In case you haven't been following financial news over the past decade, it seems that one of the most debated topics is regarding the merits of passive investing versus active investing and which might win out at the end of time. Unfortunately, or perhaps fortunately if I'm able to convey something new, I feel compelled to at least address the issue in the context of our prior posts and how I believe the financial industry may evolve in time. This will build a conceptual foundation for later posts as well.
Let’s assume there are three categories that asset management can fit into, which is probably an oversimplification, but it’s a place to start. First, we have completely “passive” investments. We’ll generalize and say that any individual who has money to invest, but wants to make minimal investment decisions and just wants to be “in the market at minimal cost” can put their money into an index fund. Sure, there are many to choose from even then, but let’s just assume being in the market is investing in an S&P Index Fund (likely a low-cost ETF such as SPY or IVV). Then, at the other extreme is “active” investments. This firm or person follows an active process by which they select investments for themselves or clients. They may interview company officials, read financial statements, complete a little financial statement analysis, etc. Then, they buy stocks of companies that meet their requirements, whatever those may be. Lastly, in the middle of the entirely passive and entirely active is what we’ll call the quantitatively selected investments (“quant”). There is a wide range of what this entails, but generally it involves using static or evolving mathematic and statistical models to choose investments.
In continuation of the active/passive/quant discussion, we must explore the additional concept of price discovery. In short, price discovery is the activity by which market participants compute and agree to pricing for each security. Not to muddy the conceptual waters, but we need to remember that the market acts as both an input and output tool as explained in our prior post here. You might recall we referred to this input/output process as the "market process". Also, you should recall from the above linked post that we identified two primary motivations for buying stocks: The first motivation is the price based on some perspective regarding intrinsic value relative to the last trade price as discussed above (value investing). The second motivation is the price based on what they believe that other market participants are going to be willing to buy or sell the security at in the future (momentum investing).
Now, let’s return to the passive/quant/active discussion. Taking each separately, let’s assess whether each performs price discovery, and thus provides input to the markets, and thereby allowing the market process to function. We’ll start with active first. Active managers generally complete valuation assessment activities that provide some evidence as to what the intrinsic value of a stock is at a point in time (eg. Earnings, growth, quality of the company, etc). They then compare that intrinsic value against the current market value of the stock and determine if there is any margin of error present. Generally speaking, if the current price is at or below what they compute as intrinsic value, they will proceed with purchasing the stock and vice versa if selling. Therefore, it appears that active investment managers perform price discovery, which is valuable to the market process and helps market cycles avoid becoming bubbles.
Next, let’s assess quants or quantitative strategies. Quants compute a myriad of metrics on stocks and purchase or sell based on those metrics. Sometimes the metrics are valuation driven, sometimes they are momentum driven and sometimes they are driven by countless other metrics, including combinations of metrics. Regardless of the metrics used, quants are using some form of input from some combination of the market and company data and translating that into buy/sell transactions, which results in providing the abovementioned input to markets. As with active managers, this allows the market process to continue and can help avoid bubbles, which arise when market valuations become detached from real fundamentally driven intrinsic value. Also, we should recall and acknowledge that some aspects of what drive quants’ investment decisions are based on assumptions that prices will continue upward (in the case of momentum investing), while other aspects such as value driven investments are more motivated by price discovery and securing a margin of safety. Because of these differing approaches and inherent motivations that quants employ, we might conclude that their activities are a hybrid of the two motivations outlined above for purchasing stocks. Perhaps an argument could be made that momentum strategies are not performing price discovery, while value strategies are performing price discovery, because in general, only the latter considers the relationship to fundamental earnings growth or the root drivers of an investment’s value in the absence of an expectation that a “greater fool” is going to come along later to buy at a higher price.
Last, let’s assess passive investments. In general, the nature of the term passive is that there is nothing active guiding the decision process, or simply put, there is little or no decision process. I will admit, I’ve been using passive investment tools for well over the past ten years and I do not believe that it is inherently bad on its own as long as other market participants are actively pricing assets. There is generally no price discovery involved when someone has money to invest and simply wants “to get into the market” and doesn’t know how better to do it than by purchasing an S&P 500 Index fund, which is very economical in terms of management cost. In my experience as an investment manager, I've often found there is a trade-off between speed of investment transactions and price of investment transactions. Generally, if an investor is adamant about the price they want to pay, they may not be able to purchase that stock currently, as they may have to wait until the market price aligns with their perspective regarding its intrinsic value. However, if an investor is more adamant about timing (they insist on buying now), then they generally have to concede on the price side by paying a higher price, and vice versa if they're selling. In the case of a purely passive investor, when they want to invest only in an index fund, I suspect most investors prefer to focus on time of execution (now) versus the purchase price. Focusing on time instead of price tends to have more impact on market prices than a focus on price.
