Free rides in index land…but active managers are not really pricing, or being priced effectively.

I was passed along (hat tip Ken Kivenko) an interesting blog commentary on index funds and the free rides they were taking on the back of active fund managers.  It also pointed out that passive investing was skewing the market: .

Briefly, there are a few comments I would like to make.

Number 1 – yes, in a way, ETF’s and other indexed investments are enjoying some sort of free ride.  Yes, without proper active management, valuations and allocations within markets would become skewed (as they have been) and there would be unwanted risks.

Number 2yes, blindly allocating to broad large market cap based indexed investment can be risky at times because of inappropriate market pricing, but most active mutual funds/collectives also tend to be very similarly weighted, but at a higher cost.

Number 4-  no: the problem is that many… many active managers, in general, are not really active in the sense that their allocations do not differ markedly enough from the market.   A large part of their allocations are reinforcing herd like mentality, when what you really need from active management is to take on risk when there is little demand for it and selling it when there is too much demand.   Active management is really being compromised by the broader portfolio and risk management objectives of the more diversified fund objective.

The active part of a fund should be that part of the allocation which exceeds/is less than the market allocation.  We need active managers to focus only on differentials to price and value the markets.   In other words, if a manager differs from indexed allocations by say 20%, 80% of the fund is effectively indexed and only 20% is genuinely active (acting against relative demand and supply flows in the market place). 

We need active managers to focus only differential pricing.   The less efficiently priced the market the more active management and vice versa.  The less efficiently priced the higher the returns to true active management and the greater the allocation to active management and vice versa.

Number 4 – If active managers were properly compartmentalised, then instead of passive investors riding piggy back on the market, it would be the passive investor who would be leaving the return to pricing to the active managers.  In this case active managers would be the parasites.

It should not really take too large a true “active” manager segment to move markets and share prices towards proper pricing – allocations would be much more short term (that is they are not generating return from compounding but from mispricing) for one, meaning that all the active manager activity would be focussed.   You just need to look at those days in the markets where you have large swings in share prices to realise how big an impact the marginal buyer and seller can have on share prices to realise this. 

But, we do not just need a change in the way active managers manage and allocate or the way in which portfolios are structured.  Regulation needs to change to allow for what are effectively hedge type funds into the mainstream financial services market place.    Isolating the active, would also make it easier to price and reward active management and for investors to better assess the costs and rewards of such.

One other issue which is not really discussed, but which is also important, is the fact that excessive monetary growth has also impacted market valuations and forced markets over the few decades to misprice assets based on long term real returns and risks.  Another is the belief that markets are efficient and that prices are correct, allowing many to ignore valuation differentials and risk in decision making.

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