Dear
Speculators,
Theoretically,
equity market investments provide the most attractive returns of any financial
market. Since investors assume higher risks when purchasing common stocks, they
are rewarded with high returns if the risk fails to materialize. Value
conscious investors invest capital in stocks to gain returns in excess of
inflation whilst moderately increasing their real wealth. However stock picking
and market timing are two very important elements of investing that most (if
not all) investors are still yet to perfect. While active money managers for
decades have tried to outperform the market, very few have achieved this feat.
This has increased interests in passive investing over the last few decades. In
fact the introduction of index funds which allows investors to earn market
returns at very little cost has provided investors an opportunity to quit
fighting and accept the inevitable that they just can't beat the market!
Today index
funds manage trillions of dollars around the world. Many fear that indexing may
cause asset prices to deviate from their intrinsic value which will make the
stock market less efficient. Market inefficiency may occur because index
investors do not trade stocks based on the expected performance of individual
companies rather it's ideology is that the law of large numbers will protect
investors who purchase bad or overvalued stocks since on the average there
should always be more decent performing stocks than poorly performing stocks
thus providing the index investor with a positive return greater than the risk
free rate with less risk, less cost and less stress. While the argument may
have a bit of sense attached to it, it dangerously plays down the economic
hazard of inefficient prices and misallocation of one of the most important
resources to production and growth, CAPITAL. Since poorly performing firms can
receive capital more than they require or deserve due to discrepancy in stock
prices, this will prevent excellent companies who require additional
capital from getting the full capital that they deserve.
To prove the
unsustainability of the indexing strategy and its harm to market efficiency,
one would have to imagine a world where the stock market is fully capitalized
by index funds. Stocks prices will fail to react to changes in the economic
fundamentals and only respond to changes in the flow of money in and out of
index funds. New securities included into the index will receive capital not
based on merit but simply because these companies went public. This then
creates a moral hazard problem as investment bankers will now simply unload
into the market worthless companies at exorbitant prices since nobody seems to
care about the quality of the businesses they invest in as long as they are
listed in the capital market. A period of market bubble and potential financial
doom will ensue as the rate of financial crimes will rise to its highest level
ever in human history. Investment bankers will steal trillions from
unsuspecting ignorant investors. Once investors realize the level of financial
crimes permitted by indexing, it will lead to a period of massive cyclical
outflows out of index funds to actively managed funds. Giant bubble build ups
will pop and the market will endure the world ever financial depression. A few
investors will be able to get out early but many won't be so lucky. But at
least investors will again learn something new from history that no investment
strategy can be overdone and still remain valuable.
Emeka Ucheaga,
Managing
Partner,
Emeka Ucheaga Advisory
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