Passive Investing
Numerous organizations and individual investors have elected to use Index Funds to invest a major portion of their equity assets because active human money managers have fail to beat the performance of a simple market cap weighted index. Although totally rational from an investor’s point of view, the decision to use Index Funds compromises the free enterprise system and jeopardizes the economic process that supports the equity markets. If the use of Index Funds does not kill the goose that lays the golden egg, it will certainly reduce its laying capacity.
Historically, financial analysts have performed a critical service by helping the market economy funnel funds to new ideas and products represented by emerging, rapidly growing companies. This vital service will be lost if the only way a company’s stock is valued is if it is included in some index. The idea that a company’s stock appreciates in proportion to its market cap representation in some index, rather than its managerial skills, new ideas, or products is totally counterproductive. This will lead to significant problems for our economic system.
Our economic system depends on a resource allocation process that is based on logic and merit, a system that rewards progress and performance. Many corporations offer stock or stock option incentive programs to their employees today to help motivate them and to reward good performance. If the value of the stock or stock options is based, not on merit, but on the company’s inclusion in some stock index, the system loses its value
More and more public institutions are adopting Index based strategies to cover themselves and avoid criticism that they are under-performing the market indices. In so doing, they are actually undermining the very economic system they are hoping to benefit from. If the market is totally random and beyond interpretation, then it no longer becomes an affective vehicle for channeling resources to where they are needed and can be most effectively used to enhance the free enterprise system. If no value can be added by studying a company’s fundamentals, then investors acting in their own self-interest should invest in Index Funds. Then we, as an economic system, have a problem!
By investing in an Index Fund you buy the good, the bad, and the ugly. No attempt is made to separate the innovative from the old line, the dynamic from the stogie, or the superior performing companies from those that are struggling and having trouble. You rely upon the committee of analysts at Standard & Poors, Vanguard, Morgan Stanley or Wilshire to select reasonable companies. The job of these committees, however, is not to find good performing companies. Their job is to find companies the represent the market and its various sectors so that their Index accurately reflects the market performance. Their motivation for selecting companies is not necessarily the same as the investor’s.
The growth of Index Funds is symptomatic of a more basic problem; the failure of the money management and the security analyst communities to adopt new ideas and technology. The information sciences are making tremendous progress harnessing technologies such as; case based reasoning, fuzzy logic, expert systems, genetic algorithms, neural networks, and evolutionary programming. Until the financial community embraces these and similar technologies, Index Funds will continue to win out and our economic system will be compromised. To stem the tide of Index Funds, money managers must be able to add value to their managed portfolios.
There is ample evidence that these decision support technologies work and can add value to managed portfolios. Advanced AI computer systems tend to take on human like characteristics. They can recognize relationships and patterns that we have normally thought only understood by humans. And in fact, they can detect relationships among financial variables far too complex for humans to perceive or understand.
Because the term indexing has a negative connotation in some circles, recent articles written on the subject have introduced the term “passive investing.” This term is often used interchangeably with indexing, but we would like to make a distinction here between the two. Indexing can be thought of as “taking all human thought and reasoning out of the investment selection process,” whereas we would like to think of passive investing as just removing the human from the process and retaining thought and reasoning. As the proponents of Behavioral Finance will tell you, the human is the source of the problem, not the thought and reasoning. The problem is that up until now we have not been able to separate the idea of thought and reasoning from humans. It has only been in the last ten or fifteen years that intelligent computer technology has developed to the point that it can now take on some of the tasks that we have normally reserved for humans.
Passive Investing does not necessarily mean accepting market index returns. If outperforming the market indices is your goal, you need to be exploring the use of intelligent computer technology. The use of intelligent computers removes the active human manager from the process but still applies the high level logic and understanding that you need to beat a dumb market index. Intelligent computers are capable of performing a level of analysis that is so sophisticated and intricate, that it is far beyond anything that a human financial analyst could even contemplate.
Many people mistakenly classify Artificially Intelligent computer systems as a form of quantitative analysis. There are two distinct differences between advanced AI systems and traditional quantitative analysis. They are: (1) who makes up the selection rules and weighting, and (2) what information is used to discriminate between good and poor performing securities.
In most quantitative systems, even in an advance Expert System form, humans make up the investment rules and mathematically derive the weightings associated with the rules. Computer systems that depend on outside human intelligence to program their actions are not inherently intelligent. In advanced AI systems, the computer makes up its own rules and weightings. The computer learns from examples of good and poor performing stocks, and determines its own ways for discriminating between them. The procedures that are derived by the computer are often so complex that they defy human understanding.
In addition to making up its own rules, advanced AI systems look at corporate financial data differently. Just like in the human brain, where information is not stored in the brain cells, but rather in the connections and relationships between cells, so too is corporate performance information stored in the relationships between financial numbers. Assessing the performance of companies is not so much in the numbers as it is in the connections between the numbers. Financial analysts recognized this early on and have used first order relational information in the form of financial ratios for many years (price/book, debt/equity, current assets/current liabilities, price/earnings, etc.). Now with advanced AI systems we are finally able to look at and evaluate high order interrelationships in financial data that have been far too complex to analyze with less sophisticated systems. These then are the fundamental differences between what has been used in the past and what will be used in the future.
Portfolios managed by intelligent computers are truly the next step in passive management. They avoid all of the human emotional and intellectual limitations, and eliminate investment style considerations. They focus totally on the primary objective; maximizing investment returns. With intelligent computer passive investing you avoid the weak companies and focus on the strong. You get the diversification of an index, but avoid the underperforming sectors and companies that constrain the index’s performance. The intelligent computer’s objectives are aligned with the investors.