An article in yesterday’s FT (16/3/2015) on active investment management, versus passive, by Sophia Grene prompted some thoughts on the topic of “public goods”. Passive management is where a manager is simply tracking an index whereas active managers are actually making their own investment decisions. Active management typically costs more to the investor, on the premise that more work is required to be put in by the manager, but they argue that it is justified because they can outperform the market. Others suggest their additional costs are not worth paying.
Let’s not get into that debate here. But the interesting point made by Ms Grene was, and I quote: “Passive investors reap the benefit of having active managers do the work, while only the active managers’ clients pay for it”. As she points out this is called “free-riding”.
Without the active managers doing specific stock selection, and buying and selling stocks based on their independent views, there would be no real market. You can see this if you consider the extreme case where there was one active manager with the other 99% of the market tracking an index. It would be extremely volatile as the active manager’s every move would swing the whole market. If the active manager did not consider it wise to hold a stock, nobody would want to hold it and the price would rapidly fall lower and lower. If the active manager decided to buy a stock then the herd would quickly follow. Indeed with such a high percentage of the market now held by index trackers and “closet trackers”, one can possibly already perceive this herd instinct in play.
Ultimately one might have to tackle this problem by regulation or other means to ensure that there was sufficient diversity to make a market. However the more “herding” there is, the more the lone active manager can profit because all they have to do is bet on themselves being followed, or anticipate when momentum effects will no longer persist. In other words in the latter case when the market is becoming truly illogical and therefore offering exceptional value. So this might put a limit on the lack of diversity in the market.
Now as an aside ShareSoc like many representative organisations has the “free-riding” problem. We campaign on matters of public interest, or at least in the interest of a wide spectrum of investors. But we are supported by very few of them financially. Why should others join when they potentially will get the benefit of our campaigns on such matters as shareholder rights when they can freeload on the support of others? This is of course a typical problem for trade unions. Potential union members may be willing to pay subscriptions when a strike is looming, but not at other times and for general representation.
A good book on this subject is “The Logic of Collective Action” – subtitled “Public Goods and the Theory of Groups” – by Mancur Olson. One of the things that groups can do to engage a wider audience and cover the cost of representing the free-riders is to provide other services. So for example, the AA was an organisation originally formed to promote the interests of motorists (and actually to help them avoid speed traps), subsequently started to offer breakdown and other services and have finally became a totally commercial organisation with the “public benefit” sidelined and spun off. That is one reason why ShareSoc not only does representation (to Governments or companies on behalf of members), but we also provide an information service, discounts on third party services and education. One might say our members get a lot of the representation aspects thrown in for free. But by offering other services it enables us to keep our membership cost low. That is how we manage to do so much with so little.
It isn’t just the actions of the managers, but all the information they’re based on. There’s a huge amount of research done on companies by brokers and analysts, some of which is public and some private, all of which goes into keeping the prices reasonably sane (most of the time). The fact that all that information is available is precisely why fund managers tend not to outperform – that’s the essence of the efficient market hypothesis, that all available information is already in the price. As more funds go into trackers and quasi-trackers there will be fewer people prepared to pay for all that analysis – in the end even the remaining active managers may have less to go on, or will have to charge even more.
Stephen, – a good point. The fewer active managers there are, the fewer people are paying to support research.