Speaker 1: Hello, and welcome to another episode of the Odd Thoughts podcast.
Speaker 1: I'm Tracy Allowitt and I'm Joe. So, Joe, we've talked
Speaker 1: before on this podcast about passive investing, right, I seem
Speaker 1: to remember that. I'm sure we must have. In fact,
Speaker 1: I didn't. Are there any other types of investing anymore?
Speaker 1: If we talked about investing, I'm sure we talked about
Speaker 1: passive investing. No, you're absolutely right, But I'm trying to
Speaker 1: think now, I guess that means we haven't talked about
Speaker 1: the sort of basis of passive investing, which is index construction. Right.
Speaker 1: If you're going to invest passively, you need to be
Speaker 1: investing essentially in some sort of index or benchmark exactly, right.
Speaker 1: So you could say, oh, I'm not going to make
Speaker 1: any choices in my investment, I'm just going to invest
Speaker 1: in the market. But even that has to have some definition.
Speaker 1: If it's the SNP five hundred, then whoever designed the
Speaker 1: SMP five hundred is ultimately the one constructing your portfolio.
Speaker 1: So ultimately someone is making a decision, even if you
Speaker 1: think you're sort of trying to take human discretion out
Speaker 1: of the process. Right, And there's really been an explosion
Speaker 1: in all types of indices recently, sort of growing in
Speaker 1: tandem with the big growth that we've seen in passive
Speaker 1: investing in general. One thing that gets bandied around quite
Speaker 1: a lot is that there are now more indices in
Speaker 1: the world than there are individual stocks, which, you know,
Speaker 1: stop and think about that for a moment. It's it's
Speaker 1: pretty amazing, although I guess, you know, you could say,
Speaker 1: given the amount of stocks available in the world, there's
Speaker 1: sort of an infinite number of combinations that you could
Speaker 1: get at that point. But it does suggest that something
Speaker 1: that was supposed to be a simple reflection of a
Speaker 1: particular market has sort of morphed into something else, right.
Speaker 1: I think Bloomberg uh Eric Belcoon has had a really
Speaker 1: interesting column this week, you know, pointing out that, you know,
Speaker 1: there's only really twelve notes on an octave, but there's
Speaker 1: hundreds of millions of songs, and I think that's a
Speaker 1: pretty good analogy for the relationship between individual components and indexes.
Speaker 1: And of course there's essentially an infinite number of ways
Speaker 1: that you can arrange them and wait the components and
Speaker 1: wait them by size or factor or whatever. So it's
Speaker 1: not surprising that there is an incredible amount of interest
Speaker 1: and important place on a index construction these days, right,
Speaker 1: and people thinking about this indexation kind of issue or
Speaker 1: explosion and indices, it tends to either be of of
Speaker 1: that sort of ilk where people think, oh, well, it's
Speaker 1: it's natural that this is happening because we have these
Speaker 1: different varieties of indexes that you can build using different
Speaker 1: types of stocks. But there's another extreme dream end of this,
Speaker 1: and you know people who actually find it quite worrying
Speaker 1: and quite dangerous for one reason or another. End. Today
Speaker 1: we're going to be speaking with someone who is firmly
Speaker 1: at that end of the discussion. I can't wait. This
Speaker 1: is a really important topic. I joked in the beginning
Speaker 1: that is there any other type of investing besides passive
Speaker 1: because it really does feel like that is swallowing everything.
Speaker 1: And I think there's a real existential question about the
Speaker 1: role of what used to be called discretionary investing. And
Speaker 1: so I think there's it's a great it's a great
Speaker 1: timely and timeless topic for us. Yes, indeed, all right,
Speaker 1: So without further ado, our guest for this episode is
Speaker 1: Intego Fraser Jenkins. He is a quantitative strategist over at
Speaker 1: Bernstein you may remember him listeners as the guy who
Speaker 1: wrote The Silent Road to Serfdom why passive investing is
Speaker 1: worse than Marxism. So, I promise this is going to
Speaker 1: be an interesting discussion. And Ago, thank you so much
Speaker 1: for coming on, but thank you for having me on.
