Passive Active

Concentrated Power

When I started my career in investment banking, the grand belief held by all who worked on the trading floor was that we were doing God’s work. Making markets. Optimizing returns. Talking value into being. Advising some of the most powerful decision makers in corporate Africa. There was some truth to it – and are we not all part of God’s great design? – but I now believe in the necessity of our market activities more keenly than I ever did then.
To clarify, this is not an article about taking and exiting short-term positions. I categorically believe that fewer actions lead to better investment outcomes; and indeed wear the hat of investor rather than trader for its much better fit. This is to lament passive investing and the corruption it is bringing into the market.

The market has rules

Active investing has rules. It has principles, morals, and standards under which transactions are to take place. Not everyone follows the same rules, but one can understand them, learn to apply them, and have a decent conversation with the party on the other side of a trade to see why the rule might not apply to them. Underpinning the various rulesets and games played across the financial world is a core principle: value.

Active investors aim to capture as much of it as possible. And, by acting rationally in order to do so, they make a market. Those are the rules: chase the best long-term outcomes, and build a rational strategy in order to get there.

These rules are under threat by mindless flows of money chasing neither coherent strategy nor best long-term outcomes.

Passive investing as a strategy

Is passive investing not a strategy itself? Like most things: it depends. Let’s for clarity focus on index funds. These are instruments which track a set of assets such as stocks or bonds within a specifically-weighted portfolio. The only ‘strategy’ here is the automatic re-weighting of assets. It lacks any further sophistication.

This regular re-weighting of positions held in the index creates artificial momentum -movement divorced from the fundamental rules of the market. It is neither reallocating capital due to strategic insight nor correcting for a better long-term outcome. The index simply follows the market.

And herein lies the problem. At scale, this becomes a self-fulfilling illusion of value. We’re already beginning to see it in the US market. Mag 7 valuations are mind-alteringly-stupefying. Index funds are driving more capital towards the largest pools of capital due to – and creating more – momentum.

This has generated an unprecedented level of concentration in the market due (primarily, I believe) to this cycle of re-weighting of index funds. As more money is pumped into the system, then held by passive investment managers who then allocate such monies based on quarterly, monthly or annual re-weightings, real signal and investment skill is lost, and winners are those who stick to the biggest – not necessarily the best.

Impacts

The impact of this cycle is not limited to lamenting writers and private equity firms. In a society in which size advantage compounds over time, we are fast rushing toward a rebalance of political, social and economic power to the largest corporations of the day. Whilst decades ago this threat would have carried limited threat (how exactly would a fisherman in Namibia be influenced by IBM’s dominance of mainframe computing?) today’s society is far more interconnected, and online.

It is no surprise therefore that the largest companies – those that are growing larger with each new re-weighting cycle – are technology companies, each with tools designed to engage humanity in a form of digital engagement. Control is not just about purchase participation, but also about framing society’s worldview. Ask Mark Zuckerberg, who recently put Facebook forward as a solution to loneliness or Satya Nadella, who is determined to bake Microsoft’s version of AI into every Office and enterprise application to force mass adoption.

Society is discounting individual choice – much like that of the active, eager, intelligent investor fighting against mindless momentum – in favour of consumer product virality and FOMO. Consumer adoption begets adoption, and virality is becoming a science for those who can afford to run R&D long enough to get products just right.

Counter positioning

If the compounding of size and power continues, this will accelerate disparity and extend the distance between the haves and the have-nots, the world over. In a truly dystopian future our choices will be made for us by ten companies who will run the world. A vision which a younger me might have once upon a time found a compelling alternative to current political drama at home and abroad… but would be shortsighted and ignorant of the very real destruction of purpose, value and diversity in maintaining the wide world in all its wonder.
Initiatives like Purchase with Purpose give a clue as to how best to position against – and thereby prevent – the coming dystopia. It provides alternative products against an incumbent in a growing catalogue of technology tools. From browsers to music streaming services, photo management to email clients, choice is being preserved and celebrated – and particularly in Europe and Canada, anti-US sentiment is bleeding into this movement away from the notion that biggest is always best.

https://purchasewithpurpose.io