Why there is still a role for active investing
Nassim Taleb’s book, “The Black Swan” was described by The Sunday Times as one of the 12 most influential books since World War II. His most recent work, “Skin in the Game” is just as insightful, and includes strong arguments that support the value of active over passive investing.
In his latest work, Taleb focuses on asymmetries and sharing of risk and reward. He highlights that the division of these fundamental tenants of markets (risk/reward) are often imbalanced between participants, creating non linearities and divergences which can produce mind boggling order of magnitude effects. At Montgomery Global we are constantly on the lookout for these types of hidden asymmetries to take advantage of for our investors.
An interesting framework explored by Taleb is the “minority rule,” which he calls the “mother of all asymmetries.” It presents the notion that the world (and the financial market) is not driven by majority consensus, but by small, stubborn minorities. For example, he looks at halal meat in society and notes that only 3-4 per cent of the population care whether meat is halal or not (usually for religious reasons). However, when looking at the presence of halal meat in these same markets, it can be as high as around 70 per cent. So why does a 3-4 per cent minority cause 70 per cent of the population to do things differently rather being forced to change themselves? The reason is a stubborn minority (in this case driven by religion), can impose its will on a relatively disinterested majority (unlikely to care or notice if they are eating Halal or not).
Extending this concept to financial markets, Taleb notes that price movements are NOT the sum of market participants, but the activity reflected by the desire of the most motivated buyer and most motivated seller. For instance, in January 2008 the value of equity markets was approximately $30 trillion, however a single sell-order worth $50 billion, less than 0.2 per cent of total market value triggered a ~$3 trillion (~10 per cent) drop. The “sell order” came at the directive of senior management at the French bank Societe Generale, once they discovered unauthorised trading positions established by a rogue trader (Jérôme Kerviel) and hence became the “stubborn minority.”
The idea is of particular interest in today’s market as we consider whether stocks are moving on genuine fundamentals or projecting trading swings from what can be a relatively small part of the financial market (e.g. central banks, ETF flows, risk parity funds, algorithmic trading, quantitative strategies, etc.).
Extending this more generally, as the role of passive investing becomes more widespread, perhaps we should be asking whether passive capital is becoming the disinterested majority? Under this framework, passive funds would be much more open to an asymmetric shock (both on the way up and down) relative to active portfolios which would represent the stubborn minority and potential catalyst for the swing.