Investing is not a zero-sum game
The arms race among investors never stops. The rampant bull market of the past decade could already be a thing of the past and institutional investors are understandably nervous about the future. But even during bull markets, the question of how to generate returns is often replaced by another, arguably different, question of how to beat markets.
The two questions are often used interchangeably by pension funds because they simply cannot rely on investing in risk-free assets to meet their objectives. At the same time, pension funds have a professional duty to apply the best practices in investment.
For these reasons, pension funds depend on increasingly complex financial tools. Such tools, at the best of times, are created using robust financial economic theories.
While financial tools apparently grow in complexity, financial theory is still relatively simple. It is a social science that shares the same flaws of the other social sciences – for example, the difficulty of using experiments reliably.
This tension produces a gap between theory and practice. Factor investing is a good example of this divide. In simplistic terms, proponents of factor investing tend to make two assumptions: that there are behavioural biases; and that these biases can be exploited to an investor’s advantage. The first assumption is clearly true, while evidence that the second is true is mixed.
This is not to say there is no merit in using concepts such as factor investing or, more generally, risk management in investment. However, it is striking that all of these concepts are based on a vision of investment as a zero-sum game. The idea is that to meet their objectives, investors have to beat other investors.
Does that vision represent reality? Pension funds may find that they will only deliver their results if they become good at doing something that, at least in principle, is simple. That is, investing in good businesses that are creating growth and prosperity. That is what investing should be about. Of course, it could be argued that identifying those businesses is exceptionally difficult. But rather than focusing on beating the market, investors should focus on contributing to value creation.
That is why there is perhaps more merit in long-term investing in public and private equity. This approach is often best encapsulated in concentrated equity portfolios with a long-term horizon. These portfolios are based on a deep analysis of each constituent. Analytical tools should be qualitative as well as quantitative and go beyond the simple economics of making and selling things for profit.