Index capitalism

Here, I go into a new type of capitalism: index capitalism.

Both financial market valuations and a sense of risk are at an all time high these days. You might wonder, why? Could it be that investors are overconfident or complacent, as a consequence of ultra relaxed monetary policy.

It could be.. But, there is a striking trend that might instead be the cause of all this. A trend that might mark the next stage in the evolution of global financial markets. One could call this trend ‘index capitalism.’ This name was inspired by the famous economist Hyman Minsky. In the 1980s, he observed that financial markets increasingly revolved around large institutional investors rather than household investing. He called this “money manager capitalism.”

The world has changed since then. Investors that use ‘fundamentals’ – actively picking stocks based on the quality of the underlying companies, now manage a smaller and smaller trading volume. Who are the new “money managers” in town? Increasingly, money is moving into Exchange Traded Funds (ETFs) that track certain indices.

So, index capitalism is the next evolution of money manager capitalism. This could help explain the abnormality of high stock prices and high fear. Prices being far from their fundamental value is an obvious consequence if money pours blindly into index funds.

The role of fundamental value investors is to develop a view on a company’s value – when a price falls below this they buy, when it rises above justifiable levels, they sell. If they do their homework on the company’s health and prospects, fundamental investors ensure prices never stray too far from the underlying companies’ values. This is not to say they are rational investment machines, but their long-term behavior stabilizes markets and channels capital to its most productive use.

ETFs, on the other hand, do not do this. They are passive investors, who allocate capital based on mechanical rules, disconnected from the underlying company’s features.

Market valuations are driven by investment flows to and from index funds, stock buybacks and the relative popularity of different investment strategies, such as trend-following and mean-reversion. These strategies drive stock price developments that are decoupled from a company’s profit or productivity.

Of course, in money manager capitalism, financial markets also occasionally become divorced from the fundamentals. Every now and then investors go into a frenzy, forget fundamentals and pursue the froth in the market.

But index capitalism simply does not distinguish fundamentals from froth and frenzy. The market becomes a self-referential system with mechanical rules.

There are very few fundamental investors left to counteract price deviations from fundamentals. In index capitalism, features that were anomalies in the old system of fundamental investors become the norm.

Like money manager capitalism did before it, index capitalism this will weaken capitalism and decrease economic growth, since capital is less efficiently allocated. It will also change financial market dynamics in ways that we do not yet understand.

Recent market quirks may well be today’s new normal; whether we like it or not, index capitalism is here to stay.

It is already branching into distinct varieties, like factor investing, already popular with UK pensions funds, but perhaps we need to update our frame of reference to understand index capitalism’s logic, just as Minsky did in his time. Time to say goodbye to the fundamental investor, and welcome the index capitalist.

This post, in a longer form, was written with Stefan Lundbergh and Dirk Bezemer and published by Pension Expert

Written on February 6, 2020