“Extremistan” and Active Investing

The world is moving more and more to extremes in many facets, most notably wealth, with those in the middle suffering in the great “hollowing out” — a process Nicholas Taleb (author of the Black Swan) has dubbed extremistan. I believe the same hollowing out is set to occur in active investing in finance, whereby if you’re not fanatical activists then you shouldn’t even try and beat the market, but instead be the market (i.e. passive investing).

In finance, there is the efficient market paradox, whereby for markets to remain efficient some people must not consider them efficient (to incentivise them to do the work required to maintain up to date prices that reflect all relevant information).

There was a good FT piece this week about index investing and how the rise of ETF’s ($3 trillion in assets alone) are now distorting markets through their sheer size. Index providers (who have a sometimes opaque selection criteria) decide whether a security should be placed in an index or not and have the power to move around tens of billions of dollars by passive investors having to update their holdings accordingly.

Active investors can benefit from this trend by predicting which securities will be added/removed from an index and front running the passive investors.

With the rise and rise of passive investing in the last few years (also accentuated by robo advisors such as Wealthfront who now have $2.6bn AUM), active investors are a natural counter weight, as this quote from the FT piece shows:

“The more money tracks passive, the more opportunity there is for active managers who can demonstrate value. They should be able to find more opportunities in certain assets”

I believe that much like wealth inequality, there will be an “extremistan” in investing styles as well in the future; pure alpha strategies run by hedge fund billionaires combined with pure index trackers, without much else in between. The people who lose out in this situation are the less aggressive active investors, who might just aim to beat the market by 1 or 2% (but invariably lose after fees anyway). The more aggressive the active investing style, the more chance it has of outperforming (you can’t beat the market by being the market), ensuring that the hedgies will not be harmed in this hollowing out.

If this extremistan does come to fruition in the investing world, then the most important thing is to ensure you are not stuck in the middle.

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