Index Investing is not Inherently Socialistic

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Index Investing is not Inherently Socialistic
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Index Investing is not Inherently Socialistic

How does capital get allocated to the public stock markets?  Through the following means:

  • Initial Public Offerings [IPOs]
  • Follow-on offerings of stock (including PIPEs, etc.)
  • Employees who give up wage income in exchange for stock, or contingent stock (options)
  • Through rights offerings
  • Company-issued warrants and convertible preferred stock, bonds, and bank debt (rare)
  • Receiving equity in exchange for other claims in bankruptcy
  • Issuing stock to pay for the purchase of a private company
  • And other less common ways, such as promoted stocks giving cheap shares to vendors to pay for goods or services rendered.  (spit, spit)

How does capital get allocated away from the public stock markets?  Through the following means:

  • Companies getting acquired with payment fully or partially in cash.  (including going private)
  • Buybacks, including tender offers
  • Dividends
  • Buying for cash company-issued warrants and convertible preferred stock, bonds, and bank debt
  • Going dark transactions are arguable — the company is still public, but no longer has to publish data publicly.

I’m sure there are more for each of the above categories, but I think I got the big ones.  But note what largely does not matter:

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  • The stock price going up or down, and
  • who owns the stock

Now, I have previously commented on how the stock price does have an effect on the actual business of the company, even if the effects are of the second order:

My initial main point is this: capital allocation to public companies does not in any large way depend on what happens in secondary market stock trading, but on what happens in the primary market, where shares are traded for cash or something else in place of cash.  When that happens, businessmen make decisions as to whether the cash is worth giving up in exchange for the new shares, or shares getting retired in exchange for cash.

In the secondary market, companies do not directly get any additional capital from all the trading that goes on.  Also, in the long run, stocks don’t care who owns them.  The prices of the stocks will eventually reflect the value of the underlying claims on the business, with a lot of noise in the process.

My second main point is this: as a result, indexing, or any other secondary market investment management strategy does not affect capital allocation much at all.  Companies going into an index for the first time typically have been public for some time, and do not issue new shares as a direct consequence of going into the index.  The price may jump, but that does not affect capital allocation unless the company does decide to issue new shares to take advantage of captive index buyers who can’t sell, which doesn’t happen often.

The same is true in reverse for companies that get kicked out of an index: they do not buy back and retire shares as a direct consequence of going into the index.  They may buy back shares when the price falls, but not because there aren’t indexers in the stock anymore.

So why did I write about this this evening?  I get an email each week from Evergreen Gavekal, and generally, I recommend it.  Generally it is pretty erudite, so if you want to get it, email them and ask for it.

In their most recent email, Charles Gave (a genuinely bright guy that I usually agree with) argues that indexing is inherently socialist because you lose discipline in capital allocation, and allocate to companies in proportion to their market capitalization, which is inherently pro-momentum, and favors large companies that have few good opportunities to deploy capital.

I agree that indexing is slightly pro-momentum as a strategy, and maybe, that you can do better if you remove the biggest companies out of your portfolio.  Where I don’t agree is that indexing changes capital allocation to companies all that much, because no cash gets allocated to or from companies as a result of being in an index.  As a result, indexing is not an inherently socialistic strategy, as Gave states.

Rather, it is a free-market strategy, because no one is constrained to do it, and it shrinks the economic take of the fund management industry, which is good for outside passive minority investors.  Let clever active managers earn their relatively high fees, but for most people who can’t identify those managers, let them index.

If indexing did lead to misallocation of capital, we would expect to see non-indexed assets outperform indexed over the long haul.  In general, we don’t see that, and so I would argue the indexing is beneficial to the investing public.

I write this as one who makes all of his money off of active value investing, so I have no interest in promoting indexing for its own sake.  I just agree with Buffett that most people should index unless they know a clever active manager.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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