In a post last week I linked to Friedrich Hayek’s, The Use of Knowledge in Society. Hayek passionately and clearly articulated the fundamental problem with centralized systems — the act of centralization often destroys knowledge. A design goal in most of the products I build is to distribute decisions TO those with knowledge rather than moving knowledge TO a single decision maker or centralized body.
While there are so many markets where knowledge is destroyed through attempts at centralization, the public financial markets are relatively good at leveraging distributed knowledge. Most of the ideas we will discuss at Laserlike will be focused on those areas where inefficiencies are obvious. But today we face a much tougher challenge — can we beat the financial markets with…a market?
First, a little [conventional] economic theory…
You can find a brief history of mutual funds here. The first mutual fund started in 1924 and in 1976 John Bogle opened the first index fund.
First year Finance classes at most U.S. MBA programs teach students that: (1) you must be diversified in order to lower your cost of capital from total risk to systematic risk, (2) the efficient market hypothesis tells us that, without board control or inside information, we cannot beat the U.S. equity markets on a risk adjusted basis, and (3) it therefore follows, that you should invest your money in highly diversified investment vehicles with the lowest overhead (usually, index funds).
Yet, while global assets under management (AUM) reached nearly $62 trillion in 2006, index funds accounted for a fraction of AUM. Index funds have experienced impressive growth, but it is clear that a very large sector of the public believes that actively managed funds can beat index funds — even after adjusting for the higher cost of active management.
In fact, the incredible growth of actively managed hedge funds is a dramatic move in the opposite direction. Many hedge funds take “2 and 20” which refers to 2% of money under management per year and 20% of all profits. Index funds usually take less than 1% of fees under management per year and don’t take any share of profits. Those actively managed funds [particularly hedge funds] are charging a hefty premium for their expertise.
Idea: Shadow Market.
1. Consumers invest in our mutual fund, and then help us manage it.
Any consumer (“retail investor”) can invest her money in the Shadow Market. Let’s say we have a minimum US$100 investment requirement and a US$100,000 maximum investment per person. Investors then allocate their investment in stocks they like. There are no management fees, no performance fees and no trading costs!
Our pitch to retail investors is, help control your fate and put your money to work with no fees (your investment, it should be noted, is a share of the overall fund — it’s not purely based on your allocations). What do you have to lose?
So, how do we make money? Volume. Let me explain.
Our goal is never to make money on retail customers who are actively trading in our internal market — in fact, we are actually going to pay some of them (more on that later). Instead, think of retail investors with <$100,000 invested as our investment team. If we can get enough traders and we can remove all transaction costs for investors to convey information about stocks, we can assemble information that no existing fund has at their disposal. And we are going to use that information to [try to] beat the market.
2. Raise a large fund from institutions (limited partners).
In order to make money in the investment management business, you either need a massive amount of capital (actively managed and index funds) or a massive amount of leverage (hedge funds). Our fund will not employ massive leverage, so we will need a large fund.
Our pitch to limited partners is that we will leverage the wisdom of the crowds to beat the best actively managed funds out there. Remember, while we aim to beat the overall market we just need to beat actively managed funds on a risk adjusted basis. What do you have to lose?
3. A different way to organize funds within our fund.
Most large mutual funds organize around investment styles like “growth,” “value,” and “income.” Our funds will also be organized around investment style. But our style will pivot around the methodology used to analyze the data provided by our retail traders rather than some historical financial ratio.
For example, a “wisdom-of-the-crowds” fund may simply reflect the net transactions on a dollar-weighted basis of all trades in our market. Mike buys $10 of Google and Jeff sells $12 would result in a the sale of $2 of GOOG at the end of the day (thereby eliminating trading fees for all “internal” trades). An “all-star” fund may weight the trades of those who have performed well in the past. And an “industry expert” fund may weight the trades of those with industry expertise (e.g., assume users with an @yahoo-inc.com, @google.com, or @microsoft.com address know more about the web and software) more highly.
4. Pay for performance.
Earlier I suggested that retail investors would have the opportunity to get paid beyond the returns earned by their investments. This is particularly important because doing so will provide an incentive for those with knowledge to bring it to the Shadow Market rather than trading on it in their own account. Or perhaps, they will do both. The leverage of having a big fund is that we can jump on important information (captured by our retail traders).
So we will share the proceeds earned from our fees with our best investment professionals. Perhaps an algorithm that rewards a balance of the amount an investor puts to work and the performance of their picks — with a very large payout for the top decile of performers. Remember, our system scales much better than existing labor-heavy actively managed funds. We can afford to share the gains.