Speaker 1: So and I guess my my first question is you've
Speaker 1: written quite a few notes about indexing at this point
Speaker 1: in time. Your latest one is sort of unusual in
Speaker 1: the field of analyst research. You know, it was called
Speaker 1: fund Management Strategy the man who created the last index,
Speaker 1: and it's sort of a fictional slash historical look at
Speaker 1: index creation. How did you focus on this particular topic. Yes, so,
Speaker 1: when we think about the way investment works at the moment,
Speaker 1: I think this five trillion switch from active a passive
Speaker 1: has taken place in last decade is one of the
Speaker 1: biggest changes that we've seen, and I think that passive
Speaker 1: as a lot of further to grow. I think that
Speaker 1: some people have interpreted some of our previous work, because
Speaker 1: that's the one you just mentioned earlier, as us being
Speaker 1: anti passive in some way. I wouldn't describe myself anti
Speaker 1: passive because passive is and more to democratize access to
Speaker 1: capital markets than any other invention in investing in the
Speaker 1: last couple of decades. But it does change the calculus
Speaker 1: for investors, both at the micro level, for an individual
Speaker 1: investor and for society overall. And so if an individual investor,
Speaker 1: there's a question of how active and passive interact with
Speaker 1: each other in their overall holdings. For society of all
Speaker 1: are big implications for capital allocation and for stewardship. And
Speaker 1: I think that what it all comes down to is
Speaker 1: the relationship between a fund buyer and an asset manager
Speaker 1: is changing and as further to change, and that's been
Speaker 1: driven to something sent by the increase in passive options
Speaker 1: that are out there. Now you mentioned we've written about
Speaker 1: this in research notes in the past. We want to
Speaker 1: say a bit bit different here by writing a work
Speaker 1: of fiction, um, I mean, firstly hopefully a bit more fun.
Speaker 1: It allows us to use kind of language is not
Speaker 1: possible in a normal style side research note, but also
Speaker 1: allows us to approach the active assive split from a
Speaker 1: few different perspectives. Where do you see this showing up?
Speaker 1: So it's one thing to talk about changes in governance,
Speaker 1: it's another thing to talk about changes in capital allocation
Speaker 1: and how that goes about. But when you look at
Speaker 1: the market, you still see some stocks doing well. You
Speaker 1: still see some stocks doing badly, some companies thriving. Can
Speaker 1: you point to something happening in the market that's sort
Speaker 1: of independently observable and say, okay, here is a change
Speaker 1: in the way markets behave that we can associate with
Speaker 1: all the money leaving active and flowing into passive. I
Speaker 1: think the biggest issue here is just it's a question
Speaker 1: of what an investor expects to get out of an
Speaker 1: active manager, and I think we've seen some miss beans
Speaker 1: have blown up about that in the last decade or so.
Speaker 1: So the idea the one could charge for beta as
Speaker 1: as an active manager UM has been obviously deep anked
Speaker 1: some time ago with the role of passive broad index funds.
Speaker 1: I think the next stage really is the idea of
Speaker 1: charging for factor beta in sense active managers who are
Speaker 1: actually just consistently hugging some factors in the market, well,
Speaker 1: and now you can buy those factors the current going
Speaker 1: rates four basis points. I think smart beta will be
Speaker 1: free within a year or so, based in terms of
Speaker 1: headline fee if nothing else UM, And so that really
Speaker 1: kind of focused attention on on what the point of
Speaker 1: an active manager is, and so I think that's where
Speaker 1: the biggest change comes here. I think there's been perhaps
Speaker 1: a mistaken belief that because it's very easy to measure
Speaker 1: headline fee, that has become the key determinant in so
Speaker 1: many fund allocation decisions. And when you look at the
Speaker 1: allocations both with an active and with impassive in the
Speaker 1: last few years, more than a hundred percent the net
Speaker 1: flow has gone the cheapest of active funds and the
Speaker 1: cheapest of passive funds. Now, on one hand, that's great,
Speaker 1: and it's allowed asset owners to lower their overall cost
Speaker 1: of employing asset managers, But headline fee only really matters
Speaker 1: to extent that it influences the quality of the net
Speaker 1: of fee outcome, and I think that there needs to
Speaker 1: be a focusing on the minds about what kind of
Speaker 1: outcome people want from investment decisions. Um and this sort
Speaker 1: of just fit into a much bigger picture, which is
Speaker 1: last thirty five years, Exus and got Up bonds have
Speaker 1: gone up, and they've managed to do so in a
Speaker 1: way that's given a negative correlation between them. So an
Speaker 1: extraordinarily benign set of circumstances, and that's as least been
Speaker 1: part of the reason why at least of the hindspee
Speaker 1: made sense for people to allocate from acts of the passive.
