Article II. The active fund industry facing its fate: or why Mr. Keynes still matters.


Keynes was the greatest economist of the last century. He was acute and most of the time right in his analysis. Why? Because he was embracing a very modest and humble attitude: To understand what is going on, to provide advice, and so to improve the current state of affairs, you need to be present/involved. That is, you must patiently spend time carefully describing the mechanisms, that define an economy. What matters is to face what is in use in the economy, not what we believe is used. A theoretical debate is useful for shedding light on human choices. However, institutions, such as the stock market, must be carefully described for what they are because their mechanisms deeply influence agents’ choices!

In short, Keynes was like a biologist: What is killing a virus today is unlikely to work tomorrow because the virus will evolve into something different and therefore unknown. But to understand the virus evolution you need to carefully study the environment. As an observer, you must constantly be open to reviewing your analysis and starting from scratch!
It is not surprising, then, that at the core of his main contribution, The General Theory [1], he spent a chapter, the twelfth one titled “The State of Long-Term Expectation” [2] depicting the structures of the financial markets, at his time.
Is this detailed description still useful for us?
Yes, it is for at least two reasons:

A. Keynes acknowledged a key factor: The stock market runs on a fuel called uncertainty. The only sure element you can take for granted in this market is that all participants share the same burden: the inability to forecast the future. This implies that predictions on monetary streams that determine the fundamental value of a share, are not certain, and this is due to our inability to forecast the events that will determine the future firm business environment. There is only one way to narrow down our uncertainty about a share price: You must forget your own estimation about the fundamental value of a share and focus on what the other participants think its value is.
Alternatively, the idea goes like this: You can easily have in your hands, the most sophisticated price forecast mechanism on Earth, but if the other participants do not share your view, the price today and its evolution ahead are likely to differ from your forecast. The market is a social institution, not an abstract mechanism in which quantities or values are judged by an impartial actioner: To cope with it, you need to foresee others’ estimates, because, ultimately, these are the factors that will determine prices-thus values-and their dynamics.

Basically, the central message underlying the Keynesian beautiful contest analogy is twofold: on the one hand, the likely winner in the stock market game will be the one who evaluates where the majority thinks the “right” prices are better than others. On the other hand, as a participant, you have to live with your time; that is, investment ideas and strategies that were valid in the past are likely to fail today simply because those procedures become common knowledge among participants [3]. Today financial literature often refers to this process by using the term “model decay”: basically, the underlying idea is always the same, a winning strategy will be always copied and “arbitraging” so to become “standard”. On that side, there is nothing more frustrating and useless than the nostalgia of old methods and investment procedures. Given that the majority of the participants are interested in maximizing their returns, past successful ideas are not gone, they are integrated in the background, routinely applied by various participants. Therefore, they are just unfitted to be alpha generator.
Now, the active fund manager, who offers an investment vehicle that promises to beat a given benchmark index, must tackle the market as closely as he/she can, and, simultaneously, he/she must depart from it, by a series of “discretionary” choices [4].
It is this departure, this willingness to seize opportunities, albeit strictly observing others, which represents the fund manager’s real challenge and added value. Given this duality, the active fund’s success will entirely depend on two main factors:

(i) What others are doing, which is basically the way in which agents are selecting, judging stocks and finally acting given the set of opportunities at their disposal.

(ii) The pool of opportunities available for “departing” from the market, which in the case of a fund means from its chosen benchmark.
Presently, as an example of (i), we can definitely consider the current huge investment by active fund managers in AI-ML.
Those procedures for detecting opportunities are not yet commoditized, so they are viewed like a promising signaling source of unexploited actions or informational participant gaps. Today, a fund manager is ready to do a stringent AI-ML inquiry of the data available then use those results to bet on the abilities of the market; that is, ultimately, the abilities of other participants to reabsorb the gaps, which would imply to receive a reward as first mover.
Clearly, as time goes by, the standardization of procedures and data will continue on and, thus these opportunities will decrease. Investment in AI-ML-Big Data sounds like a valid decision but you should not count on it too much in the medium or long term.
Despite having a larger potential, AI-ML-Big Data waves are similar-on that side- to the high frequency trading wave, as well as any generalization of decision process in the stock-picking domain: time means standardization and it will always work against new techniques. Ultimately, we should always bear in mind the words of Ben Graham’- a Keynesian fellow, so to speak- who, just before he died (1976), was asked whether a detailed analysis of individual stocks, a tactic he became famous for, was still a rewarding option: “This was a rewarding activity, say, 40 years ago, when our textbook was first published. But the situation has changed a great deal since then.” [5]

