Competition exists because firms, and in general, economic agents, have imperfect information. The irreducible complexity of the economy makes prediction a fraught exercise and veils the future with uncertainty. Contrary to the dominant neoclassical economic paradigm, if firms had perfect information, where one knows all the relevant facts to make a decision, as happens under perfect competition, they would not compete, it is the veil of uncertainty thrown over economic activity that makes competition necessary. The greater the uncertainty, the greater the competition. Competition is a learning process in response to ill-defined situations.
Joseph Noko, in “Uncertainty, Information and Digital Firms: a Framework for Understanding Meta Platforms and its Peers”
F.A. Hayek’s great insight was that competition is a discovery process that occurs precisely because economic agents have imperfect information. A neglected arena of competition is between active and passive management. If we employ the kind of transaction cost framework made famous by Ronald Coase, and which I have used to analyse Meta Platforms’ business model, it is clear that, assuming matching total returns between active and passive managers, passive managers exist because of the larger costs of active management. William F. Sharpe, in “The Arithmetic of Active Management”, makes a similar point, stating that,
If “active” and “passive” management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return
on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be less than the
return on the average passively managed dollar
William F. Sharpe in “The Arithmetic of Active Management”
The reasons are obvious: active managers assume search costs for finding attractive investments, and they do this while facing overwhelming odds of failure. In his earthquake of a paper, “Do Stocks Outperform Treasury Bills?”, Hendrik Bessembinder found that, between 1926 and 2017, four in seven U.S. stocks had lower compound returns than one-month Treasuries. In terms of lifetime dollar wealth creation, he found that just four percent of public companies generated the net gain for the entire U.S. stock market, with the rest earning returns that merely matched Treasury bills. In “Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks”, Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, found that this positive skewness of stock returns was a global phenomenon. Between 1990 and 2020, 55.2 percent of U.S. stocks and 57.4 percent of non-U.S. stocks, had lower compound returns than one-month U.S. Treasury bills. In terms of lifetime dollar wealth creation, they found that just 2.4 percent of the 64,000 firms they studied generated all the net gain of the global stock market. Ex-U.S., just 1.41 percent of firms generated $30.7 trillion in net wealth creation. The implications seem clear: an active manager is more likely to create a portfolio that underperforms one-month Treasuries, than outperforms it. This differs from Sharpe’s assertion that the difference between active and passive managers are fees. If only a sliver of the market is generating all its net gain, then a portfolio that does not capture the whole universe of stocks is unlikely to have returns that, pre-fees, match or exceed those of the market. Nonetheless, whether one views the arithmetic of active management from a Sharpean point of view or mine, active management is a loser’s game. Consider that, according to S&P Global’s SPIVA, which measures the performance of active managers against the S&P 500 and other indices across the world, in the last fifteen years, 87.98 percent of Large-Cap active managers have underperformed the S&P 500, and only 12.02% have outperformed.
Properly understood, risk should be viewed myopically, as being primarily the possibility of incurring a loss (the moment and existence of loss are more important than the knowledge of it), and secondarily, the possibility of underperforming some target rate of return.
Joseph Noko in “The Nature of Risk”,
It should be said that an index fund is not, strictly speaking, “passive”, nor does it represent the “market”. The S&P 500 is created around a simple set of rules: the 500 largest firms are chosen, each firm is allocated a share of the portfolio according to its relative size, and the portfolio is rebalanced every quarter. It should also be said that Claude Shannon’s demon, the Kelly criterion, Daniel Bernoulli’s work on risk, and Renaissance Technologies’ Medallion Fund, show that it is possible to beat the market while investing in firms that have zero-to-negative lifetime net gains. Moreover, the diligent investor can also work to make the necessary accounting adjustments to uncover a business’ true economics and properly value it. Investors such as Warren Buffet and Charlie Munger, Peter Lynch, and Davis Swensen, have displayed the requisite diligence and aptitude for this kind of work. In addition, active managers can reduce their search costs by hiring an investment research firm like New Constructs, who deploy their AI technology on thousands of financial reports to produce the best fundamental data in the world. Active investors have tools to bridge the gap between their results and those of passive investors, at the portfolio or accounting level, and this explains why the positive skewness is not as pronounced between active and passive managers as it is between stocks and one-month Treasuries. Nevertheless, it exists.
Time Preference and the Flow of Funds
It is an axiom of economics that an economic agent faces a number of choices when allocating capital: whether to save and invest, or to consume. Consumption occurs when an economic agent has a present preference for money, and uses their money to satisfy current wants, whereas saving and investment occur when an economic agent has a future preference for money and “lends” capital to an entrepreneur, either directly through the stock market, or indirectly by depositing money in the bank. The economic agent who prefers to defer consumption to some point in the future is paid an interest rate for doing so. At the aggregate level, society too has a time preference, with a changing appetite for consumption, saving and investment.
