The Wall Street Journal reported this week that Seminole Capital Management, a hedge fund with an enviable long-term track record, would be returning $400 million of its $3 billion under management back to outside investors. Here were some of the reasons given:
In an unusually frank letter to investors reviewed by The Wall Street Journal, Michael Messner and Paul Shiverick laid out a laundry list of woes that included the incursion of high-frequency traders, the rise of passive investments like exchange-traded funds and the U.S. Federal Reserve’s low interest-rate policy.
“In short, the game has changed,” they said. “We are not confident our model can maintain historical-like returns in the future,” without slimming down, they said.
I actually applaud this firm for taking these steps. They’re admitting their limitations and trying to become more lean to improve their odds for success. They could have easily continued to earn fees on that money, but instead did the right thing and returned investor capital. There aren’t enough fund managers who would do the same.
Here’s another one of the reasons that really caught my eye:
They also said “there are fewer traders at the poker table to play against” because of the growing popularity of passive investing.
The light bulb immediately went off when I read this because it sounded so familiar. In fact, it’s the same exact theory that Larry Swedroe and Andrew Berkin laid out in their book, The Incredibly Shrinking Alpha. Here’s what they had to say (emphasis mine):
As ‘less-skilled’ investors abandon active strategies, the remaining competition, on average, is likely to get tougher and tougher. As the trend to passive investing marches on there will be fewer and fewer victims to exploit, leaving the remaining active managers to trade against themselves. And that is a game in aggregate they cannot win.
This theory is extremely counter-intuitive to most investors. The prevailing wisdom of most in the investment community is that the more passive investors there are the easier it becomes to find compelling opportunities. If there are fewer investors looking to exploit mispricings this would have to be the case, right? That may be true at a certain threshold of indexed investors, but my guess is the number would have to come up substantially from current levels for this to be the case.
Active investors still rule the market by a wide margin. Some would like to assume they’re just throwing darts in the dark, but in reality active investors are only getting smarter and better over time as more competition enters and technology progresses. As Michael Mauboussin has postulated in his work, the paradox of skill means that as more sophisticated investors have entered the marketplace the level of outperformance will continue to narrower over time. And as skill improves, luck becomes a much bigger factor in separating the winners from the losers.
Swedroe and Berkin continued:
What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, it is the relative level of skill that plays the more important role in determining outcomes, not the absolute level.
Intelligent people have an especially hard time admitting this to themselves. Finance is filled with those who have been the smartest person in the room their entire life. Type As don’t want to accept that this doesn’t always translate into market-beating results in their portfolios.
I’m not saying that passive investing is always the answer or that it will be anyone’s sure path to riches in the markets. No form of investing is easy and in many ways all investors are making different degrees of active bets. But there have always been a large number of investors who had no business trying to compete in legitimate actively managed strategies.
There’s an old saying that if you can’t figure out in the first five minutes of a poker game who the sucker at the table is, it’s you. What happens when most of the suckers decide to stop playing at the professional poker player’s table? As Warren Buffett once said, “Paradoxically, when dumb money acknowledges its limitations, it ceases to be dumb.”
Hedge Fund Seminole Management to Return $400 Million to Investors (WSJ)
The Incredibly Shrinking Alpha: And What You Can Do To Escape Its Clutches
Putting Passive Inflows Into Context
We’re All Smart
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I’ve never seen an academic paper researching this topic (though I haven’t looked either), but it seems like passive investors (ie those who invest in line with market cap indices or, assuming number of shares are fixed in the short run, invest based on the stock price) depend on the work of active investors (ie those that discover the stock price). The rewards of active investing aren’t stable and don’t accrue consistently to the same actors, but are vital to ensure a robust price discovery mechanism.
Though that last point may not be exactly dependent solely on active investors. Wharton did a paper that showed increasingly the institutions that operate large passive investment funds (Vanguard et al) use proxy voting to advocate for shareholder friendly policies. I don’t know if that encompasses share buy backs and dividends, but it may. I’ve also heard that activist investors court mutual fund owners for proxy votes when making a run at a target–though I don’t know if passive mutual funds would be a part of that.
It would be interesting to figure out if passive investing as a whole has weakened price discovery (large portion of assets that are price insensitive), strengthened it (allow “high conviction” actors to push one way or another), or no change (all the trading was noise anyway and price discovery requires very infrequent inputs by a small number of people).
Anyway you slice it, passive investing requires someone to be an active investor.
Agreed. The good thing is that there’s no way that passive will ever get big enough to make this an issue. Institutions control the bulk of assets the they are active my a wide margin. Plus, humans love to gamble, take risks and are mostly overconfident. Active will almost certainly always be more than passive in terms of market share.
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I think there are 2 reasons the ‘suckers at the poker table’ thesis is maybe a bit misguided.
The first is, unlike poker, it’s not a zero sum game. The great active investor puts money in an early Apple or Google or Microsoft or Starbucks, the company puts it to work, new products, stores, factories are created which didn’t exist before, that earn a good return, the investor profits, the pie grows. Ron Baron put money into Wynn without which the first hotel might not have been opened in 2005, or maybe never in its ultimate form. Now some of that came out of the pockets of investors in competitors. And the pie will grow and shrink for reasons beyond any individual investor’s control. But I think fighting for the biggest slice of a limited pie by fleecing the suckers is a trader mentality, not an investor financing a capital asset and business that will grow over time. Sufficiently smart money doesn’t need suckers, or makes its own suckers. It would be a shame if private equity became the only venue for people who want to own and grow businesses.
The second is, as you allude to, the sucker who moves to passive investing is still a sucker. More people moving to indexing means more herding, more correlation, more volatility. A sucker may give up trying to pick stocks, but it doesn’t make him stop being a sucker. He is probably going to be the one buying the Nasdaq 100 at the dotcom top and selling the Russell 2000 ETF at a 15% discount at the next market bottom, leaving maybe just as much on the table for the pros, just in a different way.
Whenever an active investor underperforms, you hear “omg the heeedge funds”…”omg the hf tees”…”omg the ETFs and passive investors…” “hoocoodanode this or that or the other thing.” It’s the sign of a bad investor. You have to zig when everyone else zags. So if more people are passive investors, market timing becomes more important and you have to find stuff outside the indexes. And yeah those who can’t should probably exit. If the exit of the bottom 20% of active investors puts you at the median you have a problem but you weren’t in great shape to begin with.
You’re not going to hear Warren Buffett complaining if everyone switches to indexing. More herding is great for him in the long run. But if you’re doing medium term stock selection within an actively traded index, yeah, yer gonna have a bad time.
Had blogged about similarities between investing and poker…http://blog.streeteye.com/blog/2013/08/risk-arbitrage-investing-and-poker/ …Blog post about differences forthcoming, probably…