Are Index Funds Communist? - Bloomberg https://www.bloomberg.com/view/articles/2016-08-24/are-index...

OPINION WALL STREET

Are Index Funds

Communist?
There won't be much left to do once the investment robots perfect
capitalism.
By Matt Levine
51 August 24, 2016, 3:05 PM EDT

Just some statues of Karl Marx. Photographer: Hannelore Foerster/Getty Images.

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I have been half-joking for a year and a half <https://www.bloomberg.com

/view/articles/2015-04-16/should-mutual-funds-be-illegal-> that maybe index
funds should be illegal, but here is an almost entirely serious claim from Sanford
C. Bernstein & Co. that they are worse than communism
<http://www.bloomberg.com/news/articles/2016-08-23/bernstein-passive-
investing-is-worse-for-society-than-marxism> :

In a note titled "The Silent Road to Serfdom: Why Passive Investing is

Worse Than Marxism," a team led by Head of Global Quantitative and
European Equity Strategy Inigo Fraser-Jenkins, says that politicians and
regulators need to be cognizant of the social case for active management in
the investment industry.

"A supposedly capitalist economy where the only investment is passive is

worse than either a centrally planned economy or an economy with active
market led capital management," they write.

The basic idea is straightforward. 1 The function of the capital markets is to

allocate capital. Good companies' stock prices should go up, so they can raise
money and expand. Bad companies should go bankrupt, so that their resources
can be re-allocated to more productive purposes. Analysts should be constantly
thinking about whether companies are over- or underpriced, so that they can
buy the underpriced ones and sell the overpriced ones and keep capital owing
to its best possible uses.

But when those thoughtful active analysts are replaced with passive index
funds, the market stops serving that function. Whatever the biggest company is
today will remain the biggest company tomorrow, and capital will never be
allocated from bad uses to good ones. Indexing is cheaper, yes, but that's because
active management has positive externalities, and if no one will pay for it, those
benets will disappear. 2

There is a lot of debate over whether this is actually how it works. For one thing,
public stock markets are not really a mechanism for raising capital

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<https://www.bloomberg.com/view/articles/2015-03-24/private-companies-will-
take-money-public-companies-don-t-want> any more. 3 But more
fundamentally, there is an alternative view that the rise of passive investing
will improve capital allocation, because bad active investors will be driven out
but good ones will remain. 4 The passive investors can't inuence relative
prices, since they just buy the market portfolio, meaning that the fewer but
better active investors will continue to make the capital allocation decisions. On
this view, lower returns to active management are a sign that prices are more
ecient and capital allocation is getting better. 5

Fraser-Jenkins et al. don't buy it. 6 Their worry is that the growth in passive
and quasi-passive products -- not just true index funds but "smart beta" funds
that invest based on historically predictive factors -- has caused markets to
become more correlated, as all the passive funds buy all the same stocks for the
same reasons. They are not alone here; I like to quote
<https://www.bloomberg.com/view/articles/2016-01-06/indexes-accounting-and-
atm-fees> Nevsky Capital's nal investor letter:

In such a world dominated by index and algorithmic funds historically

logical correlations between dierent asset classes can remain in place long
after they have ceased to be logical.

"By denition," write Fraser-Jenkins et al., "passive ows of capital, given that
they seek to emulate or replicate what has already occurred must be backward
looking." And a market that is more correlated, they argue, will do a worse job of
allocating capital. 7

Anyway it is a fascinating and delightful note but now let's talk about something
slightly dierent.

Imagine you are in charge of the economy. You decide how much of everything
people should produce, and what the prices should be. It is hard! It's hard to nd
out how much of the dierent things people want, and how much everything
costs to make, and how to motivate people to make things, and so forth.

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There are three basic approaches that you can take 8 :

1. You can be bad at it. You can just announce prices and quantities, and get
them wrong, and there will be shortages and bread lines and corruption.
2. You can be good at it. But I just said it was hard, so being good at it probably
requires you to have a really fancy computer that takes lots of data and
crunches it to decide on prices and quantities and so forth. 9

3. You can have a market. You can just think of a market as a giant distributed
computer for balancing supply and demand; each person's preferences are
data, and their interaction is the algorithm that creates prices and quantities.
10

Choice 1 is more or less actually existing communism. 11 Choice 3 is more or

less capitalism. 12 Choice 2 is more or less a fantasy, but the problem of guring
out how the computer would work is sometimes called the "socialist calculation
problem <https://en.wikipedia.org/wiki/Socialist_calculation_debate> ," and
there is a shockingly wonderful novel about it, Francis Spuord's "Red Plenty
<http://www.nytimes.com/2012/02/15/books/red-plenty-by-francis-
spuord.html> ."

