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Strategies & Market Trends : Moomin Valley (formerly Troll-free Zone)

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To: CharlieChina who wrote (1407)	8/11/2006 11:05:45 AM
From: Moominoid	Read Replies (2) of 2852

The Paradox of Indexed Investing Recently I have been reading a lot on the theory of trading and hedge funds and musing about what trends in investment strategies mean for the future of returns on different forms of investment and trading. The following thoughts are hypotheses rather than any worked out kind of theory. In a world where everyone is an active investor (and investing on the long side only) trying to exploit valuation anomalies perhaps the market index reflects the average of their returns. Therefore, if you hire a manager, the average manager will return to you less than the index return once you pay their fees. The best managers will also migrate to the hedge fund world where they can charge larger fees leaving the average mutual fund manager making less than the index even before fees. Hedge fund managers can also exploit opportunities on the short side and therefore even after their fees do better than long-only mutual fund managers - at least the better hedge fund managers do. In comes passive indexed investment. What is the point of paying for an active manager if they earn less than the index say investors? So they put their money in index funds, ETFs, futures etc. That is about where the investing world was at a few years ago. The potential paradox is this - all the investors who are putting their money into indexed products are no longer pursuing valuation anomalies except to the extent to which they do this is when losing stocks are dropped from the index and winning stocks added. These market participants are no longer contributing to making the market efficient. This means that the remaining active investors have more opportunities to exploit as some of their competition is removed! The bigger indexing gets the more it will again underperform active management. In recent years actively managed funds have outperformed the index in the US markets. I blogged before that this was likely because we were no longer in the strongly trending markets of the 1980s and 1990s. This is probably true but could indexation also be a factor? We could even envisage long term cycles of active and passive management being more and less popular. Any thoughts?

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