Speaker 1: I think that if one projects forward from here and says, well,
Speaker 1: there are a number of reasons to suspect that what
Speaker 1: might be in a lower return world across asset classes
Speaker 1: um and it raised the question of well, what is
Speaker 1: the outcome people want? What is the real benchmark that
Speaker 1: investors care about? That real benchmark probably ultimately comes down
Speaker 1: to trying to fund retirement, healthcare cost, school fees, etcetera.
Speaker 1: All those things trade more like CPI than like a
Speaker 1: capital market return. The question is, can um asset owners
Speaker 1: come to active managers and buy a return stream the
Speaker 1: net of fees will beat that UM. That in my
Speaker 1: mind's an active decision, but it's been somewhat subsumed by
Speaker 1: everyone assuming that the right thing to go and do
Speaker 1: is to hire a series of active managers who can
Speaker 1: perform a relative to a very specific benchmark in a
Speaker 1: series of pigeonholes across the market. Mhm, So could you
Speaker 1: maybe step back for a second and describe how we
Speaker 1: got from you know, a sort of a relatively simple
Speaker 1: or simpler place where we had the Dow Jones index.
Speaker 1: I mean, when the Dow Jones index was invented, it
Speaker 1: had I think something like a dozen stocks in it.
Speaker 1: And now we're at this place where we have hundreds,
Speaker 1: if not thousands, of different industries and benchmarks of all
Speaker 1: different types of flavors, smart, beata, factor investing, whatever you
Speaker 1: want to call it. How did we actually get here? Yeah? So, um.
Speaker 1: In the background to doing this note, was spent some
Speaker 1: times reading the early work of Dow and Paul and
Speaker 1: it's kind of fascinating to see the motivation behind the
Speaker 1: work that they did. Um. The work of down Poor
Speaker 1: was firmly in the camp of financial journalism, not in
Speaker 1: the camp of investing. UM. So people may complain about
Speaker 1: price witted industries, but it was perfectly sensible decision for
Speaker 1: Dow if he wanted to report on the movement of
Speaker 1: the market the day before, seeming to add up prices
Speaker 1: and divide them by the number of stocks that he
Speaker 1: was using apartment anything else. Without modern calculating machines, it
Speaker 1: was hard to do that work any other way. UM.
Speaker 1: And that was a fair way to give a sense
Speaker 1: of broad market movements. You can go back before that,
Speaker 1: the work of Poor and his work on the history
Speaker 1: of railroads in the US. It doesn't seem like ones
Speaker 1: reading a work of an index constructor when one picks
Speaker 1: up that book. But I would argue that one is
Speaker 1: because he has this massive enumeration of facts, which in
Speaker 1: this case miles of new track laid each year and
Speaker 1: dividends paid by railroad companies. And it's basically a prose
Speaker 1: version of an index, I would argue, I guess as
Speaker 1: one roller clocks forward, the question of indexing became kind
Speaker 1: of critical for solving the agency problem, which is always inherent.
Speaker 1: If one goes out and hires an asset manager to
Speaker 1: run assets for you, how do I know I'm getting
Speaker 1: good value for money from this asset manager. How do
Speaker 1: I know they're doing something for me that I couldn't
Speaker 1: get more cheaply somewhere else. And of course that's become
Speaker 1: a very broadly embedded as the as the idea of
Speaker 1: needing to perform a board market index, and that's driven
Speaker 1: the initial role of passive um. But once one accepts
Speaker 1: that idea that an index could be a rules driven
Speaker 1: approach to selecting kind of companies, as you said in
Speaker 1: your introduction to this piece, then suddenly the possibilities are endless.
Speaker 1: And who's to say that a given definition of broad
Speaker 1: index is the benchmarks people have and there are a
Speaker 1: massive number of other ways of doing that. The question,
Speaker 1: I think, then becomes confused about whether one is right
Speaker 1: in a given circumstance to get rid of an active
Speaker 1: manager and replace them with a passive manager, which you
Speaker 1: know that would be the right thing to go and
Speaker 1: do if that active manager was doing nothing other than
Speaker 1: hugging a passive index. But that gets confused with a
Speaker 1: broader question of well, what is the end outcome that
Speaker 1: people want to have? And I think there's been almost
Speaker 1: a inversion in the direction of causation, if I can
Speaker 1: say that, in the way people think about industries. The
Speaker 1: initial industries were there to report on what had happened
Speaker 1: in the market the day before. Now the construction of
Speaker 1: new induseries, particularly on the smart beta induseries, are actually
Speaker 1: directing capital allocation um and become a the essentially a
Speaker 1: forward looking a guide to where equity capital goes. Right.