We cannot pretend to offer an investment vehicle without considering today’s market forces-i.e., chiefly information on used-, technologies and procedures: Many ways exist by which you can select the opportunities, and those methods are constantly evolving, you need to be up to date to have a chance of winning your battle against the market. There is no problem on that side. Still, one needs to evaluate the real factor that, whether in the short term or in the long term, represents the main deal of any active fund proposition: the presence of numerous or at least enough opportunities for “departing from the market”, as noted in point (ii) above.

The fund manager’s hope of beating the market is related to having a pool of opportunities “large” enough.
The key queries become the following: Are we sure that today’s pool is “large” enough?

What exactly do we mean by “large”? Is it not more a question of availability of enough “fresh” dynamic stocks in the market? Is not this dynamism the real indicator of stock market health? And finally, if it is the case, when a market becomes less dynamic what happens to the fulfillment of its social role?
We should always remember, as in the case of biological evolution, that if an institutional framework loses its primary function, another institutional arrangement appears and gradually takes its place.
Few are interested in those questions, when, this is exactly where we should start from if we want to judge and evaluate the stock market. The last part of this article is devoted to outlining the answers to these questions and thus depicting the contours and the limits of the new institutional arrangement partially already in place.

B. The beauty contest analogy was encapsulated in a section called “The Inducement to Invest”. Keynes was investigating the motivations to invest. As discussed in point A., Keynes was alerting us that the stock market can easily become a pure sophisticated game among insiders. In this game participants anticipate each other’s moves and subsequent prices’ movements by analyzing all sorts of information. It is precisely in this section that Keynes presented the famous analogy of a stock market appearing as a casino in the public eye: The strategic choices made by the market’s players easily appear incomprehensible to the layperson.
Nonetheless, despite this negative outlook from the market’s outsiders, the system will always manage to provide a price structure, helping to efficiently allocate people’s savings and thus to guarantee cheap capital to the “right” producers-that is, those who are expected to be in line with future social needs-. After all, the key benefit of a capitalistic system is that markets are institutions that allow optimal social choices to be determined and properly financed simultaneously.
Equivalently, economic growth will be dictated by people’s aspirations: In particular, savings will be allocated to generate the capital goods used to produce items, which will be in heavy demand because, a priori, they will increase people’s well-behaving.
What was Keynes’s real worry about this institutional arrangement?
To be honest, I believe that his main concern was more about seeing everyone participating in the game. His view was quite straightforward: Until, the participants were people with enough wealth to occasionally support significant losses, the game was harmless to the economy.
No one is free from investment misjudgments because no one knows the future, what the economy will be like or what will happen, i.e. what will be the main activities ahead. By investing, you are taking a bet, which you can definitely lose!
On that point, the trouble would start only once a number of ordinary people were entering without having a buffer to carry on losses. These participants would borrow to have a say in the market. Rightly, Keynes saw coming the spiral of private debt leverage that would be dangerous because it was borne by weak shoulders. It is no surprise that the brutality and widespread impact of the 1929 stock crash was also due to the burst of a generalized debt spiral (like in 2007-08, by the way). This last aspect is fundamentally one of the core facets of a free economy, and nothing has changed with time: we just changed the scale, the numbers associated with different forms of leverage are just bigger, more out of control and difficult to evaluate in their full, dangerous potential.

Despite this despicable debt-related feature, Keynes was not castigating the system. Clearly, this magnanimous attitude towards the capitalistic economy was on one side, historically based: Keynes had no idea about the cost in terms of negative externalities, e.g. environmental costs, due to an economic growth process sets on “biased” prices. And on the other side, his analysis was more concerned with what to do next and how to repair an economy in trouble.