So, why is price discovery important? To address this question appropriately, we need to return to what we’ve so far referred to as the market process. This is not the same as the macro market cycle as described by Howard Marks in Mastering the Market Cycle, but rather the simple input/output loop nature of the market as described here. This process is completed over and over many millions and likely even billions of times every day. For any machine to work effectively, all of its parts generally need to operate and work well together. When we consider that market participants contribute input to the market to effect buy/sell transactions, we also see the market transmit that transaction price (output) as the best indication of market value for the stock exchanged. However, if market participants (buyers or sellers) begin to avoid price discovery and simply transact at whatever price is required by the opposing party, we might begin to see a degradation of the output value provided by the market as the transaction effectively becomes one-sided and is overly driven by the opposing party rather than by both parties being in balance. In this case, the input part of our market process is not functioning appropriately, so the output part might also become corrupted. This could result in significant swings in market valuations based on market sentiment, individual needs of investors unrelated to intrinsic value or other causes. When market valuations become detached from logical, realistic intrinsic values, we see market inefficiencies result and the possibility of creating bubbles increases. Effectively, the best environment for a capitalist market system is for everyone to come to the market armed with their best estimate of fair value of a stock and then fight to buy or sell the stock for as close as possible as they can to that value. Ideally, both parties to each transaction would be equally price sensitive, without one being more or less motivated by time than the other.
One of the best examples of a lack of price discovery I’ve observed in recent years was in Bitcoin valuations. Being relatively new to public markets, the intrinsic valuation of Bitcoin as an asset has been somewhat nebulous since its inception, insofar as I can tell. When an investor purchases a share of stock of a company, they are generally purchasing a right to the future cash flows of that company, which can be discounted to a present value. In contrast, the intrinsic value of Bitcoin is much harder to value and even contemplate. Therefore, if anyone was buying Bitcoin based on a computed intrinsic value, it was almost assuredly a significantly different value than anyone else was able to compute because the inputs are of debatable significance and varied, resulting in wildly varying assertions of intrinsic value. When there was little consensus as to a Bitcoin’s intrinsic value, there was no anchor of its valuation to reality (a stream of future cash flows). Because of this, it was much easier for most investors to justify buying Bitcoin on its meteoric ascent to $19,783 in December 2017, and prior to its crash to $3,183 in December 2018.
Tying this into the concept of the market process explained above, it appears that while the market was continually providing its output, there was no one (or very few parties) providing input computed based on fundamental or intrinsic valuations. Again, insofar as I could tell, the only fundamental change in information regarding Bitcoin was its popularity and therefore its scarcity because it is a fixed quantity commodity. Therefore, the market process became lopsided to the point that investors began to buy only on hope that the momentum that raised the price prior to their buying would continue after their purchase so that they could sell at a gain later. Again, as long as the music continued to play and others were continuing to buy simply based on the belief that later buyers would buy at a higher price rather than a fundamentally sound computation of intrinsic value, an investor would be alright. However, if the music stopped, and all other investors in the market realized that there were no actual rights to a stream of future cash flows or some other fundamentally sound intrinsic value as there is with a stock investment, look out below as the bubble would burst. This is effectively what happened from late 2017 to 2018 and is an excellent example of the one-sided market process failing due to lack of price discovery to many investors’ chagrin.
Does this mean that passive investing is inherently bad? I don’t believe so. However, I believe that everything in life requires balance and it is when things get out of balance that bad situations are the result. This is as true in equities markets as it is in all other aspects of life. In essence, I believe that there has to be some minimal level of price discovery occurring in the markets to offset the lack of price discovery occurring from passive investment. Over the past ten to twenty years, we’ve seen a prolific trend in mutual funds and ETF’s that have fueled the passive investment migration. More on this later.
At Triobe Management, we are careful to select stocks based on a balance of value and momentum metrics to take advantage of both types of style factors. In doing so, our investment screens allow us to take advantage of fair or underpriced stocks that have also shown signs of positive momentum. We believe our approach contributes to the market process in a balanced and responsible way that allows the market to function in a naturally efficient way.
Disclaimer: I will happily disclose that I am no expert on Bitcoin valuation and I'm sure there are a number of folks who can prove out reasonable calculations on the intrinsic value of a Bitcoin, but I believe they are far fewer than the number of people who invested in Bitcoin during the Fall of 2017, resulting in the outcome we observed.
Comments