Speaker 1: I think about this a lot. So you know, we're
Speaker 1: talking about smart beta, So for people who aren't necessarily
Speaker 1: familiar with it. This idea that there are factors within
Speaker 1: stocks that by some sort of researchers have you know,
Speaker 1: characterized out performance, whether it's stocks that are cheap on
Speaker 1: a pe basis, or stocks that exhibit high levels of momentum,
Speaker 1: things like that. And so this idea is that, well,
Speaker 1: why not just invest in a E T F for
Speaker 1: an index that capture all those things, and don't you
Speaker 1: don't have to do the work. One thing I wonder
Speaker 1: about is like, Okay, you make a interesting and important
Speaker 1: point that the issue for investors shouldn't be fees per se,
Speaker 1: but that return negative fees. That still raises the question
Speaker 1: of that even if there are active managers who can
Speaker 1: deliver superior performance negative fees, does the individual investor have
Speaker 1: any way to identify them? Um. I think the investor
Speaker 1: needs to be clear about what kind of return stream
Speaker 1: they want from their active manager. So I think it's
Speaker 1: normal for people nowadays to think about a manage has
Speaker 1: been a good manager if they deliver a return that
Speaker 1: exceeds that of the index. But of course, if one
Speaker 1: goes to a manager, one's buying a whole bundle of
Speaker 1: return streams all wrapped together in what their fund produced
Speaker 1: is Some of that's a market beata. Some of it
Speaker 1: will happen to be factors as you outlined just earlier
Speaker 1: than to inform of smart beta. Some of it will
Speaker 1: be very stock stetific decisions that the manager has made.
Speaker 1: I think that one really important change is happening is
Speaker 1: by smart beta or these sort of simple factors essentially
Speaker 1: becoming free or something close to that. It really focused
Speaker 1: attention on what one should get out of an active manager,
Speaker 1: because it's always impossible for more sophisticate investors, say, to
Speaker 1: disentangle the kinds of return streams that they've had from
Speaker 1: the fund manager. But it's been much harder to do
Speaker 1: that more broadly across the whole uh A space of
Speaker 1: fund buyers UM. And now the one can buy these
Speaker 1: factors essentially for free, A very important distinction gets made
Speaker 1: and one can say, well, it is manager giving me
Speaker 1: a return stream that is idiosyncratic, eye is different from
Speaker 1: UM this set of factors that I can buy. I
Speaker 1: think that's enormous important development because it allows us to
Speaker 1: say which kind of return streams become genuinely valuable for
Speaker 1: the asset owner. Return streams you cannot get from simply
Speaker 1: holding a static combination of factors. So I'd argue that
Speaker 1: actually with UM, with the cheapening of in the season,
Speaker 1: the growth a more industries, maybe ironically, it's actually made
Speaker 1: it much easier perhaps to now identify what one would
Speaker 1: want from an active manager, and that is idiosyncratic returns. UM.
Speaker 1: Why is that not more reflected in flows into active
Speaker 1: management then? Because you know, this is the discussion that
Speaker 1: comes up all the time with the explosion of passive investing.
Speaker 1: Most people would say, well, eventually passive investment is going
Speaker 1: to misdirect capital or misallocate capital, and there's going to
Speaker 1: be big price discrepancies that active managers can come in
Speaker 1: and exploit in some way, maybe by producing you know,
Speaker 1: idiosyncratic or specialized returns as you put it. Why aren't
Speaker 1: we actually seeing that play out in the market. Then? Yeah,
Speaker 1: I think there a few reasons that. I mean, I
Speaker 1: guess the initial answer is that the entire focus of
Speaker 1: fund selection seems to be overly focused on headline fee.
Speaker 1: I mean, it's obviously very easy to ident for a
Speaker 1: headline fee up front ahead of time. UM, And I
Speaker 1: said earlier, UM, that has meant there's been a huge
Speaker 1: flow into the cheapest funds, both through an active and
Speaker 1: with impassive. UM. I guess another reason is that different
Speaker 1: goes back ten years. Then, yes, it's true there were
Speaker 1: too many active investors who are charging an active fee
Speaker 1: for delivering something that was very close to the index.