Generally speaking, excessive euphoria followed by slumps and depressions were part of an overall picture defining the essence of a capitalistic economy. There were definitely measures to limit excesses-e.g., less generalized leverage- and fight slumps- e.g., such as the active intervention of the government. But what matters more is that Keynes was taking the centrality of the stock market for granted. The stock market was fundamentally the right place to guide economic social choices, because a very large set of alternative projects were evaluated and available to investors. To be complete, Keynes was also taking for granted another aspect: Firms had the possibility of financing their projects using debt, but this way was not view as a valid long-term solution. Basically, for long-term projects an entrepreneur was almost forced to consider the stock market solution. As a side note, we should stress that, at least in several developed countries in the last few decades, firms’ debt financing has been excessively fiscally favored compared to an equity financing scheme.
At his time, any dynamic entrepreneurs were quite certainly at the moment of financing their project sharing their plan with the market by going public.
It is specifically on this point that our world differs substantially from the Keynesian one. The size and the role of this allocation of capital out of the market, i.e. without a public offering on a centralized market place, has totally changed since his time and this has a direct consequence on the number of fresh opportunities in the markets.
Three main factors can be considered to explain this sharply different ecosystem:

1- In Keynes’s time, the stock market was “alive” and at the core of the economy. New firms in need of capital or old ones already quoted were actively using the market, such as by publicly increasing the number of shares or becoming participants. Nowadays, the centrality is not fully gone but is seriously fading away. Indeed, today, when considering the biggest and most develop stock market of all, the US stock market is literally “drying up”. This is due to a series of phenomena that include fewer IPOs notably for very young, small-caps firms (data from OECD Business and Finance Outlook 2015 p. 211-14, and the latest data concerning the last two years confirm the trend), as well as the constant high numbers of M&A, stocks Buy Back operations, and, finally, delisting of small and medium caps [6].

Here, we can easily see a reason for the difficulty of beating the market for an active stock fund. Despite the efforts to find fresh, not yet correctly priced stocks, the bundle of opportunities available is shrinking over time. It is like having to catch a fish in a barrel: It is a lot easier to catch one if the barrel contains plenty of fishes instead of a few. Now, clearly, in the case of the US, we cannot forget that there is a lot of competition to catch the remaining fishes, which drastically reduces the chances of each fund manager getting the right one and then reaching the frantic end of beating the market.
What is really interesting, and rarely commented, on, is that the US story does not generalize so easily in the case of other developed, old, capitalistic economies. In Europe, for instance, we observe that active funds are beating the market more easily. [7]

Personally, we do not believe that such European performance is only due to less heavy competition among fund managers. In our view, this result is also partially explained by a less dramatic “drying up” phenomenon in this part of the Atlantic. The presence of dynamic medium and small firms in European exchanges is less under threat than in the US. For instance, M&A activities are less intense due to national and cultural barriers in Europe.
Besides, the US and Europe differ in another key respect: the organization and professionalism, mainly in terms of money availability, of this out-of-the-market framework. These features constitute our second and third points.

2-In the US we have a huge web of out-of-the-market financial institutions, from Private Equity solutions to Venture Capital and Business Angel structures, which can easily provide important capital injections into new firms. After 2007-08 crisis, the extremely loose FED monetary policy has certainly favored the availability of money out-of-the-market ready to be invested in this start-ups ecosystem. On that note, we cannot exclude that a too brutal end of the loose monetary policy would generate a sharp decrease of this form of financing: the very cautious FED tapering approach can be explained by this concern.
What is clear is that under these conditions, there is no need, then, to go public quickly and even at a late stage, becoming public is no more crucial! To go public is a late option, which is often delayed and seriously considered only once the firm’s founder wants to monetarize part of his/her success.

3-US big firms, more so than European ones, are behaving, more and more like venture capital organizations. In a time when the innovation process has reached a stunning pace, big firms are perhaps, paradoxically, the best equipped to mitigate this breathtaking constraint because they can figuratively build (defense) frameworks around themselves. Big firms become framework builders by surrounding themselves with dynamic pools of start-ups.

The key question remains:

Is this new institutional arrangement a better solution or a worse one from an economic point of view?
This is an extremely difficult question to consider. We can only guess at some insights:

We should always remember that at any point, whether AI and Big Data are available, we do not have any idea about, for instance, the steps and the path that will lead us to our next main technology, which will be the real force that reshapes our own economic system.

It is the Blade Runner paradox, in reference to the original film released in 1982: The hero of this famous science fiction film is communicating with a replica of humankind using telephone boxes!

