Indexation = Parasitism – by Charles Gave

It’s not just us that believes passive index investing is a poor choice. The following extract is from leading independent research company, Gavekal.

The role of financial markets is to evaluate in real time the marginal return on capital of different assets. This is done through a ‘price discovery mechanism’, with the ‘right price’ found out through a system of constant trial and error. To discover this price calls for a community of active money managers, each doing his or her due diligence before buying and selling. This price is a function of the return on capital and of the expected growth rate of this return. It has nothing at all to do with the size of the investment under consideration. What’s more, if the price of an asset has been going down for the ‘wrong’ reasons, then active money managers should buy more of it. Over time this process will help to stabilize the system.
Active money management is essentially a ‘mean reversion’ strategy. That’s not so for indexation. In the indexation process, there is no attempt at price discovery. The only thing that matters is the relative size of the asset: the bigger the market capitalization, the more an investor should own. This means if the price of a large asset goes up more than the market as a whole, indexers have to buy even more of it.
Thus indexation is a momentum-based strategy. New money is allocated not according to the expected return on capital but rather according to the current price of an asset relative to other assets. The bigger an asset, the more one should own…
In a true capitalist system, the rule is the higher the price, the lower the demand. With indexation, the higher the price, the higher the demand. This is insane.
Where it becomes really ridiculous is in the bond markets. Over time, the government bond market of a very badly managed country (like France) will become much bigger than the bond market of a well-managed country (like Sweden). As a result, over time indexers have to buy more French bonds than Swedish bonds. The bond vigilantes of yesteryear are now condoning the very crimes they once condemned… and they have no choice about it.
Any economic system based on momentum must be extremely unstable, moving relentlessly from boom to bust and back again, which over time will cause a massive waste of capital. The swings will only be reinforced by zero interest rate policies, since these suppress the cost of capital against which returns on capital should be measured.
The deep thinkers on the New York Times bestseller list all wonder why our economies are moving ex-growth. May I offer a simple explanation?
We cannot have economic growth without a proper cost of capital, nor if capital is allocated, not according to the marginal growth rate of the return on invested capital, but according to the market capitalization of the existing capital stock. What matters is the expected changes in the ROIC (return on capital employed) and not the current value which the market puts on that return.
Indexation could work if it remained a satellite strategy, with say 10% of the money being managed through indexation, the rest being managed by active money managers. As such, it would be a parasitic strategy. Indexers would benefit from the price discovery work done by others without paying the costs associated with the process.
But a system where everybody wants to be a freeloader cannot work. The real problem here is that investment ‘consultants’ (read failed money managers) have defined risk as a deviation from the index against which the money manager is benchmarked. This is idiotic. It forces even mean reversion managers to become closet indexers.

From Indexation = Parasitism
By Charles Gave of Gavekal
15 July 2014


This document has been produced for information only. It should not be construed as investment advice. Every effort is taken to ensure the accuracy of the data used in this document but no warranties are given.

Past performance is not a reliable indicator of future results.

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