Speaker 1: And it's right that someone has created a series of
Speaker 1: passive indices and taken capital from those managers. I think
Speaker 1: where it gets more complicated, UM is that again, as
Speaker 1: I mentioned earlier, this has been an environment for thirty
Speaker 1: thirty five years when with hindsight, having a passive long
Speaker 1: only exposure to equities and a passive longer exposure to
Speaker 1: bonds has been not only good from a return perspective,
Speaker 1: is beaten CPI, but they've offered a diversification between them
Speaker 1: to go back of a longer horizon. That diversification is
Speaker 1: actually quite unusual. UM. So I think that some of
Speaker 1: the support that passive has had has been a matter
Speaker 1: of circumstance and where we happen to have been from
Speaker 1: macro respective the last in a few decades, and that's
Speaker 1: going to evolve now negative but now inevitably it will
Speaker 1: take time for people to realize that we're in a
Speaker 1: new lower return world where bonds and equities aren't diversifying.
Speaker 1: That will take some time to be more broadly recognized,
Speaker 1: but when it does, it does change the calculus between
Speaker 1: active and passion investing um. Also, the other thing I
Speaker 1: would just pick up on is your point about this
Speaker 1: discussion around does the market become inefficient in some way
Speaker 1: when there's so much passive that it creates perhaps unusually
Speaker 1: good opportunities for active managers. Well, I mean, in theory
Speaker 1: we can say that that's the case. I think in
Speaker 1: practice it's very hard to identify. To my knowledge, no
Speaker 1: one has managed to theoretically identify where such a limit
Speaker 1: might apply. We don't even know if the relationship between
Speaker 1: amount of past investing um that exists in the market
Speaker 1: and the efficiency of the market is something that is
Speaker 1: a linear thing that simply gets a worse and worse
Speaker 1: over time as passive gets larger, whether there's some the
Speaker 1: tipping point. But we can say is the case of
Speaker 1: Japan where the penetration of past investing has gone away
Speaker 1: beyond the level that the US has got to, and
Speaker 1: the Japanese market is still functioning. So I think we
Speaker 1: can say that we should expect more growth impassive to
Speaker 1: come um and that to identify a point at which
Speaker 1: there is where we should expect a mean version back
Speaker 1: into active, I think is very hard and something that's
Speaker 1: very far off in the future. I thought it was
Speaker 1: very interesting what you said about our faith in passive
Speaker 1: strategies as being somewhat dictated by the backdrop of markets
Speaker 1: over the last few decades and the inverse relationship between
Speaker 1: stocks and treasuries. I think it is the same point
Speaker 1: made in our recent discussion with Chris Cole of Artemis
Speaker 1: Capital about expectations of volatility. I think it's been a
Speaker 1: consistent theme on this UH podcast. I mean Tracy said
Speaker 1: at the beginning, have we talked about passive and we
Speaker 1: definitely have. But I do think that a consistent idea
Speaker 1: that we've heard a lot of people discussed from a
Speaker 1: lot of different angles has been this question of whether
Speaker 1: investors have been lulled into thinking that there's some strategy
Speaker 1: that's clearly the best strategy, but that it's only the
Speaker 1: best strategy in fact, because of the certain behavior of
Speaker 1: markets over the last few decades, particularly the relations ship
Speaker 1: between stocks and bonds, that has made that the best strategy.
Speaker 1: So I'm curious if you could expand more on that
Speaker 1: and talk about why the way a lot of uh,
Speaker 1: you know, maybe individual investors or more sophisticated investors have
Speaker 1: their portfolios constructed. Why passive strategies may not thrive if
Speaker 1: there is a regime shift or if there is a
Speaker 1: relationship shift between asset classes. Yes, I think there's a
Speaker 1: lot of recency bias, which is hard to avoid for
Speaker 1: good reasons, um in lots of financial research takes place.
Speaker 1: I mean, I guess we could point to the last
Speaker 1: decade of a que dominating environment as giving rise to
Speaker 1: a series of interactions in the market that might not
Speaker 1: be normal, and as that comes to an end, uh,
Speaker 1: they may change. I think there's also recently bus in
Speaker 1: the longer run which the peers since the early eighties
Speaker 1: has been one of declining yields across after classes or
Speaker 1: deals have come down, bond deals have come down, there's
Speaker 1: been asset price inflation at the same time inflation has
Speaker 1: come down as well. UM that's contributed to returns from
Speaker 1: stocks and bonds being much higher than returns are required
Speaker 1: to beat inflation. And this negative stock bond correlation as well,
Speaker 1: which is Unusually, if you go back over a couple
Speaker 1: of centuries, you don't normally see negative stock bond correlation,
Speaker 1: and only that's a positive number. And so I guess
Speaker 1: to try and put in perspective how important that is.
