Indexing, Communism, Capitalism and Equilibrium

Leading global research and brokerage firm Sanford Bernstein, in a recent analyst report, described Index Funds (which celebrated their 40th birthday yesterday) as being “worse than Marxism“. This comes on the back of some recent research which have accused index funds of fostering “anticompetitive practices“.

According to an article that says that indexing is “capitalism at its best“, Sanford Bernstein’s contention is that indexers “free ride” on the investment and asset allocation decisions made by active investors who spend considerable time, money and effort in analysing the companies in order to pick the best stocks.

Sanford Bernstein, in their report, raise the spectre of all investors abandoning active stock picking and moving towards index funds. In this world, they argue, allocations to different assets will not change (since all funds will converge on a particular allocation), and there will be nobody to perform the function of actually allocating capital to companies that deserve them. This situation, they claim, is “worse than Marxism”.

The point, however, is that as long as there is no regulation that requires everyone to move to index funds, this kind of an equilibrium can never be reached. The simple fact of the matter is that as more and more people move to indexing, the value that can be gained from fairly basic analysis and stock picking will increase. So there will always be a non-negative flow (even if it’s a trickle) in the opposite direction.

In that sense, there is an optimal “mixed strategy” that the universe of investors can play between indexing and active management (depending upon each person’s beliefs and risk preferences). As more and more investors move to indexing, the returns from active management improve, and this “negative feedback” keeps the market in equilibrium!


So in that sense, it doesn’t matter if indexing is capitalist or communist or whateverist. The negative feedback and varying investor preferences means that there will always be takers for both indexing and active management. Whether we are already at equilibrium is another question!

Betting against your co-investors’ misery

I don’t remember the name of the driver who drove me home that rainy night. I remember asking him, but it was almost three years back and I’ve forgotten. As was my usual practice then, I was sitting in the front seat of the cab, and chatted up the driver as we navigated the heavy Koramangala traffic. Our conversation would get interrupted by him getting calls asking him for money.

He had lost a considerable amount of money in chit funds, he explained. There was a chit fund in which he and his family members had invested. The fund gave them what he called “good returns” in the first cycle. The fund opened again for a second cycle, and once again he and his cousins all invested. This time, however, the fund manager had disappeared, taking with him his investors’ money.

While running a fund well for one cycle and disappearing with investors’ money the next is a classic fraud scheme in undocumented financial services, what intrigued me was that the driver and all of his cousins had invested in the same chit fund. The reason I was surprised is that in chit funds you bet against the misery of your co-investors. Let me explain how this works.

It is like a game played out by N investors over a period of N months (notice that the number of investors and the period of the cycle are equal). Each month, each investor contributes a fixed sum to the pot. And then the pot gets auctioned to the same set of investors, and goes to the investor who is willing to take the biggest “haircut”. Investors who are more desperately in need of money are likely to bid to take a larger haircut than those who need the money less. Once an investor has taken the discounted pot, he loses the right to bid for the pot in subsequent rounds (though he continues to contribute the fixed sum). Each round, the money left over after paying the “winning” investor is distributed as dividend among other investors (with the fund manager taking a portion as management fees).

Notice that this single instrument serves as both savings and loan instrument, with the catch being that it is all in-house. The “haircut” that investors are willing to take while they bid for the pot can be considered equivalent to the interest rate they are willing to pay on that loan (it is a loan – since they need to continue to pay the “premiums” for the full period of the fund). The assumption is that when you assemble a chit fund with a set of investors, each of them has different preferences in terms of when they need the money. Some see it as a savings instrument, and are liable to bid for the pot in later rounds. Others see it as a loan instrument, and bid for it in an early round. All the fund manager is doing is to facilitate this intra-group lending through a formal mechanism.

Also notice that the larger the haircut your co-investors are willing to take, the bigger is the profit that you stand to make. If nobody in the group is desperate for money at any point in time, the bids for the haircuts are going to be rather low. So if you invest in a chit fund and hope to make money off it, you must have reason to believe that there are other investors who are much more desperate for the money than others. So if I invest in a chit fund along with you, I’m betting that at some point in time you’ll need money so badly that you are willing to take a large haircut, so that I make a good dividend. So in effect, I’m betting against your misery!

So if a chit fund investor is actually betting against the misery of other investors in the same fund, there is no point in two people from the same family to invest in the same chit fund – they stand nothing to gain by betting against each other. It was a long drive home that day, and I explained it to the driver, and told him that it doesn’t make sense for him to invest along with his relatives in the same fund. He understood, he said, and added that he didn’t want to invest in the fund that he had lost money in (where the manager decamped), but his relatives accused him of being a “traitor” for not investing along with them, and so he complied! And they all went down together.