In Money in a Theory of Finance, John G. Gurley and Edward S. Shaw give a simple taxonomy of money, classifying it under “inside money” and “outside money”. These two kinds of money are produced by two sources: the government and the private sector. Inside money is composed of debt securities and loans created by private financial intermediaries, who exist to match the supply of capital, provided by savers, to the demand for it, emerging from investors. Outside money is so-called because it comes from outside the private sector, being a creation of the government. In the economic literature, it is often referred to as high-powered money, and colloquially, it is government money. Being from outside the private sector, the supply of outside money is not cancelled out by the demand for it, it is a net asset for the private sector.
These money forms are produced by a complex institutional structure made up of households, production firms, banks and governments. These sectors make decisions, and allocate capital, interacting with each other in the process, through the flow of inside and outside money, building up stocks of assets and liabilities. In keeping with double-entry bookkeeping, one investor’s financial asset is another’s liability, every transaction by one sector has an equivalent transaction in another, and every financial balance is met with an equivalent change in its net financial position. Wynne Godley, and Marc Lavoie, remark in their Monetary Economics,
Provided all the sectoral transactions are fully articulated so that ‘everything comes from somewhere and everything goes somewhere’ such an arrangement of concepts will describe the activities and evolution of the whole economic system, with all financial transactions (including changes in the money supply) fully integrated, at the level of accounting, into the processes which generate factor income, expenditure and production.
Monetary Economics, Wynne Godley, and Marc Lavoie
These economic activities can be demonstrated by way of a simple model of a closed economy, which is to say, an economy without any foreign trade or foreign capital flows. In this economy, there are just three sectors: households, firms and the government. This closed economy can be examined in terms of its sectoral balance sheets, balance sheets that may be combined as below:
In this simple model, households hold “cash instruments” issued by both firms and the government. By “cash instruments” means those financial instruments whose value is determined directly by the markets, such as securities, loans and deposits. Possessing no liabilities, their net worth is the sum of these cash instruments. Firms hold high-powered money as well as tangible assets, which they have acquired by issuing bonds and equities. The net worth of firms is zero. The government, possessing no assets, issued high-powered money to households and firms, and has a net worth that is the sum of these liabilities.
It can be said that the time preference of each part of the economy results in a demand for some type of money, a type of money that is supplied by another economic agent. In our simple model, a household’s preference for future consumption, or saving and investment, is a demand for the money of firms, in the form bonds and equities.
For our purposes, the question is, “What is the interest rate with which society is rewarded for investing in equities?” To simplify the problem, one can think of the S&P 500 as a single company whose outstanding shares have a market capitalization of $44.17 trillion. Companies supply these shares for investors at some market-determined price. This is our aggregate supply. Let “equity preference” or aggregate demand be the share of society’s portfolio devoted to equities. Where aggregate supply is a trivial thing to calculate, equity preference demands a more involved procedure. The pseudonymous author of the Philosophical Economics blog, Jesse Livermore, explains such a procedure in this article, “The Single Greatest Predictor of Future Stock Market Returns”. I encourage the reader to read it in conjunction with this article, as I have repurposed his calculation of aggregate demand for my own purposes.
Equity Preference and Future Returns
A more complex model of the sectoral balance sheets of the economy is presented by governments across the world and is known as a “flow of funds” report. The United States’ flow of funds accounts are prepared by the Flow of Funds section of the Federal Reserve, and published quarterly as the Z.1 Statistical Release. An early exponent of flow of funds analysis, Lawrence S. Ritter, wrote that,
The flow of funds is a system of social accounting in which (a) the economy is divided into a number of sectors and (b) a “sources- and-uses-of-funds statement” is constructed for each sector. When all these sector sources-and-uses-of-funds statements are placed side by side, we obtain (c) the flow-of-funds matrix for the economy as a whole. That is the sum and substance of the matter.
"An Exposition of the Structure of the Flow-of-Funds Accounts", Lawrence S. Ritter
Flow of funds accounts model the sectoral balances of an economy, that is, the financial stocks and flows of an economy, and the relationships between the two, in a consistent way. The sectors recognised within the flow of funds reporting are grouped into non-financial, and financial sectors. Of non-financial sectors, there are five: households and non-profit organisations, non-financial corporate business, federal government, state and local governments, and the rest of the world. Financial sectors consist of firms, including the Federal Reserve, and instruments.