The capital allocation problem is a subset of that more general resource

allocation problem, 13 and has similar answer choices: You can have clunky
central planning, or you can have a market where investors compete to buy
securities and thus set prices, or you can have an ideal but as-yet-undiscovered
computer do the allocating. Or I guess pure indexing -- everyone passively
throws money at everything that there is, with no judgment at all -- is an
imaginable fourth answer, and is strictly worse than the others. 14

But the Bernstein note isn't really about pure passive indexing, just buying and

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holding the market-cap-weighted portfolio of global nancial assets. Not many

people do that anyway. Instead they buy a S&P 500 index fund, say, which is a
market-cap-weighted portfolio of large-cap U.S. stocks -- itself a capital-
allocation decision. Or they buy a smart beta fund, which is a portfolio of stocks
chosen and weighted based on some set of factors that have historically
determined performance. Fraser-Jenkins et al. note
<http://thereformedbroker.com/2016/08/24/the-index-bubble/> "the bizarre
situation that there are more indices than there are large cap stocks." They can't
all just be throwing money at every stock with no judgment. There is something
a bit more going on there.

One way to think about them is that they are all crude algorithms for picking the
best companies to allocate capital to. True, diversied, market-cap-weighted
index funds are the crudest algorithm. They essentially assume that the
companies that were good yesterday will probably be good tomorrow. This is not
entirely true, of course, but it's true enough to be useful, or at least to outperform
most human money managers most of the time.

But there is no need to stick with such a crude algorithm. You might notice that,
historically, some factors <https://www.bloomberg.com/gady/articles
/2016-05-26/is-smart-beta-investing-really-smarter> have been associated with
outperformance. Companies with low price-to-book ratios might have
outperformed companies with high price-to-book ratios, most of the time. So
you might invest in a smart-beta value fund that focuses on buying stocks with
low price-to-book ratios. If you do that, you are making a capital-allocation
decision; you are giving money to companies that you think the market
undervalues, whose fundamental performance should justify higher prices.

Even that is pretty crude, though. You could get more nuanced, and invest in a
fancy quantitative hedge fund that digs through mountains of data to nd
signals that have historically predicted stock prices, and then applies those
signals to future prices.

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As these algorithms get more complicated, they also get more expensive to
implement. S&P 500 indexing is basically free. Smart beta is more expensive, but
everyone expects the price of smart beta to eventually fall
<https://www.bloomberg.com/gady/articles/2016-05-26/is-smart-beta-
investing-really-smarter> to, basically, free. 15 Fancy algorithmic hedge funds
are expensive, but they are perhaps being disrupted by hobbyist sites
<https://www.ft.com/content/0a706330-5f28-11e6-ae3f-77baadeb1c93> that let
random data scientists build algorithms to predict future stock prices, and then
allocate money to the best-performing ones.

In Fraser-Jenkins's taxonomy, all of these algorithms more or less count as

"passive," because they all look at historical correlations to predict future
returns, as opposed to an "active" style that attempts to predict future returns
based on a fundamental analysis of real economic factors. 16 But that
distinction is not particularly clean. A smart-beta fund focused on the value
factor is in a sense doing very crude fundamental analysis: It looks at a
company's nancial statements, compares them to its stock price, and buys
stocks that seem to be mispriced based on their fundamentals. My Bloomberg
View colleague Noah Smith <https://www.bloomberg.com/view/articles
/2016-08-24/the-fundamental-reason-buett-beats-the-market> wrote today
about two nancial economists who published a more sophisticated
fundamental-investing algorithm -- one that uses 28 items from nancial
statements -- that seems to outperform the market. You could implement that
algorithm "passively," as it were, but it seems to be making investing decisions
based on where it sees fundamental mispricing, not just on past stock prices.

And of course any human active investor is mostly relying on historical

correlations and pattern-matching to make predictions of future fair value. You
invest in Twitter because you think it will be the next Facebook, or you don't
invest in Twitter because you think it will be the next MySpace; you go long oil
companies because real-economy conditions remind you of the last time oil
rallied, or you go short because those conditions remind you of the last time oil
tanked. Human investors reason by this sort of informal empiricism; robot

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investors just formalize it.

