Immanuel Kant and the role of active investing (by Compass)

Do not be afraid.This is not a piece on philosophy.
It is a very short essay on one of the market themes I am more emotionally attached: active investing.
The reason is straightforward: I am an active investor. In an era of ever-rising prominence of passive investing, I want to spend few words defending the social usefulness of my work and the one of my fellow colleagues that put all their brains in the tough but fascinating world of active investing.
At this stage, you probably wonder what would be the link with Immanuel Kant in the title. It is stronger than you think.

The German philosopher is a central figure of modern philosophy. His ideas are studied globally. I first came across his thoughts during high school. Honestly, I did not understand much then but the importance of his work as a breakthrough in the western philosophy was pretty clear. This greatness and wide global reach is in stark contrast with Kant’s daily life. Apparently, Immanuel Kant never left the city of Konigsberg in Prussia, where he was born, and his routines were so precise that people in his neighbourhood could set their clocks watching him passing by. This gives me some hope. Sitting on a desk of an asset management boutique in Switzerland I will try to spread some of my personal thoughts that I consider valid for the asset management industry as a whole. I know I could be pretending too much

Readers are the ultimate judges and any errors remain responsibility of the author.
Emmanuel Kant left an immense body of work on the relationship between reason and religion and on the epistemology of science. However, for our purposes, we will use one of his well-known concepts on “morality”. It is the idea of “categorical imperative”: a principle that is intrinsically valid that must be obeyed by everyone in all situations and circumstances. This must be dictated by reason and not derived by experience. Quoting the philosopher: “Act that your principle of action might safely be made a law for the whole world”.

Today, this eighteen century idea of a behaviour driven by reason to obey a moral duty sounds old-fashioned. In spite of this, let’s see the implications it has for the world of investing. As an investor you can follow two main roads: you can believe markets are efficient, or simply difficult to beat, and opt for passive investing; alternatively, you could be convinced that there might be gaps between price and value than can be exploited and choose to be an active investor. Nowadays, the latter choice is not rewarding. Active investors as a whole are experiencing a streak of underperformance that goes back several years. Buyers of active strategies got tired of this underperformance. Funds are leaving traditional asset managers and hedge funds and flowing into the world of ETFs and the likes. Let’s translate for a moment this behaviour into a categorical imperative and analyse the effects. We might say: “invest only passively”. This is not a bad idea on an individual basis. You can get access to a diversified index such as the S&P and the MSCI World at a very low cost and participate in the long term growth of the respective economies over time. It is important that the indices are big, liquid and well diversified to make sure you get most benefits from your choice.

There is no need to venture into specialized ETFs or obscure rule-based passive products. Keep it simple. As Warren Buffet said, most retail investors should buy an index fund and live happy. We agree. However, let’s get back to the original idea. What if everybody follows this rule as the only one dictated by reason? Well, the results are not ideal. Passive investing is an allocation of capital driven by some measure of size, usually market capitalization. Whatever happens in the world, you know that the top positions you own are the ones you will buy the most, the bottom positions you will buy the least and viceversa. In a world of passive investors there is only space for trend following strategies with no inherent solution for the inevitable bubbles or deep dives that change in liquidity could cause. At the extremes, a “passive only” capital allocation would not be rational. We need some internal market forces that act as mean reversion catalysts. In aggregate, these forces will move prices to reflect the differentials in return of capital between alternatives. In essence, for the market to work properly, we need the price discovery function of active investing. After such a long discussion to justify my existence as an active investor, we can try to settle in the middle.

Traditional active strategies still represent the vast majority of managed assets and are charging fees that, in many cases, are not justified by the service they provide. On top of that, the rise of new technologies in finance drove down trading costs and allowed the emergence of passive low cost products almost everywhere. Additionally, right now, passive strategies have a free riding on all the work of active investors that eliminate systematic errors also for them. The three effects combined and a general rising trend in equity markets justify the success of passive strategies and the difficulties of active ones in recent years. Having said that, active and passive investing must coexist. Going forward, we can expect the relative growth in passive products to continue and the profitability of a smaller number of active managers to go down until we will reach a new equilibrium. To me, it may still take another market cycle but the trend is clear. It is going to be tough. Active investors can compete focusing on scale or specialization. Only the fittest will survive… a categorical imperative.

Peppe Ganci, CFA