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!

Corruption and Communism

In an article arguing why Kolkata is best placed to be India’s “best city” in another 20 years, Aakar Patel (I’ve started looking forward to his columns in Mint Lounge) mentions that there isn’t much corruption in the governments in Bengal (at both the center and city level). I don’t know the reasoning for this, but I wonder if this is primarily responsible for the long run that the Communists had at the helm in that  state.

I had argued in a not-so-recent piece in Pragati that big governments tend to be bad governments . I had argued that big government means more ways in which government employees can seek rents, and hence one way of reducing corruption is by reducing the size of the government. Now, assume that for some magical reason, a certain section of the population is sincere and incorruptible. In that case, big government need not be bad government. In other words, people don’t really resent the presence of government everywhere since they don’t see any rent seeking by the government officers. And since they are not unhappy with the size of the government, they don’t mind voting in every time the communists, who will keep the big government!

So I wonder if it is the incorruptibility of the Bengali (for whatever reason; I’m drawing this inference from Patel’s article) that has led to the long communist rule there. Incidentally, the one time the government was seen to be corrupt (in discretionary land allotments in favour of the Tatas, Salim Group, etc.) it wasn’t voted back to power!