One broadly plausible thing to expect is that, in the long run, the robots will be
better at this than the humans. 17 Another broadly plausible thing to expect is
that, in the long run, the robots will keep getting better at it.

What does it mean to say that the robots will keep getting better at it? Surely it
means that robots will become more accurate at allocating capital to businesses
that will perform best in the future. They will make those decisions partly by
looking at the prices of nancial assets (correlations among stock prices), and
partly by looking at fundamental nancial data (correlations
between companies' stock prices and their nancial statements), and partly by
looking at operational data (correlations between retail-industry stock prices
and satellite pictures of retailers' parking lots <http://www.wsj.com/articles
/satellites-hedge-funds-eye-in-the-sky-1471207062> ), and partly by looking at
macroeconomic data (correlations between stock prices and interest rates or oil
prices), and partly by looking at whatever else is handy and might somehow
predict stock prices (correlations between stock prices and sunspots, or Twitter
sentiment). And as more data is available and analytical techniques improve,
they will get better and better at all of this. Along the way, there will be missteps
and spurious correlations and herding into bad ideas, but in the very long run
you'd expect the robots to constantly improve their capital-allocation decisions.

I mean, I would, though I don't assert it as a law of economics or computer

science. It's more of an aesthetic sense about the possibilities for technology.

One other thing to consider is that eventually the best robot will predictably and
repeatedly outperform the second-best robot, so why would you invest with the
second-best robot? (This is, to some extent, what it means when people say
<https://www.bloomberg.com/view/articles/2016-08-24/trading-teens-and-bank-
blockchains> that returns to algorithmic investing are declining.) Modern
investment management supports a diversity of investing styles and products in
part because people have truly dierent preferences about risk and where they

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want to invest, but also in part because it is hard to tell which style will perform
better in the future. But as the Best Capital Allocating Robot gets better and
better at allocating capital, it will be harder to justify investing in the
Concentrated Mid-Cap Ultra Value Fund or whatever. Just invest in the Best
Capital Allocating Robot! 18 He's the best.

So the logical/whimsical end point is, if you want to invest in U.S. business, you
give your money to the Best Capital Allocating Robot (U.S. Division), and that
robot -- whose prowess has been proven over time in erce competition --
applies the best algorithms to the best data set to make the best possible capital-
allocation decisions, and you get the best returns, and the economy gets the best
capital allocation.

Obviously this is all nonsense. I mean! Obviously! The robots will always be
imperfect, and random chance will always intrude, and decisions based on past
data will never perfectly predict the future, and investing preferences will always
dier, and you'll never be able to scientically identify the best algorithm, and
competition and diversity will always be important, and all of this is silly.

But isn't it fun? I have joked, a couple <https://www.bloomberg.com/view/articles

/2016-03-04/unicorns-aren-t-so-beloved-by-investors-anymore> of times
<https://www.bloomberg.com/view/articles/2016-05-04/dividends-annuities-
and-hedge-funds> , about modern nancial capitalism solving the socialist
calculation problem. One of those times was about Uber
<https://www.bloomberg.com/view/articles/2016-05-04/dividends-annuities-
and-hedge-funds> , which is apparently working on an algorithm
<http://www.npr.org/sections/alltechconsidered/2016/05/03/476513775/uber-
plans-to-kill-surge-pricing-though-drivers-say-it-makes-job-worth-it> to allocate
cars based on data in the world, without the intermediation of a price system.
There will just ... magically ... be more Ubers when demand is high, and fewer
when demand is low, and that won't be because the invisible hand of the market
pulls more self-interested drivers onto the streets as more passengers bid up the
price of their service, but just because Uber has a computer program that

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is really smart at telling cars where to go. The Best Capital Allocating Robot will
be like that, only for nancial capital instead of cars.

That is: The market is the best algorithm ever developed for allocating capital. So
far! But it also creates incentives for someone to build a better algorithm.

Again: I know this is silly. But as a wild extrapolation of the far future of nancial
capitalism, I submit to you that it is less silly than the "Silent Road to Serfdom"
thesis. That thesis is that, in the long run, nancial markets will tend toward
mindlessness, a sort of central planning -- by an index fund -- that is worse than
1950s communism because it's not even trying to make the right decisions.

