Indexation Is A Socialist Way Of Allocating Capital

Authored by Charles Gave of Evergreen 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. Worse, it is a form of socialism, since 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 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.

Let me be clear: in a properly managed capitalist economy there should only be three returns - in real terms - to worry about:

1) 1%—if one buys 3 month T-bills and does not want to take a duration risk
2) 3%—if one buys long government bonds and is willing to take a duration risk
3) 6%—if one buys shares and accepts the risk one may not get all of one’s money back

Over the long term, equity managers should be measured against the 6% real target. All other benchmarks will lead to the misallocation of capital and create a deeply unstable financial system together with a much lower growth rate and higher unemployment.

In effect, by pursuing indexation we have introduced a socialist way of allocating capital in the heart of the capitalist system.

As we all know, socialism is the ultimate form of freeloading. It has never worked, and it never will. This indexation is one of the most obvious forms of parasitism I have ever encountered.

Comments

[FredFlintstone]

Example of socialism? Not only do we have Medicare and Medicaid, but I think the Feds have struck a deal to mask the inreasing costs by colluding with the healthcare industrial complex. In exchange for cuts in Medicare/Medicaid is big health being allowed to rape and pillage the private insurance consumer in order to make up the difference?

It used to be that insurance companies used to fight tooth and nail to hold costs in. Now it seems that they will pay for anything and just jack up premimums the next year to cover costs with our government giving them all a wink and nod.

[swmnguy]

+1.  If "ObamaCare" were Socialism, the focus would be on ensuring access for patients at prices they can afford.  And of course, that is the marketing spin.  But any examination of the real mechanics shows exactly what you point out.  It's nothing more than a bailout for the medical/financial two-man con.  And it's only one feature of the overall merger of State and Corporate Finance.  Our financial system is based on lending at interest, which requires infinite money, markets, resources and energy.  Of these, only money can be made infinite, and that only by making it abstract.  Now that we've hit the physical limits of markets, resources and energy, or at least those limits are in view, the system is breaking down and eating itself.  In order to keep the interest cycle functioning, more and more capital has to be diverted to abstract pursuits, since actual physical efforts cannot provide infinite growth anymore.  Finance has grown from around 5% of economic activity to over 40%.  That share will continue to grow.  But the vast majority of people still gain their income from direct employment, not finance.  So finance will inevitably need to collapse and reorganize.  To prevent that, Finance has bought out Government.  It's a short-term marriage of convenience, and it will only prolong and extend the suffering. 

ObamaCare is QE for the medical/finance sector.  Just as QE exists only to launder worthless mortgage-backed financial schemes, ObamaCare exists only to save finance from the natural consequences of having priced itself out of the reach of its customers.

[ArmyofOne]

There's indexing and then there is there's the lack of indexing.

CBO: Everyone’s taxes will go up quietly

http://www.politico.com/story/2014/07/tax-increase-ahead-congressional-b...

[AnAnonymous]

In a true 'american' world, people never die.

In a true 'american' world, you produce more than you consume.

In a true American world, you are already to the stars and beyond.

In a true American world, you are walking to the Moon. Americans have been producing so more much than they 've consumed that the vaccuum between the Moon and the Eart is filled with matter.

In a true American world, diversity is a key word, everybody speak the same language, have the same mental pattern.

In a true American world, American countries are energy free.

In a true American world, the FED is making the American middle class poorer, not richer because central planning does not work.

In a true American world, there is no war because Americans waged the war to end all the wars long ago.

Without all these signs, you can tell without erring that the current world is not an American world. You can even affirm that Americanism does not exist.

Signed: an American.

[number06]

With performance like this, I'd hate indexing as well : http://www.gavekalfunds.com/mutualfund.php

[Homer E. Rectus]

I just found out how to find the top in the Zerohedge comment market. All the new peckerwoods commenting with bitch rants and little sense.