of our economic systems.

Beyond the growth of hedge funds, another solution might be to break up the big pension funds, and return the monies to their legitimate owners. These owners, who (in the Western World at least) tend to be more financially savvy than their forefathers, would then select their own money managers. The big money management firm would then have to deal with the public in general; a public who tends to define risk as 'losing money', and not as a divergence from the index.

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And here, once again, the revolution we are witnessing in the organizational structures of businesses in the Western World might lead to that result anyway. Indeed, as the workforces in Western economies move from massive industrial organized companies to small, service-oriented firms, the ability to draw pension contributions from a large number of workers disappears. With the death of the large, top-down, integrated companies, how can the large pension funds survive? Our answer: they won't. Which means that, along with a rethink of our welfare states, we also need to rethink how retirement in the Western world will be funded.

Conclusion

Comments by John Mauldin

It is precisely this problem which has led to the rapid growth of hedge funds, as Indexing" yields lower long term returns in an investment climate which is fully, or at a minimum, highly valued. The only way to get "alpha" is to be willing to invest without looking over your shoulder at some index.

And because indexing is actually misallocating capital, it is creating investment possibilities that were not available in previous years. For instance, investment banks used to fund small secondary offerings for small public companies. Now, very few investment banks are in that business. It is mostly done by hedge funds. Roll-ups, bank loans, all sorts of credit are all done by hedge funds. Looked at in one way, there are numerous hedge funds which are essentially private banks by another name, with a compensation structure rewarding management with a portion of the profits, using investor capital rather than depositor capital.

It is important that hedge funds continue to grow in size and scope, as they do indeed help to rationalize the allocation of capital more efficiently. This is a trend we will look at more and more as time goes on.

Your never have liked index funds anyway analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 11-28-2005 1:59 AM by John Mauldin