One thing that the rise of quantitative, index-centric strategies has done is make the stock market more of an abstraction. When looked through the lens of indices, factors and ETFs it all just looks like a bunch of statistics and numbers. One could argue that the rise of quants, writ large, has pushed aside the traditional hedge fund industry. Josh Brown at The Reformed Broker writes:
The allure of systematic trading strategies because of these success stories has led to a mass migration of dollars, effort and energy being put toward the hiring of quants and the setting up of substantial computer networks – akin to a gold rush, although the dollar amounts we’re talking about now dwarf what was going on in 19th century California. The mass adoption and ubiquitous availability of these tools and data sets and software programs will not be kind to future returns in the aggregate.
Who knows, maybe at some point in the future the rise of passive investing will affect the efficiency of the overall stock market. Sushko and Turner from their paper The implications of passive investing for securities markets*:
An increase in the share of passive portfolios might reduce the amount of information embedded in prices, and contribute to pricing inefficiency and the misallocation of capital… passive portfolio managers have scant interest in the idiosyncratic attributes of individual securities in an index. They do not devote resources to seeking out and using security-specific information relevant for valuing individual securities…At some point, greater anomalies in individual security prices would be expected to increase the gains from informed analysis.
It doesn’t seem like we are there yet but it does point out the disconnect we have between what a growing number of investors are doing and what is happening in the real world of business. For some time now we have seen a falling number of publicly traded companies in the US. While many claim that this trend isn’t a negative, there aren’t many people out there arguing that it is a net-positive.
It is the existence of these companies that makes an equity market and by extension (hopefully) an equity risk premium. It is the equity risk premium that lies of the heart of the future returns of every investor with more than a short-term time horizon. Steve Bleiberg writing at Barron’s and in longer form at Epoch Investment Partners has a some really interesting thoughts on the role of modern portfolio theory on how we got to where we are today.
You should read the entire piece but at its heart Bleiberg argues for a re-focus on what makes the equity market and the ERP run: companies. Bleiberg isn’t against financial theory and MPT. What he is for is recognizing that this is at best, an abstraction not reality. He writes:
None of this is intended to imply that MPT is all wrong, or should be ignored. MPT is indeed very useful, and helps us think more clearly about risk. Our point is simply that we all need to remind ourselves occasionally that in the end, MPT is a mental model, not a description of a physical reality. We should not lose sight of the fact that in the real world, the equity risk premium is not some sort of abstract “fundamental quantity,” as the New York Fed paper described it, but simply the result of companies successfully earning high—but by their nature variable—returns on the capital they invest in their businesses.
Actual businesses. I don’t know which way the causality runs but this may be a reason why we have seen the increasing importance of private capital to fund new companies. Maybe venture capital investors are better at allocating capital to new and growing companies. The public markets may have lost their ability to do that along the way. The abstraction of the company into a set of statistics may be the culprit. Bleiberg again:
But stocks are more than a collection of statistics such as mean return, variance, or a set of factor exposures. As the 1968 investor understood well, they are actual businesses. Their success or failure as businesses, which is dependent on their ability to meet the needs of customers and to allocate their cash flow sensibly, ultimately drives their stock price higher or lower. And it is the success or failure of actual businesses in the real world that creates the theoretical factor returns through the resulting stock price movements. That is, company stock price movements drive factor returns; factor returns don’t drive company stock price movements. Or to put it yet another way, markets don’t reward or punish abstract factors; they reward or punish companies because of how well or poorly their business is doing, and that in turn creates what we end up measuring as “factor returns.” But we should never lose sight of the fact that those factor returns are a derivative. They are not the starting point.
Said another way at what point does treating companies like a set of factor exposures instead of organic entities begin to degrade the entire engine driving things in the first place. To be clear, I have been an advocate of low-cost, index-centric investing for investors from the outset of this blog. Nothing written here above changes that baseline advice. That being said it is worth taking a big step back to think about whether we are killing the golden goose of public capitalism by treating it not as a living, breathing creature instead of a set of numbers on a spreadsheet.