When we imagine and see the future we think about big changes -replicas, flying cars- but we are less ready to consider a bundle of key technological breakthroughs that revealed as being the real modifier of our lives. The mobile web technologies are the best examples ever on that side because they emerged from unpredictable marriage between new telecommunication infrastructure, phone industry improvements and web-IT technologies all available and released in a short period of time!

This misjudgment is everywhere and thus influences the people and AI machines-which look at the past by definition-in financial markets as well. Building the economic future, is a huge and messy stop-and-go game, in which the final result is also determined by an ultimate big divider: luck. That is to say, often a technological advancement can be achieved because several other small parts are released simultaneously or are available but used for other purposes. It is mainly this shift in purpose, that explains why engineers are extremely creative human beings and also why the time of success of a promising commercial idea is so difficult to forecast.

Now, if we think of a centralized market as a fantastic institutional framework that aggregates the intelligence of all participants, a priori, and despite the noise of excessive speculative games, the “fair” value will be determined and investors may use it as a guide. The share price should fairly reflect a wise, intelligent and rationally based consensus about the future quality of the proposed firm’s production.
A priori, being a young innovative firm early quoted in the stock market implies having its shares available to everyone and submitting to some high quality “standard” in terms of the financial results displayed.
The lottery ticket is available to all participants and, in particular, to the fund manager eager to beat the market.

Now, this is all in theory. In practice, overly harsh short-term concerns, may just prevent innovative entrepreneurs from focusing on their long-term goals. Today, the market is generally asking for money too quickly, and thus entrepreneurs may end in an optimization trap-that is, to paraphrase Alan Perlis- they may be forced to choose between “optimization and evolution[8].
The centrality of the stock market is at risk due to an excessive pressure on short-term objectives. The market is the reign of optimization more than ever before. Firms are devoting their R&D budget to development efforts and a lot less to research plans; everything is done to obtain quick and high shareholders monetary returns, groups are too often seen and treated as money cows, basically.
This is why, research efforts are likely to be better assessed, understood and financed out of the market as well as any projects with long-term prospectus and low return on a short-term period.
However, this framework has at least two major shortcomings:

(i) Being out of the market, implies currently, being unavailable to the majority of people’s savings, savings which they “happily” invest in tracking the market’s momentum, such as by buying an index tracker ETF, which means favor big companies and disparage small ones!
Now, the money to finance the ‘evolution’ is likely to be in short supply due to existential worldwide risks ahead, which could be solved only by collectively embracing and accelerating the effort at ‘evolution’.
On that point, the truly sad part is to see institutional investors (i.e. our pension funds) being prevented, by governments’ too strict risk rules, from diversifying their portfolios on these out-of-the-market activities: not really a sign of an intergenerational solidarity and neither a coherent message, since environmental concerns are endlessly repeated by world-political leaders, with few exceptions of course!

(ii) At the same time, the out-of-the-market allocation process needs to be protected and helped. For instance, if current market players enter on this out-of-market world with the same eagerness and short-term habits, the “evolution” is likely to be restricted lost on lunch money.
Nowadays, in the stock market, we lack real evolution giants: We are financing new digitalized distribution platforms, keeping oil companies among big capitalizations and guarantee stellar quotation to huge AI driven advertising powerhouses like Facebook and, partially, Google while grid energy storage and distribution firms and other innovative de-pollution firms are scattered in companies’ portfolios, such as Tesla, and thus not properly financed and pushed to the front within the system!
I am perhaps exaggerating, but we are too focused on analyzing and pricing assets based on current sales and costs and not enough on investments and plans (with only few exceptions): The future is simply too much undervalued and unseen. If, as it is true, the best way to have an amazing future is to build it then today market activity is just too focus on keeping the present.
The unrealized market crisis lacks an appetite for risk, it is the reign of the optimization, which prevents us to accelerate and push through private investments.
AI/ML or any other digitalized analytic technique will not change this gloomy picture an iota: The spiral of asking firms to distribute more money to push consumption and thus confirm the sales figures the computers are asking for is tragically already realized!
Alternatively, AI will not be the device helping to challenge this “keep the present running” spiral: AI is an amazing tool to detect trends on data and its logical decisions-making is based, basically, on keeping running those trends.
How to solve this problem? Two axes seem feasible.