Speaker 1: One again comes back the question of why people trying
Speaker 1: to to invest, and I think they're trying to invest
Speaker 1: to fund needs that they have with the set in
Speaker 1: the real economy. If the set in the real economy,
Speaker 1: it's more likely that inflation is a better benchmark for
Speaker 1: people UM. And so when people want to assess to
Speaker 1: return from a strategy going forward, I think it's more
Speaker 1: likely that people are focused on inflation plus as a benchmark,
Speaker 1: or thinking of absolute outcomes UM, so guaranteed outcome or
Speaker 1: a hard outcome target UM such as five percent or
Speaker 1: six percent, as being a return that people should expect UM.
Speaker 1: Now that's not to say that I'm barish on the
Speaker 1: stock market. UM. The bid does not require UM start
Speaker 1: to go down to focus people's minds on the market
Speaker 1: in this way, but from a shillipe in the low
Speaker 1: thirties it does strongly imply subpar returns many years in
Speaker 1: the future. I briefly mentioned this in your intro. But
Speaker 1: I'd be curious. You know, the note that you wrote,
Speaker 1: why passive investing is worse than Marxism that got a
Speaker 1: lot of attention at the time and certainly cropped up
Speaker 1: in a bunch of different financial media. What was that
Speaker 1: like for you? Like, what sort of feedback did you
Speaker 1: get from from clients or or readers. Uh, and maybe
Speaker 1: even you got some backlash from index providers. I don't
Speaker 1: know what was what was the reaction? Yes, certainly surprised
Speaker 1: by the scale the reaction, I have to say. Um.
Speaker 1: I think the feedback I got if many people was
Speaker 1: that this is a topic that people were concerned about
Speaker 1: and it and it often falls been the planks of
Speaker 1: the way the research is conducted. UM. Certainly in terms
Speaker 1: of reach on the south side. People don't normally write
Speaker 1: about business strategies U on the buy side, UM. And
Speaker 1: so it certainly spoke to a lot of the concerns
Speaker 1: that people had. I think. UM. Also it finds some
Speaker 1: agreement from people in NASA management companies who have been
Speaker 1: trying to engage with policymakers and trying to make the case.
Speaker 1: So there are some strategic issues at stake here Aside
Speaker 1: from them the more specific issues around an individual fund
Speaker 1: um and whether an individual asset owner should buy an
Speaker 1: active or passive fund in that particular case. Maybe you
Speaker 1: can just sort of quickly summarize your argument because in
Speaker 1: talking to you so far as you said, you're not
Speaker 1: really anti passive per se and you point out that
Speaker 1: we don't know where the tipping point would be, that
Speaker 1: in Japan the share that goes to passive is much
Speaker 1: higher than it is here in the Japanese market still
Speaker 1: more or less function fine. So for those who haven't
Speaker 1: read your note, which is most people, what does that
Speaker 1: mean worse than Marxism? How would you describe it? And
Speaker 1: I would not be surprised if the media distorted your
Speaker 1: argument in someone um. Well, the argument is quite a
Speaker 1: simple one, which is simply to think about how capitals
Speaker 1: allocate in society. So it's the worst of Marksism is
Speaker 1: definitely not from the point of an investor. It's from
Speaker 1: the point of view of society, of rule and the
Speaker 1: role of capital allocation in society. So I thought about
Speaker 1: investment outcomes, per se Um, and I can think about
Speaker 1: three different possible types of society. One a fully capital
Speaker 1: society where people make very active as allocation decisions. Another
Speaker 1: marks of society where someone is given the job centrally
Speaker 1: to plan how capital is allocated. Uh. And then a
Speaker 1: third possibility, which should be a sort of fake capitalis
Speaker 1: society if you like, in which the capital allocation is
Speaker 1: done on a sort of passive trailing basis. So companies
Speaker 1: that have done well simply are accorded bigger weights and
Speaker 1: equity indusseries. And I guess the pushback on it um
Speaker 1: and there's been various forms of it, but one of
Speaker 1: the main forms of pushback was the idea that do
Speaker 1: companies actually need to raise equity? If we're in a
Speaker 1: capitalite economy where the growth, especially coming from more service
Speaker 1: based industries, how important is the capital allocation process from
Speaker 1: active investors? And I'd argue that it is still important.
