Reading Matt Levine on Bloomberg is a bit like a daily sugar fix. One can be guaranteed that he’s identified some market lunacy and will endlessly riff on its inanity. That said, too much exposure to Levine can also warp one’s thinking. One can begin to think that everyone is a bit mad (and duplicitous) and irrational and that investing has quite literally gone to hell in a handcart. To be fair to Levine he’s also scrupulous to drag everyone into the mud with his stories and he’s as horrified by the behaviour of ‘professional’ types as he is by mad Robin Hooders.
But once one moves beyond Levine one encounters a widely expressed sentiment that is almost nostalgic for ‘good old days’ when professionals dominated investing and everything was about rational institutional behaviour. This sentiment takes shape in two arguments that I hear frequently. The first is that as that the world is irrationally going passive and that nothing good will come of this as we head into peak passive where its market share is above say 70%. The other conviction is that the great flood of private investors into the markets over the last few years – the rise of the meme stocks/Robin hood/crypto – is a car crash waiting to happen.
Dig around inside these views and I think that one confronts the ‘good old days’ mentality. Before passive and frenzied retail speculation, things were more rational. Institutions behaved professionally – codified within the regulatory rules which assume that professionals are more able to understand risk – and the world was a more predictable place.
It will come as no surprise that I’ve always thought this was a ridiculous argument, full of assumptions and prejudices that don’t match up with reality. I would offer an alternative narrative that I think is more useful.
Lurking in the background of many of these narratives is the efficient markets hypothesis. This has been widely misconstrued but one reading of this bank of theory is that investors largely behave rationally and that on a day-to-day basis the markets are efficient. I subscribe to the weak form of the efficient markets theory which argues for day to day efficiency but think the first argument is junk. Anyone with more than a passing knowledge of behavioural finance will be well versed in the evidence that investors are neither irrational nor rational – by and large – but influenced by systematic behavioural biases which find expression in investing. At its most obvious we can see the various forms of speculative greed at work with some private investors, but these biases are pervasive. In the table below I’ve outlined a hierarchy of behaviours that I see in the markets which helps to explain why investors do what they do. Of course, there is rampant greed which powers pure speculation and thus motivates great momentum pushes powered in turn by liquidity flows.
But professionals are as guilty of bias as anyone else. Take the professional imperative to emphasise ESG investing. I know for a fact that most professionals I talk to are personally deeply suspicious of the cant surrounding ESG but they are also professionals working within affirmation seeking institutions and to be seen to be dismissive of ESG and sustainability concerns is a dangerous thing. I commend the first big retail-friendly asset manager who says ESG doesn’t work for them and they’d rather pursue a different strategy – I note with interest that Vanguard for instance is notoriously quiet on the subject of ESG.
Another bias is what I call regulatory cringe, which can shade into my ESG concerns but is more powered by institutional investors, especially in pension funds. This involves kowtowing to regulators and professionals (actuaries) and Gadarene-like chasing after ever ‘safer’ asset classes to the point at which any hope of a positive return vanishes.
Signal following behaviour is yet another bias that I think needs to be called out. In my recent Citywire columns I’ve argued that market timing has acquired a dirty reputation but that many discretionary fund managers still pursue the idea of tactically/dynamically managing asset allocations using signals eg which might as well be magical rune stones for their usefulness.
Market timing can be done but even the ‘experts’ think it is bloody hard and one can only guess what damage ‘amateur’ asset allocators are doing to investor portfolios because they believe they can spot the macro signals and switch asset allocations accordingly. I would argue that this is every bit self-defeating as the ‘ignorant’ Robin Hooders engaging in their rampant meme speculation.
Then there are those biases that are functional and in one sense entirely rational but also deeply illogical at times. Take the functional imperative for income which is I think entirely understandable but not always grounded in evidence. I understand why some end investors need to generate an income but that does not necessarily mean they need to seek out income-producing assets. They could for instance make use of tax allowances and simply sell down capital gains on a regular basis. Or they could use tax wrapper structures to achieve a similar objective. What matters is the total return from holding risky assets like equity. Decomposing the functional elements might be a foolhardy exercise.
And of course, sitting at the bottom of my hierarchy of biases is the long term imperative to have access to beta eg the long term capital appreciation above inflation from holding risky assets. This beta seeking behaviour is arguably well suited to the passive imperative, partly because it removes idiosyncratic stockpicking manager behaviour from the mix but also because it lowers costs.
A hierarchy of investing biases
|Professional imperative eg ESG
|Functional imperative eg need for income
|Regulatory cringe eg pension funds
|Signal following eg trend investing
|Beta eg long term exposure to ‘growth’
All of which brings me nicely back to the argument that the increasing dominance of passive is possibly negative. I would argue that all of these biases generates behaviour which powers idiosyncratic investing behaviour. In many cases those biases and behaviour can be expressed through passive funds but implicit in many of the biases is the notion that someone with expertise can do better than someone without – thus reinforcing the bias towards active.
And also in each case, even if the expression of the bias into a passive fund was total, then I assume there will be good money to be made by an active investor sitting on the other side of the bias trade. They will be willing to see through the emotions and biases and think ‘rationally’ and ‘efficiently’ and use evidence-based techniques to capture a risk premia. So, in that sense, the argument that passive will destroy the current models of investing behaviour is to entirely misread the current situation. We are a collection of biases and prejudices, entranced by narratives, and sometimes we will use passive funds to implement a narrative (sometimes not) but that very act of using passive funds creates an opportunity for the active investor to sit on the other side of the bias trade. And boy, are there lots of biases out there!! But rather than denigrate them, let’s recognise them for what they are and act accordingly.