Stock picking is dead, long live stock picking!
The shift from active managed funds to passive alternatives like unlisted index funds and exchange traded funds (ETF) has been well documented. The transition makes a lot of sense. Much of my superannuation is invested this way. Paying a fund manager 1.0% in fees to hug an index is indefensible.
But I do wonder about how markets will look in future if passive investing gains further popularity. It should create opportunities for the few diligent active investors that remain.
Today, active investing still retains some sway and most of us make many investing decisions each year. Some of those decisions are ludicrous, but our individual foibles and kinks tend to cancel out at the collective. I’m no fan of the efficient market hypothesis. But markets are quite efficient most of the time. It’s a wisdom of the crowd effect. But a precondition to that wisdom is each of us thinking and placing our individual bets accordingly.
The folly of the crowd?
Indexing skips that. We instead accept the benchmark return and minimise frictional costs in order to make the most of that return. We’re not trying to beat the freight train. Rather, we’re buying the cheapest ticket available and jumping on board. It makes immense sense at the individual level.
It worked very well when passive investing was a small subset of the total market. But passive investing is rapidly becoming an elephant, and the wisdom of the crowd effect is getting blunted in the process. Indexing could be individually smart and collectively stupid.
Of course, I’m not the first to notice this. Horizon Kinetics is an insightful source for analysis of distortions caused by indexing. Such distortions have already been offering plenty of opportunity for quick-footed active investors. Those opportunities should grow if the market becomes more passive.
Recent Wall Street Journal article The Dying Business of Picking Stocks is quite interesting in this context. It’s subscription access only. But the relevant point is that it’s not just individual choice driving investors to indexing anymore.
Managers of pension funds and other sensitive pools of capital – anyone you might see associated with terms like ‘fiduciary responsibility’ – are under extreme pressure to go passive. According to the lore of the land, the battle between active and passive management is long over, passive won.
Legal pressure on stock picking
New laws in the US come into effect next year concerning such fiduciary duty. If pension funds want to invest using active strategies, the onus will be on them to provide a very strong argument demonstrating why it’s in the best interests of clients. It’s an uphill argument at the individual level. Most won’t bother fighting.
And, because this is America, lawyers are already getting involved. Plantiff’s lawyers are increasingly bringing actions against companies and universities “contending the employers breached their fiduciary duty by allowing unreasonably high fees in their 401(k)-style plans”.
So, the shift from active to passive investing is likely to continue for a while yet. Those committed to hunting for inefficiencies in the market are salivating at the prospect. R.I.P. stock picking!
9 thoughts on “Stock Picking is Dead”
Long live the Grossman-Stiglitz paradox.
hi Gareth, I invest a lot passively and I’m not so concerned. The % index in the US is getting quite high. But there’s still a lot of active price discovery. Compared to many other markets like commodities and financials, where extremely large percentages of derivatives price off a very small physical/cash daily price window. The volume of paper oil traded daily is easily more than 10x the physical volume. Also I reason if index inefficiencies are chased by so many people they will quickly arbitrage and disappear. The index funds themselves are not stupid either. The start to refine their methodologies to eliminate obvious gaps. e.g. index re-weightings, Vanguard and others will start selling (or adding) before the official re-weight, if it is obvious that a stock is going to fall out of the index (or be added to the index). So in cases like that, those trying to front run might be disappointed.
Gareth, it’s a fascinating conundrum that often occupies my mind. The last time I saw headlines along the lines of “The death of equities” was circa 2008, just as equities were becoming compelling in the extreme.
Now it’s the death of stock picking.
When crowd opinion loses diversity, market efficiency can be guaranteed to be close to zero. So I agree, the day we all believe the index is right, we can be fairly sure it’s wrong.
Perhaps it’s time to start investing in (the equity of) skilled fund managers.
This already manifests itself in the form of higher multiples, and consequently lower long term returns, from the largest stocks in any major market (i.e., the index constituents).
If what you are saying is true, then there should be some weight of money effects in blue chips, that ought to mitigate the effect of their lower intrinsic returns (i.e. we should see further multiple expansion as the migration to passive investing continues).
Another effect is that it may take longer for the market to properly react to new information. I’ve noticed that sometimes, some stocks can actually have a substantial exploitable window, between when news comes out, and full extent of the resultant price swing is felt. Perhaps this is happening more in recent times.
Conversely, this may also entail that it takes longer to realise the value in investments.
I am happy to have my superannuation in a conservative low cost index hugging environment. This is about 75% of my investment income. For the remaining 25% I use higher fees stock-picking funds, but not any of the large ones or bank owned ones. I use smaller “Graham and Dodd” style managers , such as Forager funds.
I think this is the best way to do it, 75-80 percent with low cost index style managers and 20-25 percent with higher cost “Graham and Dodd,” style managers.
P.s that was an interesting article in the WSJ.
If one of the criteria for index inclusion is liquidity, what happens if a passive index funds grow to the point that they represent such a proportion of a company’s ownership that the stock is no longer considered liquid enough for index inclusion?
Great news that stock picking is dead.
As someone noted shares will soon be be dead too.
As index funds have to sell down to meet redemptions it will be interesting to see where the mis-pricing / inefficiency occurs.
Good to see PTM and its listed LICs on the nose, and China / Asia out of favour.
They may not be index funds but to some-one who knows nothing about shares in the rest of the world, they are a reasonable proxy.
Looking forward to you listing. I run my own book outside my portfolio to give a rough comparison. 10K invested every 6 months in Aus Index (VAS), Aus Property (VAP), US Index (IVV), Aus Fixed interest (VAF), LIC (TGG), MGE added last year.
I will add Forager to the mix when you list but so far things look good for index funds.
Look forward to seeing how you stack up.
There will always be stockpickers but finding the right one in the hype vs. finding an index is hard.