Speaker 1: I mean a because there is still a range of
Speaker 1: the of corporates in the market it that do need
Speaker 1: to raise capital. Secondly, even if the company is not
Speaker 1: raising equity capital, often they want credit or bank loans,
Speaker 1: and that becomes cheaper if they have a share price
Speaker 1: that reflects all the information. And Thirdly, they want to
Speaker 1: pay employees, often through stock if that's possible, So is
Speaker 1: the argument that basically capital is being allocated in a
Speaker 1: way dictated by index providers UM well merely to make
Speaker 1: the point that as new kind of capital um and
Speaker 1: is invested, UH, there are reverse ways of thinking about
Speaker 1: how that is directed to corporate um and one can
Speaker 1: either take a very active decision to say, well, a
Speaker 1: certain company has certain growth prospects determined by its fundamental
Speaker 1: outlook or its role in society overall, and accorded to
Speaker 1: certain evaluation and allocation of capital accordingly, or else it
Speaker 1: is simply grown to be a certain size of a market,
Speaker 1: and therefore, as new the capital comes in to an
Speaker 1: index that that company is simply accorded extra value purely
Speaker 1: because of the size it's reached in the index. Already,
Speaker 1: I want to ask about what it will take for
Speaker 1: active management to make a comeback, essentially, and to for
Speaker 1: managers to convince investors that there's more to life than
Speaker 1: just the upfront fee. And something I've been thinking about
Speaker 1: this year is that we have had these periods of
Speaker 1: volatility in which the relationship between stocks and bonds that
Speaker 1: we've been talking about has not in fact held up
Speaker 1: the way people might have expected. Whether it's the February
Speaker 1: volatility or volatility this fall, and yet when I look
Speaker 1: across the landscape, I don't exactly see active management appearing
Speaker 1: to have done all that well. To be honest, and
Speaker 1: I know that you know, it was a pretty brutal
Speaker 1: month for many hedge funds. I think November was pretty
Speaker 1: awful for them. So I'm curious why haven't we seen
Speaker 1: this year more examples of active managers saying, ah ha,
Speaker 1: this is what you pay us for because we can
Speaker 1: deliver in times like this and then be just what
Speaker 1: the general strategy will be for the industry to not
Speaker 1: keep bleeding A m yeah. Um. So I think that's
Speaker 1: certainly apparent from conversations have had with active managers over
Speaker 1: the last few years that a few people have taken
Speaker 1: a view what we really need is a big draw
Speaker 1: down in the market and that will separate active and passive.
Speaker 1: And my response always been, will be really careful what
Speaker 1: you wish for, because the two thousand and eight period
Speaker 1: was not a happy one for many active managers, So
Speaker 1: I'm not sure if that is something that active managers
Speaker 1: should wish for. It's not in a short term anyway.
Speaker 1: I think there is something that can be said about
Speaker 1: the potential for active out performance and the structure of
Speaker 1: the market, And by that what I mean is the
Speaker 1: performance of active managers tends to depend on how many
Speaker 1: independent bets they can put on in their portfolios. That
Speaker 1: in turn is a function of how correlated stocks are.
Speaker 1: And we happen to have gone through a period in
Speaker 1: recent years where stocks have been other stocks been very
Speaker 1: correlated amongst themselves, and that's an environment where it's generally
Speaker 1: harder for active managers to perform. So if correlation came
Speaker 1: down between stocks, they we at some point arrived in
Speaker 1: a more benign macro environment and that would help. The
Speaker 1: other thing is the dispersion between stocks and how different
Speaker 1: stocks are in terms of their valuation or their profitability. Again,
Speaker 1: if stocks are very dispersed in terms of their valuations,
Speaker 1: that then tends to help active manage performance. But all
Speaker 1: that really is just tactical and I think there's too
Speaker 1: much bigger things that would really help to drive the
Speaker 1: performance of active managers. And I'm not gonna try their performance,
Speaker 1: but but be the core focused their business models and
Speaker 1: restore faith in the industry. One is this idea of
Speaker 1: if we really are in a low return world, and
Speaker 1: if the next five to ten years is one where
Speaker 1: capital markets can only slightly beat inflation, then asset owners
Speaker 1: are gonna have to come into active managers or managers
Speaker 1: in general, and ask for return streams that can fund
Speaker 1: their liabilities. I don't think there is any such thing
Speaker 1: as passive asset allocations, so I'm almost definitionally that generation
Speaker 1: return stream has to be an active decision. Now, of
Speaker 1: course it can involve a passive instruments as part of that,
Speaker 1: but overall it has to be active, I think. And
Speaker 1: the second thing is this idea that by the creation
Speaker 1: of so many indices, and by the cheapening of broad
Speaker 1: market um exposure and the cheapening of factor exposure in particular,
Speaker 1: it finally gives a new tool for asset owners to
Speaker 1: decide which kind of returns streams they should pay for
Speaker 1: and mass the owner who has scarce has to spend
Speaker 1: on ASID management services logically should spend them on a
Speaker 1: manager who can give a return stream which you cannot
Speaker 1: get from holding a combination of simple factor strategies. Hence
Speaker 1: the idea that it's not the active share or the
Speaker 1: overall out performance of manager that becomes important, but it
Speaker 1: is how much idiosyncratic returns are they can generate. Him
Speaker 1: by that, I mean the returns that idiostyncratic to a
Speaker 1: set of factors that they could buy cheaply, alright Innego
Speaker 1: Fraser Jenkins of Bernstein Research, thank you so much for that.
