Time to wise up from FT

By John Authers

This has not been a good year for conventional wisdom.

Of course, “conventional wisdom” is rarely cited as anything other than a whipping boy – something we can expect to be wrong. But markets might be considered to be different, because conventional wisdom can be self-fulfilling. If everyone believes a stock is worth $20, then it will trade for $20.

But some of the smartest investment ideas offered to the wealthy have begun to look very bad indeed of late.

It is now almost a year since a cataclysmic week for quantitative funds heralded the beginning of the credit crisis. The quant funds made their money with a highly sophisticated “market-neutral” strategy, in which they bet on equal numbers of stocks to go up and down, exploiting subtle differences in their valuations. They found that many had made the same bets. As soon as a few fund managers started getting out of the market, suddenly all of them suffered huge losses. This had been hailed as a “low-risk” strategy uncorrelated to the markets, but some of the most prestigious funds in finance saw one-third of their value wiped out in a week.

Another bright new orthodoxy was: “commodities are good for you”. Academic studies demonstrated that investing in commodities via futures as part of a broader portfolio could give you the investor's holy grail – higher returns for no greater risk. Investment banks put together commodity indices, based on futures, providing products for private bankers to sell to their clients.

The problem is that many now claim that the money this attracted into commodities helped push up prices artificially. There have even been hearings in Congress over the claims. Debate rages over that topic but the experience of the past few weeks, with almost all commodity indices now down more than 20 per cent from their highs, has been unpleasant.

More apparent wisdom, offered to high net worth investors, was that macro hedge funds, which make big international bets on asset allocation, were the way to conserve wealth. There have certainly been trends to exploit in the financial upheaval since last summer. For many months, betting on commodities, while betting against the US dollar and the stock of US banks, was a great way to keep your head above water.

But in the middle of the market panic of mid-July, both sides of the trade suddenly went into reverse. Hedge funds that had funded investments in oil futures by selling short on bank shares were caught in a vicious squeeze, as this strategy lost more than 40 per cent in a matter of weeks.

A spoof “Dear Investor” letter from a macro hedge fund manager to his clients is currently doing the rounds on the internet. It captures nicely enough what went on. “We have no explanation, since our trades are systematically based upon doing what others are doing (only, hopefully, faster ... though, in this instance, not fast enough). Nor do we offer you apologies. You [presumably] knew the risks, and felt the glory (if only for a while).”

Again, a strategy widely offered to wealthy investors to enable them to make money during the carnage had come a cropper.

It is popular to blame complicated investments such as this for the market's problems. Excessive use of leverage, derivatives or short-selling have all helped amplify market chaos in the past year. It is supposedly good for the rich that they can take advantage of such strategies, but that is beginning to look questionable.

And conventional wisdom seems to be taking a new beating on another front. For years, that wisdom has held that for most people, index funds make sense. Passive investing keeps costs low, and avoids wasting money on trying to do what most active managers seem to find impossible – beating the market consistently.

Yet there is a problem: index funds are dumb. They cannot be contrarian. Once a trend gets going, they have no choice but to follow it, thus making that trend even stronger. Index funds arose, logically, out of the theory of efficient markets. Put very crudely, markets are efficient, so it is impossible to beat them and you should just join them. But the very existence of index funds helps make markets more inefficient and more prone to bubbles.

Experience, and not just logic, backs this argument. Indexation began to become an orthodoxy for retail investors and for big institutions about a decade ago. And in that decade, markets have grown ever more prone to bubbles – from the tech bubble to housing stocks, to China.

The logic of indexing has not gone away. It makes more sense to pay a small fee for an index return than to pay much more to an active manager who will be lucky to do even that well.

But the conventional wisdom is starting to shift against indexing. And while it is still fashionable to blame the esoteric investments of the rich, there is a good argument that index funds, the investment of the masses, have also exacerbated the world's financial problems.