Mom, Kant, and Mutual Funds

What if everyone did that?

Immanuel Kant Postage Stamp, 1974. Source: Wikipedia

That’s the question my mother would often ask me when I started on some hare-brained teenage-boy adventure, like taking the summer to canoe down the Mississippi River to the Gulf of Mexico, or letting my friends in the exit doors of a local movie theater. The question is a good one, and it comes from a solid philosophical foundation.

230 years ago Immanuel Kant outlined the basis for what could be considered a moral – and immoral – action. Rather that judge actions based on their outcomes, they should be evaluated on their own merits. That is, stealing isn’t wrong because you get caught, it’s intrinsically wrong. Kant called this his “categorical imperative,” and he put it this way: act in such a way that what you do could become a universal principal. So, stealing is always wrong, because the victim could not possibly consent to it. After all, if they consented, it wouldn’t be theft. Slavery is inherently wrong, because the world can’t become a slave to itself. And everyone can’t take the whole summer off.

That’s something I’ve considered recently as investment capital seems to flowing in greater and greater quantities from active management to passive management. Citing long-term performance, advocates of passive index funds claim that most investors should have most of their money in the S&P 500 or some other large-cap equity fund. It is based on the observation that a broad collection of market-cap weighted stocks has outperformed most stock-picking managers, over the long run. This debate has been going on since the first passive funds were designed over 40 years ago. There are actually many active decisions to be made, like which index to use, whether to adjust the weighting for available shares, how to rebalance, and so on. But I’d like to look at this in terms of my mother, Kant, and market efficiency.

Source: Morningstar, Wall Street Journal

What if everyone indexed? What if the vast majority of investors tied their fortunes to a cap-weighted index of US or global stocks? What would happen to the market, to corporate governance, and to the economy as a result? I think we’re starting to see the consequences now, as hundreds of billions move away from active managers and flow into passive funds. Vanguard Group – the world’s largest purveyor of passive funds – has been doing a series of victory laps, claiming its methodology has been vindicated.

But nothing fails like success. When everyone invests in an index, the components of the index will remain unchanged in relation to one another. That’s why, currently, expensive stocks tend to remain expensive, and cheap stocks tend to stay cheap. If the new money flowing into the stock market is flowing into the companies with the biggest capitalizations, then big companies like Apple and Google and J&J and Wells Fargo. The rich get richer and the poor get … red.

Market cap map, colored for one-year performance. Source: Finviz

Over the long run, this will tend to have a negative effect on corporate governance, innovation, and the economy. One way managers are held accountable for their performance is through active managers who can sell their shares – or at least ask pointed questions at earnings conference calls. If everyone is a passive investor, who will hold the CEO’s feet to the fire? In theory, passive investors could influence firms through proxy voting, but they don’t allocate a lot of resources to this function.

We’ve seen this movie before. During the go-go ‘60s, a lot of corporate America became complacent, failing to innovate and invest because that didn’t improve their short-run financial performance. The result was a stagnant corporate sector and the malaise – and economic contraction – of the ‘70s.

It’s safe to assume that my mother never studied Kant, and Kant could never have conceived of cap-weighted index funds. But “what if everyone did that” is a reasonable question. When it comes to passive investing, the answer might surprise you.

Douglas R. Tengdin, CFA

By | 2017-07-17T12:21:27+00:00 March 21st, 2017|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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