Speaker 1: That was great. Thank you for your time. So Joe,
Speaker 1: I found that discussion really fascinating and much more nuanced,
Speaker 1: perhaps than I would have thought based on the titles
Speaker 1: of his research. Yeah, I mean, I can't. He said
Speaker 1: he wasn't at the very beginning, that he wasn't act
Speaker 1: anti passive per se. But I'm sure it's understandable why
Speaker 1: people interpreted that he was if you're going to say
Speaker 1: it's worse than Marxism. But I get his point that
Speaker 1: from a strict capital allocation standpoint, that the essential truth
Speaker 1: of based going based on the indices, which is that
Speaker 1: the indusicries are weighted towards size, and passive investing inherently
Speaker 1: will just reward yesterday's biggest companies. That that may be
Speaker 1: one of the worst ways to allocate capital imaginable. Yeah,
Speaker 1: and there are some big picture questions embedded in that idea,
Speaker 1: one of which has to be you know, what is
Speaker 1: the stock market actually telling us if the price signal
Speaker 1: embedded in it is being so distorted by indexes and um,
Speaker 1: you know, these massive allocations of capital to the biggest companies.
Speaker 1: By the way, there are other people out there who
Speaker 1: have had a similar idea to this. You know, Matt
Speaker 1: king over at City has talked before about how markets
Speaker 1: used to be self limiting in the sense that you'd
Speaker 1: get a bunch of money moving into one asset and
Speaker 1: eventually it would become overvalued and then money would leave
Speaker 1: that asset. But he argues that because we have so
Speaker 1: much passive investing, basically the market never self limits anymore,
Speaker 1: and you have inflows essentially following inflows. So you know,
Speaker 1: this isn't necessarily a unique idea. Yeah, it's interesting to
Speaker 1: think about that. So obviously, anyone who's sort of maybe
Speaker 1: through a retirement plan just sort of throws money every
Speaker 1: month at a index fund that tracks the SPI is
Speaker 1: buying a lot of Amazon every month, and they're buying
Speaker 1: a lot of Microsoft every month, and they're buying a
Speaker 1: lot of Apple. It raises the question would they do
Speaker 1: that if they weren't just buying the index, or would
Speaker 1: they not keep throwing money and in fact the lion's
Speaker 1: share of their money at the biggest company. So really
Speaker 1: like that idea we should get Have we tried to
Speaker 1: get mad on the show? We probably he's been on
Speaker 1: the show, we weren't. Yeah, well let's get him back
Speaker 1: on and talk about that time specifically. Yeah, yeah, we
Speaker 1: totally should. Um And I just want to say, you know,
Speaker 1: I talked about a little bit, but I am fascinated
Speaker 1: by this how the relationship between stocks and bonds just
Speaker 1: keeps creeping up in our conversation, and how many different
Speaker 1: things going on in investing could change dramatically if intra
Speaker 1: asset class correlations were to change, and how many strategies
Speaker 1: that we think our sound inherently might end up being
Speaker 1: totally busted in a different environment one that could come about, say,
Speaker 1: if inflation were to pick up. Yeah, it's definitely a
Speaker 1: recurring theme on this podcast. We should start an index
Speaker 1: called risk disparity disparity. Let's do it. We have a
Speaker 1: lot of projects. Okay, this has been another edition of
Speaker 1: the Odd Thoughts podcast. I'm Tracy Alloway. You can follow
Speaker 1: me on Twitter at Tracy Alloway, and I'm Joe Why
Speaker 1: isn't all. You can follow me on Twitter at the Stalwart,
Speaker 1: and you should follow our producer on Twitter tover Foreheads.
Speaker 1: He's at foreheads t as well as the Bloomberg head
Speaker 1: of podcast Francesca leading at Francesca Today. Thanks for listening.