The alternative view is that, in the long run, nancial markets will tend toward
perfect knowledge, a sort of central planning -- by the Best Capital Allocating
Robot -- that is better than Marxism because it is perfectly informed and ideally
rational. And once you have that, you can shut down the market: The game is
over, and the Best Capital Allocating Robot won. The Fraser-Jenkins thesis is
that algorithmic investing runs the risk of destroying capitalism by abandoning
the pursuit of knowledge. But the really fun alternative is that it runs the risk of
destroying capitalism by perfecting that pursuit: Once you have solved the
socialist calculation problem, what do you need markets for? 19

This column does not necessarily reect the opinion of the editorial board or Bloomberg
LP and its owners.

1. I've sort of argued <http://dealbreaker.com/2013/03/dont-do-it-calpers/> something similar

in the past, though my views have mellowed over time.

2. From the Bernstein note:

Some would suggest that because the average net-of-fee return from
active management is less than that for passive that the fee paid for
active management is a net drain on society. This is a non sequitur. A
given investment in active may or may not be the best decision for an
individual particular investor but for the system overall there is a

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benet in the ecient allocation of capital. This can come directly

through the provision of equity capital or in forcing the dissemination
of information that is crucial for the raising of capital through lending
or credit markets.

Alas, I can't link to the note. It's been written up in, at least, Bloomberg, FT Alphaville
<http://ftalphaville.ft.com/2016/08/24/2173139/as-an-investment-strategy-grows-more-
popular-the-probability-of-a-comparison-involving-marxism-approaches-1/> , Barron's
<http://www.bloomberg.com/news/articles/2016-08-23/bernstein-passive-investing-is-
worse-for-society-than-marxism> and Josh Brown's blog <http://thereformedbroker.com
/2016/08/24/the-index-bubble/> .

3. Fraser-Jenkins et al. acknowledge this, but point out the secondary eects of equity
markets on other forms of capital raising:

However for mining, and indeed for other capital intensive sectors of
the economy, it is no longer in the requirement to source equity for
initial capital investment that the ecient functioning of the capital
markets is important. Very few of the major mining companies
actually raise signicant amounts of cash directly through the equity
markets. However it is the market value of the companies that
determines the level of indebtedness that they can support and thus
their overall spending plans and investment rate. So if anything this
role requires a more rather than less ecient functioning of the equity
markets.

I'd add that ecient public equity markets probablymake it easier for private companies
to raise money with an eye on an eventual IPO exit.

4. This strikes me as the majority view these days, though I don't get out much. Good people
to read on it include Cullen Roche <http://www.pragcap.com/passive-investing-isnt-
hurting-the-economy/> and pseudo-Jesse Livermore at Philosophical Economics
<http://www.philosophicaleconomics.com/2016/05/passive/> :

Im going to argue that the trend towards passive management is not

only sustainable, but that it actually increases the accuracy of market
prices. It does so by preferentially removing lower-skilled investors

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from the market fray, thus increasing the average skill level of those
investors that remain. It also makes economies more ecient, because
it reduces the labor and capital input used in the process of price
discovery, without appreciably impairing the price signal.

5. There is a Grossman-Stiglitz problem here but, you know, not yet.

6. In particular, they don't buy the skill argument:

It is notoriously hard to identify outperforming managers ex ante and

many frictional ineciencies in the allocation towards managers also
suggest that in practice it is unlikely that it is always the worst
manager who loses assets in any marginal allocation to passive. If, as is
more likely, it is a manager with a random level of skill who loses out
then this argument would not hold and in fact there would be a
reduction in the AUM of potentially skilled asset allocation.

Nor do they think that the problem is necessarily self-correcting:

We are often asked whether we reach a point at which the market

becomes so inecient that the opportunities for active management
become unstoppable in forcing an active recovery. So do we ever reach
this "active nirvana?" maybe not. Phenomena that only become
evident long after the event do not easily lend themselves to quick
mean-reversion and individual participants would seem to have little
power to bring to bear on the point. Moreover, there might not be any
natural mean- reversion because the commercial imperative of passive
and active asset management is very dierent when it comes to scale.
These businesses have a dierent natural size. Passive management
requires scale in order to cut the fees charged to the levels that we see
today and this pressure will always be there. Active management, by
contrast, will always have a capacity constraint. The size of that
constraint will be dierent for a concentrated 15 stock equity fund
versus a multiasset index fund, but both of those strategies have
constraints nonetheless. Thus the industry might not have a self-
correcting equilibrium process between active and passive given these
dierent forces at work in terms of natural scale.

