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Index funds are socialism (in the best and worst sense)!
The classic market inefficiency is a negative externality.
This is an activity which harms third-parties who are not part of the transaction. If a battery factory leaks toxins into a river and poisons residents nearby, the harms are borne neither by the factory owner selling batteries nor those purchasing batteries. Thus they will not be reflected in the market price, causing an oversupply of batteries and of water pollution.
When externalities were first formalised in the 1920s, economists thought that states should impose a tax onto batteries, equivalent to the harms caused by their production. Of course, it is nigh-impossible to accurately measure the dollar value of those harms from pollution!
That was until Ronald Coase came up with the Coase Theorem in his 1960 paper, “The Problem of Social Cost”. Loosely, it says the following:
If there are clear property rights and low transaction costs, an efficient outcome will arise by bargaining, regardless of the initial allocation of property rights.
Of course, this just begs the question. Externalities are usually external because it is difficult to define and enforce property rights. How can we fix this?
Seeing like a state
One way is to internalise them. If the battery factory happens to run a bottled water company which uses the river as a water source, they will supply batteries efficiently because their consumers bear the harms of poisoned water. Put another way:
When private firms get large enough, they start seeing like a state.
At a certain size, firms stop ignoring systemic problems as something that the system should worry about. Why? Because they become the system!
As the leading financier of his time, John Pierpont Morgan pulled the US economy away from the brink of collapse in the Panics of 1893 and 1907.
A consortium of 14 financial institutions bought out Long Term Capital Management in 1998, when it was on the verge of bringing down the entire US financial system with its trading losses.
FTX (and Alameda Research), as one of the largest cryptocurrency exchanges (and crypto trading firms), bailed out BlockFi and Voyager (respectively) during the 2022 crypto crisis to maintain orderly market conditions.
Stripe has rolled out Stripe Press, Stripe Climate, the Frontier Fund and more. Its incentives as a financial services provider are aligned with its mission to “increase the GDP of the internet”, which rewards social responsibility.
It is often easier to solve an externality by internalising it into a firm than by assigning property rights e.g. by handing ownership of the waterway to the residents and letting them negotiate with every company which pollutes the river.
This is based on an argument Coase made in an earlier paper from 1937, “The Nature of the Firm”. He noted that when transaction costs are high, firms may be a better coordination mechanism than markets because they avoid the hassle of writing, monitoring and enforcing contracts.
We will return to Coase in a bit, but for now, let’s pivot to financial economics. If we break down the returns of an asset portfolio into beta and alpha:
Beta is the component of portfolio returns owing to changes in the performance of the market as a whole.
Alpha is the component of portfolio returns in excess of the beta exposure of your portfolio i.e. how much you are beating the market.
When markets are close to efficient, there is little alpha left on the table, and so you get the best risk-adjusted returns by holding the representative market portfolio. Famously, Warren Buffett bet in 2006 that naively tracking the S&P 500 would beat a portfolio invested in various hedge funds across the following decade. He was right!
The realisation that many asset managers simply don’t earn their fees, coupled with the popularisation of index funds by CEO of Vanguard, Jack Bogle, has led to a huge flow of institutional money into passive market-tracking funds in the past 20 years. In fact, there’s now more money in passive funds than in active funds within the US!
However, passive funds have come under fire for being socialist. Most famously, Inigo Fraser-Jenkins of AB Bernstein wrote a memo titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism”.
The Grossman-Stiglitz paradox is the idea that any financial market efficient enough for index tracking to be optimal would provide no incentive for trading, rendering the market inefficient. A corollary to this is that passive investors free-ride off the the price discovery work done by active investors.
Not only does this mean that active investing provides positive externalities, passive investing actually imposes negative externalities. Active funds may not earn their fees, but they usually have some skill in noticing mis-pricings. Thus every time capital flows out of an active to a passive fund, the net effect is that overvalued assets will be bought up and undervalued assets will be sold.
There is certainly some truth to these criticisms, and one downside of focusing on beta is that passive investors care less about figuring out the value of individual assets. Yet in any other market, this would be seen as fine: relying on the price signal is a feature of capitalism, not a bug!
Indeed, the very thing that makes index funds so loathsome to Fraser-Jenkins and his ilk i.e. the focus on the market as a whole, is the very thing that makes them so useful in solving other problems. For example, institutional investors, whose returns are often more dependent on the market beta than the alpha that their asset manager can get, have realised that they can change beta!
By internalising externalities!
Since they may hold companies which cause negative externalities onto other companies they own and worsen the risk-return profile of the entire portfolio, they have a vested interest in making sure these spillovers get corrected. Thus they have an incentive to engage in corporate governance, thinking about how it affects the systemic risk of the market as a whole.
This is beta activism.
One bellwether of this strategy is the Japanese government’s Government Pension Investment Fund, which is the largest pension fund in the world. Its former Chief Investment Officer, Hiro Mizuno, argued that large institutional investors who are “universal owners” need to act differently:
“Environmental costs incurred by some companies in their portfolios will have an impact on companies elsewhere in the portfolio.”
Another example is Larry Fink, who is CEO of the world’s largest asset management company, BlackRock. He declared in 2020:
“Climate risk is investment risk.”
Socialism with capitalist characteristics
While traditional ESG efforts have often seemed like performative displays which leave money on the table in exchange for letting investors pat themselves on the back, beta activism is a socially conscious view of markets that has a clear economic basis: large investors can affect the risk-return profile of the market as a whole.
Index funds and passive investing may well be socialist in the worst sense of the word: owning the entire market rather than doing the socially useful job of price discovery. However, they may also be socialist in the best sense of the word: making decisions on the basis of the overall good of the market, rather than selfishly ignoring the free-riding and externalities imposed onto others!