The growth of a new company usually consists of one short period of high growth preceded and followed by rather long periods of steady growth. Sometimes there might be more than one period of high growth, but for most companies, it is that one period when there is a point of inflexion and growth goes to a new trajectory.

Now, my point is that if you want to raise venture funding, you better do it when you think you are on the cusp of one such inflexion. Usually points of inflexion are associated with some increase in “leading” investment, and a small chance that the company will get on to a new trajectory, and a big chance that the company will go under.

This crude chart shows the typical trajectory of a young company. The beginning of the red zone is when you should raise venture money
This crude chart shows the typical trajectory of a young company. The beginning of the red zone is when you should raise venture money

If you look at the picture here, the beginning of the red region is the state where you need to get venture funding. The thing with the black regions is that irrespective of how you fund those, at best you can expect steady growth. Now, venture capital funds, the way they are structured, are not set out to fund steady growth. The way venture funds make money is when one out of a number of their investments makes shockingly great returns, while the rest go under. They are not in the business of funding steady returns.

Hence, when they fund your company they value you assuming that in case your company is successful there will be steep growth, which will enable them to recover their investment. And if your company is in steady growth phase, it is never going to be able to do that. And you will have a case of your investors pushing you to do more or something different from what you had planned doing. The problem here lies in the fact that you raised the wrong kind of funding!

In times like this or at the turn of the millennium, when venture capital is big, it can sometimes become the preferred mode of fundraising for a lot of companies. The problem, however, is that most of them don’t realize that venture funding is probably not the best form of funding for them at their size and scale, and then get weighed down by investors.

On a similar note, you should go public once you know that there are no really big points of inflexion coming up, and that your company is set on a path to steady growth. Again that follows from the fact that investors in the stock market (where they pick up tiny shares in each company) are usually in it for long-term steady growth. And if you happen to take undue risks and they don’t pay off, your stock will get hammered unnecessarily.

Cab guys’ tales

I travel to and from work in the company-provided cab. It’s a fairly convenient system, offering you flexible timings, and routings that aren’t too bad. The overhead in terms of time of traveling by cab is about 15-20 minutes for a 40-minute journey, so I take it on most days.

Given a choice, I try to sit next to the driver – maybe that’s the most comfortable seat in an Indica, and it definitely is the best seat in a Sumo. On most occasions, I chat with the driver as he drives me, but sometimes I don’t have the opportunity – since the driver is too busy chatting on his mobile phone. Yeah, company rules forbid that, but I guess no one really complains, so these guys get away with being on the phone a lot of the time.

Most of the time, the conversation is about loans, and repayment. Most of it is about informal loans that people have lent each other. The amounts these guys lend each other – seen as a percentage of their income (which I’m guessing based on what one cab guy told me last year) is humongous! They make loans to each other of the order of a few months’ salaries, and it seems like these loans are in perpetual transition – between the cabbies and their friends.

I hear them shout, strategise, pacify, ideate, about these issues. And sometimes after they’ve hung up I talk to them about this. One conversation comes to mind. So there was this cabbie whose family had lost a lot of money by “investing” it in a chit fund. It was an “informal” (i.e. unregistered fund), and in the previous “round”, his family had invested and made a good return. So in this “round”, more members of the family invested in the fund. And the fund manager decamped with the money!

I remember telling him that it was a bad strategy putting all their investments with the same guy, and tried to explain to him the benefits of diversification. He replied saying that he didn’t want to invest in the chit fund (the one he lost money in) but family members forced him to invest along with them, calling him a “traitor” when he tried to diversify!! Strange.

Back then, I didn’t know how exactly chit funds work else I would’ve also told him that it was an especially bad idea for people from the same family to invest in the same chit fund. If you think about how a chit fund works, you are basically betting on the desperation for money among the other “members” of the fund. You are betting that someone else in the pool needs money so badly that they’re willing to forego a higher “discount” which will then come into your kitty. So with members of the family all putting money in the same fund, they were just betting against each other! So even if the fund “manager” hadn’t decamped, it’s unlikely they would’ve got a particularly significant return on their investment.



It was our third term in IIMB. The institute had come up with this concept called “core electives” which no one had a clue about. These courses were neither core nor elective. And one of them happened to be Investments, taught by the excellent and entertaining Prof. R Vaidyanathan.