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The note actually argues, not that passive investing has led to higher correlations, but that
it has led to higher spikes in correlations:

Consider a market that undergoes an increase in the proportion of

assets managed passively from one period to the next. In the second
period more securities will be trading in line with a macro view (ie how
they are priced with regard to an index or ETF product, say) rather
than with respect to "fundamentals". Therefore, over the course of the
transition from period 1 to period 2 the average pairwise correlation of
the securities would have increased. But that means that in period 2
there will always be a small group of active managers who will spot the
mis-pricing of securities and put trades that will eventually nudge the
securities back to their fundamental level accordingly. The result of all
this would be a spike in correlation that eventually mean-reverts. It
would imply that when such a spike occurs that it is larger if the
passive asset share of that market is larger.

Is there any evidence of this happening in practice? We think that

there is.

I am actually not sure why that would be so bad?

8. Obviously you can mix the approaches, etc.; here we are being very schematic indeed.

9. A famous paper is by Oskar Lange <https://www.jstor.org/stable

/2967660?seq=1#page_scan_tab_contents> .

10. Famous papers include Hayek <http://www.econlib.org/library/Essays/hykKnw1.html> ,

von Mises <https://mises.org/library/economic-calculation-socialist-commonwealth> and
Arrow-Debreu <https://en.wikipedia.org/wiki/Arrow%E2%80%93Debreu_model> . Also fun,
and taking the computer analogy more literally, is Philip Maymin's <http://arxiv.org
/pdf/1002.2284.pdf> "Markets are ecient if and only if P = NP."

11. Incidentally the Fraser-Jenkins note has a long discussion of Marx's theory of use-value
that strikes me as inessential to all this; you could have central planning of the economy
without Marxism, and in fact it seems to me that autocratic rulers with centralized
economic power predate Marx.

12. I mean, "capitalism" and "market economies" are not strictly synonymous, but let's not get
into that now.

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Actually the Fraser-Jenkins note derives a model of capital allocation in a society without a
nancial sector -- where entrepreneurs just reinvest their earnings in growing their
business, without borrowing or equity issuance -- but we do not need to get into that.

14. As Bloomberg's Luke Kawa puts it <http://www.bloomberg.com/news/articles/2016-08-23

/bernstein-passive-investing-is-worse-for-society-than-marxism> :

Seen through this lens, passive management is somewhat tantamount

to a nihilistic approach to capital allocation.

To adapt a line from a Coen brothers classic <http://www.imdb.com

/title/tt0118715/trivia?tab=qt&ref_=tt_trv_qu> : Say what you will
about the tenets of Marxism, Dude, at least it's a formal attempt to
direct capital to achieve a desired end.

15. Including Fraser-Jenkins et al.: "Yes, we accept that the cap-weighted index is in a sense
the only true passive index as it is the only index that all investors can buy, but declining
costs of smart beta mean that it will soon be possible to buy smart beta for the same fee as
traditional passive."

16. The note explains the dierence:

By having an understanding of where the "fair value" level ought to be

it is possible to seek to prot from this through investing capital (or
withdrawing it) in proportion to the extent that the prevailing price
level departs from that "fair value level" at any point in time. This
requires an investment philosophy that is "active" in so far as it is
forward looking and grounds its investment decisions in an eort to
understand the dynamics of the real economy.

We would say that the "passive" style of investment is paradigmatically

opposed to this approach. Rather than looking at the real economy
and seeking to understand its future development, passive asset
allocation self referentially looks to the nancial economy to inform its
asset allocations choices. It is necessarily backward looking rather
than forward looking and invests based on information gathered from
how other nancial agents have invested over some historic horizon.

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Based on this, it does not seek to discover "fair value" itself but simply
seeks to allocate more capital to those sectors which appear to be out or
underperforming based on the recent past.

17. Broadly plausible! Not inevitable. "No man is better than a machine, and no machine is
better than a man with a machine," says Paul Tudor Jones <http://www.wsj.com/articles
/investors-pull-3-billion-from-brevan-howard-fund-in-rst-half-1471341055> , which is one
hypothesis.

18. And, like, lever him up to move along the ecient frontier, or whatever.

19. Yes, I know, the answer is "freedom," but we are dealing in some pretty silly abstractions
here, cut me some slack.

To contact the author of this story:

Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:

James Grei at jgrei@bloomberg.net

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