First, from the political side, we should expect a change on fiscal rules to favor access to out-of-the-market vehicles for both institutional and private investors. Now, this fiscal reform should include all sorts of ethical/long term environmental projects: If our savings are used in these domains we should receive a fiscal discount whether this investment is done in the market or out of it. Meanwhile, all sort of fiscal holes and blind spots which still exist today and benefit polluted activities must be removed. It is definitely time to accelerate the movement and to seriously move into our next economic paradigm.
Second, the private banking industry should reshuffle its offer thanks to these new fiscal environments. On that note, the private banking industry should urgently take onboard and develop the ability to provide as large a spectrum of investments as possible to their clients.
In the future, millennials, will not readily accept only in the market solutions, they are likely to ask hybrid solutions, where classical in the market funds are mixed with (a priori less liquid therefore riskier) out of the market solutions. They may ask for direct participation to those investments, which may cover and satisfy also their ethical standards alongside a more cautious and picky selection on market stocks: The first criteria in choosing how to invest is likely to become durability and environment concerns not just short-term returns.

In any case a pedagogical effort will be required: On a planet, finally recognized by all its wealthy inhabitants as being finite, that is, with finite resources and production capabilities, unhealthy and unrealistic rate of returns on investment should simply be banned. More, if tailored and more accurate selections in and out of market must be defined then the clients should be ready to pay the price.
On that side, we should also see flourish new thematical stock funds devoted to investments in firms whose objectives are long term ones. But, may be, even more importantly, at the level of the regulator we should see some anti-trust applications coming back: Some firms are just too big and they are just preventing free ideas to be properly financed!

This message needs to enter in the financial world once and for all and the proper method is to use the fiscal incentives wisely.
One of the Keynesian implicit messages was also the following: If we are like biologist studying the dynamics of a virus we can definitely try to modify the environment in which the virus is developing itself.
But to modify it we must start thinking. Therefore, we should stop referring at data as a given. We must, instead, constantly challenging them using a critical and skeptical approach: only then we are thinking, that is we are really trying hard to solve a given problem.
Now, governments are the ultimate source of the legal power: Laws and international agreements are powerful weapons if private agents see clearly governments’ will and commitment.
We must abandon, once and for all, the carpe diem-or “après moi le déluge,” to use a famous French expression-ideology, which still defines unfortunately the cornerstone of our collective choices!

In conclusion, we should remember that one of the key roles of the regulator should always be to try to ensure that the right mix of long and short-term considerations are followed by the actors in charge of allocating people’s savings and, therefore, of creating our stock of capital: Historically, if something is unbalanced then the solution is to try to fix it via a direct fiscal intervention.


[1.] The correct and complete title of this book is “The General Theory of Employment, Interest and Money”, Keynes, John Maynard (1936). New York: Harcourt Brace and Co.

[2.] It is very interesting to note that this chapter represents the core of his Book IV, “The Inducement to Invest”: Keynes explicitly recognized the centrality of the role of finance in a capitalistic economy. Essentially, how finance works and its analysis cannot be treated as a minor or technical matter; understanding this is key if we want to have a proper view of the capitalistic ecosystem and of the forces shaping its evolution. Finance, by enhancing ex nihilo creation of capital, is the key place to measure the rhythm of transformation in the economy.

[3.] It is important to note that Keynes lived on a very different financial planet compared to our current situation: For instance, at that time there was no debate about individual stock or a portfolio performance versus a benchmark index. The index was already there, but it was used simply as a way to measure the evolution of the market as a whole. The key problem during that time was to pick the right stock that would guarantee a good return given a certain, often, long-term horizon. Clearly, we can easily guess that in this social environment, short-term returns were less valuable than long-term ones. But, once again, this is part of what we encapsulate with the expression “being there” or handling our own time.

[4.] “Discretionary” has become an ambiguous term nowadays. A fund can be classified as active, stock picking despite following a sort of mechanical “tit-for-tat” stocks selection strategy. A major example is the so called smart beta funds family.

[5.] I have to acknowledge and express my gratitude to the content of the article “The Unsolvable Puzzle” by Morgan Housel, available here , where Graham’s quote was first used.

[6.] For a full discussion, see my last paper:

[7.] We refer to a UBS paper “Active vs Passive: Why Does the Myth Persist that Passive Performs Better than Active in Europe?”,

[8.] The original Alan Perlis quote is “optimization hinders evolution

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