This was around the time when Kodhi and I had been trying hard to introduce the word “blade” (in the context of “putting blade” meaning “hitting on someone”) to campus. This word had been long established in Bangalore Slanguage, and we were trying to make IIMB also adopt the same. In order to further our efforts towards introducing this words, we even picked a batchmate each and actually started putting blade (ok I made that last one up).

So during the course of the class, Prof Vaidya said “the difference between a blade and scissors is that a blade cuts one way while a scissors cuts both ways”. I forget the context in which he said that, but it doesn’t matter. What matters is that a collective bulb lit up in the first row, where Kodhi and I had been sitting. “Blade” now had a logical extension. A new slang-word had been born at that moment, and later that day at lunch we introduced it to the general public at IIMB.

So that is the origin of the term “scissors”. Now the title of my blog post series in “arranged scissors” might make sense for you. Scissors happens when louvvu “cuts both ways”. When a pair of people put blade on each other- they are effectively “putting scissors” with each other. So in most cases, the objective of blade is to convert it to “scissors”. And so forth.

While in the frontbenches of Prof Vaidya’s class Kodhi and I were inventing the term “scissors”, Neha Jain was in the backbenches actually putting scissors with Don. Now she has come up with a nice poem on this topic. Do read it. And I want to make a Death Metal song out of it. So if you have any nice ideas regarding the tune and appropriate umlauts, do leave a comment.

Intellectual Property

A blog post earlier this month on Econlog finished off with a very strong quote by Friedrich Hayek:

One of the forms of private property that people cherish most is their ideas. If you convince them that their ideas are wrong, you have caused them to suffer a capital loss.

I ended up liking it so much that I added it to my work email signature. Thinking about it further, why is it that some people are more open to debate than others? Why do some people admit to their mistakes easily while others are dogmatic about them? Why do some people simply refuse to discuss their ideas with other people? I think Hayek’s observation offers a clue.

Let us consider two people – Mr. Brown and Mr. Green. Mr. Brown believes in diversification, and his investments are spread across several financial instruments, belonging to different categories, with a relatively small amount of money in each of them. For purposes of this analogy, let us assume that no two instruments in his portfolio are strongly correlated with each other (what is strong correlation? I don’t know. I can’t put a number on it. But I suppose you get the drift)

Mr. Green on the other hand has chosen a few instruments and has put a large amount of money on each of them. It is just to do with his investment philosophy, which we shall not go into, as this is just an analogy.

Let us suppose that both Mr. Brown and Mr. Green held Satyam stock on 6th January 2009. They were both invested in Satyam according to their respective philosophies – and the weightage of Satyam in their respective portfolios was also in line with their philosophies. The next day, 7th of January, the Satyam fraud came out. The stock crashed to a tenth of its value. Almost went to zero. How would our friends react to this situation?

Mr. Green obviously doesn’t like it. A large part of his investments has been wiped out. He has become a significantly poorer man. For a while he will be in denial about this. He will refuse to accept that such a thing could happen to one of his chosen stocks. He will try to convince himself that this fall (a 90% fall, no less) is transient, and the stock will go back to where it once was. As days go by, he realizes that his investments have been lost for ever. He is significantly poorer.

Mr. Brown will also be disappointed by the fall – after all, he too has lost money in the fall. However, his disappointment is mitigated by the fact that the loss is small compared to his portfolio. There have been other stocks in his portfolio which have been doing well, and their performance will probably absorb the Satyam losses. Some of the stocks in his portfolio may also be fundamentally negatively correlated with Satyam, which means they will now gain. There is also the possibility that the Satyam fall has opened up some new possible areas of investment for Mr. Brown, and he might put money into them. It is much easier for Mr. Brown to accept the fall of Satyam compared to Mr. Green.

So you replace stocks by ideas, and I suppose you konw what I am gettting at. The degree of openness that people show with respect to an idea they have varies inversely with the share of this particular idea in their “idea portfolio”. The smaller the proportion of this idea, the lesser will be the “capital cost” of their losing the idea. And hence, they will be more open to debate, to discussion, to letting someone critically examine their ideas. If the proportion of this particular idea in their overall portfolio is large, there will obviously be resistancce.

A corrolary of this is that when someone possesses a small number of ideas they are more likely to be dogmatic about them (I am using the indefinitive “more likely” here because even when you have a small number of securities in your portfolio, your exposure to some of them will be really small and so you’ll be less unwilling to lose them. Though I must point out that people with small ideas portfolios become so used to madly defending the big ideas in the portfolio that they start adopting the same tactic for the smaller ideas in their portfolio and become dogmatic about them – which is irrational).

I just hope I didn’t cause you a capital loss by writing this. For me, on the other hand, this was a bonus stock.