The EconomistNovember 14th 2020 Special reportAsset management 72
1seems set for a shake-up. A bold response for a midsized firm
would be to downsize: strip back to the core; cut prices; offer fewer
products; and focus on those in which one has a chance to be dis-
tinctive. In a different industry Steve Jobs followed something like
this strategy when he returned to Apple in 1996. Apple was fighting
for its survival, however. Things are not that desperate in asset
management. The fee pressure on new business is intense, but a
lot of existing customers will stay put. A mediocre firm with a big
back-book can stay alive for quite a while.
Perhaps that explains all the talk of “zombie” asset managers—
firms from which life is slowly draining as their initially fat mar-
gins grow ever thinner. Is there another means of escape? The vir-
tue of passive funds is their low cost; they buy stocks in the index
or whatever the quantitative screen prescribes. There is no need to
think deeply about the companies behind the securities. But that
virtue is also a vice. Investors increasingly care about what compa-
nies do. And many active asset managers hope there might be a liv-
ing from that. 7R
obert fleminghas a claim to be a pioneer of active asset man-
agement. His First Scottish investment trust pledged to invest
mostly in American securities, with choices informed by on-the-
ground research. Fleming saw that shareholders needed to act as
stewards in the governance of the businesses that they part-
owned. So once the fund was launched, in 1873, he sailed directly to
America. It was the first of many fact-finding trips across the At-
lantic over the next 50 years, according to Nigel Edward More-
croft’s book, “The Origins of Asset Management”.
The art of asset management is capital allocation. It is easy to
miss this amid confusing talk of alpha and beta, active and passive,
private and public markets. For investors of Fleming’s kind the
work of finding the best investment opportunities and engaging
with business was inseparable. Walter Bagehot believed the rapid
growth of the mid-Victorian economy owed much to the efficient
channelling of capital. In England, he wrote, “Capital runs as
surely and instantly where it is most wanted, and where there is
most to be made of it, as water runs to find its level.”
Most of today’s financiers will say they are engaged in capital
allocation. There are many dedicated stockpickers who take this
social role seriously and see it as a vocation. But for the most part
ties between suppliers and users of capital have become more ten-
uous. An index fund does not screen the best stocks from the
worst. It holds whatever is in the index. Other passive strategies se-
lect stocks or bonds based on narrow financial characteristics. The
nature of the entity behind the securities and how well the people
running it perform their duties are incidental. Does such disen-
gagement matter? Some evidence suggests that it might.
To understand why, it helps to distinguish two functions of
capital allocation. The first is to direct savings to their best use.
This involves finding new opportunities, comparing their merits
and deciding which should receive capital and on what terms.
John Kay, a business economist, calls this role “search”. The sec-
ond role is stewardship, ensuring that the best use is made of the
capital stock that is the product of past investment.Both matter. Search matters in the early stages of economic de-
velopment, when ideas are abundant, businesses are capital-in-
tensive and savings are scarce. The late 19th century was such a
time. In New York, Fleming’s hunting-ground, most bonds were
for railroad companies. In Britain, brewers, distillers and miners
were also thirsty for capital. In 1886 Guinness, a century-old beer
company, raised £6m in London. A few years later shares in the
Broken Hill Proprietary Mining Company (bhp), which began trad-
ing in Australia, were owned and exchanged in London.
When search works well and capital runs to “where there is
most to be made of it”, relevant information is quickly reflected in
asset prices. The case for index investing rests on the idea that the
stockmarket is, in this sense, broadly efficient. Prices are set by in-
formed buying and selling by active and engaged investors. But as
more money goes to index funds, the market might become less ef-
ficient. Whether it does rests in theory on the quality of investors
being displaced. If they are “noisy” active managers, who buy and
sell on gut feel, expect more efficiency, not less. If they are farsight-
ed stockpickers, the quality of market prices might suffer.
Some empirical studies hint at a problem. A paper in 2011 by Jef-
frey Wurgler finds that whether a share is part of an index influ-
ences its price. Shares that are included in an index go up in value
relative to similar shares that are not. When shares drop out of an
index, they tend to fall disproportionately. And once in the index, a
share’s price moves more in sympathy with others that are also in-
cluded. Another paper, by researchers at the University of Utah,
finds that index inclusion leads to a higher correlation with index
prices. Inclusion also spurs a reduction in “information produc-
tion”: fewer requests for company filings, fewer searches on Goo-
gle, and fewer research reports from brokerages. Even so, the au-
thors conclude that more intensive effort by the remaining active
investors may counter any adverse effects.
Share prices may no longer matter so much for how capital is
allocated. Most big companies are nowadays self-financing. Guin-
ness (now Diageo) and bhpare still among the leading stocks list-
ed in London. Like a lot of businesses, they generate enough cash
to cover their investment needs. When a company taps the capitalStewards’ inquiry
If investors buy index funds, who watches the companies?Capital allocation