The ebbs and flows of capital into and out of the equity market can be traced simply by cataloguing the market value of equities among investors. That alone, however, does not tell us a lot. What we want to know is how much of the aggregate or typical investor’s portfolio of cash instruments is allocated to equities.
When these entities borrow directly from investors, the investors get new bonds to hold. When the entities borrow from banks, the investors get new cash to hold. That’s because when a bank makes a loan, the money supply expands. The loan creates a new deposit that didn’t previously exist–some investor must now hold that deposit in his portfolio of assets.
It follows, then, that if we want to get an estimate of the total amount of bonds and cash that investors are holding at any given time, all we have to do is sum the total outstanding liabilities of each of the five categories of real economic borrowers. Those liabilities either translate into cash that an investor somewhere is holding (if the entity took a loan from a bank, which expands the money supply), or they translate into a bond that an investor somewhere is holding (if the entity borrowed directly from the investor). Note that the average bond trades close to par (with some above, and some below), so, in aggregate, the value of the liabilities approximates the total market value of the bonds.
Banks don’t generally hold stocks. So to estimate the total amount of stocks in investor portfolios, what we need to know is the total market value of all stocks in existence. We end up with the following equation:
Investor Allocation to Stocks (Average) = Market Value of All Stocks / (Market Value of All Stocks + Total Liabilities of All Real Economic Borrowers)
“The Single Greatest Predictor of Future Stock Market Returns”, Jesse Livermore
By real economic borrowers, Livermore means the following categories in Flow of Funds reporting: Households, Non-Financial Corporations, State and Local Governments, the Federal Government, and the Rest of the World, all of whom borrow from investors. His equation can be simplified to,
Equity Preference = Market Capitalisation to Stocks/Cash Instruments
In our simple model, household equity preference is $375/($200+$15+$375) = 6.6%. For the real economy, one is obliged to exclude financial intermediaries from this analysis, because they are obviously not investors, but matchmakers, holding financial assets on behalf of investors. The non-financial sector uses high-powered money kept by a financial intermediary and debt securities and loans borrowed from a financial intermediary, in order to finance purchases of equities. The share of equities held by the non-financial sector in relation to its financial assets and liabilities, represents the allocation to equities of the aggregate investor.
One can model this with data from FRED, the disaggregated data of which is also available.
One can then match this to the S&P 500's total returns compounded over subsequent decades, to produce the following riveting chart, for the January 1, 1952 to December 31, 2023 period:
How robust is this finding? Over that period, equity preference explained subsequent 10-year returns by an R-Squared of 0.7448618131, implying that 74.5 percent of the subsequent S&P 500 10-year total returns are explicable through U.E. equity preference.
One should say that people do not invest in equities for their own sake, one invests for future returns, and so one can say that as the demand for future returns increases, their supply decreases, and vice versa. Such is the relationship between the two that Livermore proposes to redefine total returns in the following way,
Total Return = Price Return from Change in Aggregate Investor Allocation to Stocks + Price Return from Increase in Cash-Bond Supply (Realized if Aggregate Investor Allocation to Stocks Were to Stay Constant) + Dividend Return
Forecasting Future Stock Market Returns
This is the longest period of practically uninterrupted rise in security prices in our history. The rise was more rapid than has ever been seen, and its speculative attraction influenced a larger part of the public than ever before," it read. "The psychological illusion upon which it was based, though not essentially new, has been stronger and more widespread than has ever been the case in this country in the past.
The Business Week, November 2, 1929
The current era is an era of astonishing returns, but, wealth destruction is fundamentally bound up with the nature of risk, and this era cannot go on. The truth of this model is that as the demand for future returns increases, the supply of those future returns declines. That lesson is borne out by the results of translating Livermore's framework into a forecasting model. Using a model I built to forecast 10-year S&P 500 total returns leads to an awful number: 1.16%, the average total returns that are likely, if the predictive value of the model holds, over the 2024-2033 decade, a return lower than that available by simply investing in Treasuries. As the market scales its halcyon heights, it has become almost unsustainably high.
What does this mean for the competition between active and passive investors? Instinctively, it is easy to reach for the conclusion that we are entering a golden age for active investors, but I think the true conclusion is that passive investment will continue to outperform active investors. Diversification is essential for investors because it lifts a portfolio's geometric returns toward its average returns, and this is the beauty of passive investment: one takes a group of stocks that are largely stocks that, across their life cycle, will deliver lower returns than Treasures, and convert them into a portfolio that delivers superior returns. Passive investors have the edge because they have no real information costs, costs which burden active investors. That reality will not change in the decade we have entered. So, if passive investors are earning 1.16% a year, the typical active investor will earn less. Few investors will enjoy the double-digit returns that have become a kind of lazy, achievable target.