Something I never understood about the efficient market hypothesis (in whatever “form”) is that it assumes anyone with critical information will trade on that information. But capital is not distributed evenly, so perhaps we can make the markets even more efficient by correcting that fact. For example, someone with very little incremental capital available for investment would be limited in bringing their knowledge to the market. And remember, these same investors have been instructed by the efficient market hypothesis proponents to be fully diversified — this further blunts the impact of a trader acting on information as they need to distribute their bets across at least 20-30 stocks on a dollar weighted basis. Another issue is that the impact of most information on the value of a stock is not so clear; however, there are trading fees to act on those small bits. By lowering the transaction costs of bringing that information to bear, we can gain great insight from the cumulative bits and pieces of information which may not have previously led to a trade. Shadow Market allows you to bring information to the market at virtually no cost (once you have make some minimal investment). You get diversification by virtue of being part of the fund.
Finally, even if you don’t buy either of those two arguments, surely we can identify great investors better than the existing fund manager recruiting process?
I am not a lawyer, so please run this by someone with legal expertise in the US financial system before you do anything with this idea. There are no doubt many legal and regulatory issues here. Having said that, there has got to be a better way to manage the $62 trillion of global assets under management.
18 responses so far ↓
Sue Massey // May 27, 2008 at 4:01 am |
Great post. I will read your posts frequently. Added you to the RSS reader.
jolly // May 27, 2008 at 4:49 am |
A good survey of “social investing” with sites with related ideas can be found here:
http://venturebeat.com/2008/02/11/a-survey-of-social-investing-sites-11-contenders/
A funny anecdote about Marketocracy: I made a few portfolios there long ago and then stopped paying attention to them years ago: the buy-and-neglect strategy! Looking back at the portfolios today, I see that all of them still sport positive returns since inception. 4 out of 5 have outpeformed the S&P 500 over the same time period. One portfolio based on “strong fundamentals” is up 126.25% since inception for an annualized yield of 13.99%, handily beating the S&P’s annualized yield of 5.08% over the same time period. I also slightly outperformed the so-called m100 index of marketocracy’s best 100 members. Can I go start a hedge fund and collect my 2-and-20 now?!
As to the portfolio in question, 48% of its value is now in AAPL, a holding that has a since-inception return of 1190%! At the same time, a number of names are down over 98%!
Mike Speiser // May 27, 2008 at 3:42 pm |
Thank you Sue!
Thanks Jolly. Will check out that URL.
I would encourage you to read The Black Swan before you start that hedge fund
George // May 27, 2008 at 9:46 pm |
Really interesting post.
The main arguments here seem to be that (1) the market is not truly efficient in that there are small traders with inside information who are not contributing this information to the market because they do not have sufficient available capital, (2) that the current market (managed or otherwise) could be more efficient if trading costs were lowered.
I definitely buy into the argument that not all insider information is efficiently made available to the market. There are certainly interesting regulatory challenges to address here if shadow market participants are profiting from insider information.
The management fees associated with actively managed funds are significant. One of the key benefits to a shadow market could be the lowering of information acquisition costs versus methods that are used by managed funds. Rather than paying a captive managed fund team to gather information to be used to “beat the market”, a shadow market could aggregate the distributed knowledge that is already held out there in the sales forces or accounting staffs of these investment targets. Intuitively, the cost of aggregating the knowledge of these shadow market participants seems like it should be cheaper than hiring and maintaining that captive managed fund team.
One last comment related to systematic risk. There is an interesting paper published in January 2007 by the Federal Reserve Bank of Atlanta which argues that hedge funds have increased the market’s systematic risk. The paper contains some compelling arguments. http://www.frbatlanta.org/filelegacydocs/erq406_lo.pdf
Mike Speiser // May 28, 2008 at 12:02 am |
George,
Wow, great comment. One correction: I’m not arguing that we should capture insider information, but rather than not all “information’ is captured in current prices due to transaction costs. Atomic bits of information may not warrant the trading costs on a one-off basis. But the quilt-work of the collective view of those atomic bits may be extremely valuable. So my argument is that by removing the transactions costs you can assemble knowledge not available to the market.
I will check out the Fed study — fascinating. Thanks.
-Mike
Jeffrey Ralph // May 28, 2008 at 5:00 am |
Should be interesting to see what the results are from CNBC’s “Million Dollar Portfolio Challenge”:
http://contests.cnbc.com/milliondollar/main.do
Perhaps CNBC will print them at the end of the contest. Will the “wisdom-of-the-crowds”-investing beat the index/mutual funds…?
Interesting blog, Mike. Do you ever sleep?
Jeff
Mike Speiser // May 28, 2008 at 5:18 am |
Thanks for the heads-up on that Jeff. I had no idea… I hope you are entering the contest
Venture Hacks — Free ideas. Just add execution. // May 28, 2008 at 10:25 pm |
[...] My favorite idea on his blog is Shadow Market: Money management by the masses. [...]
Mike Speiser // May 29, 2008 at 2:54 am |
Thanks Nivi (Venture Hacks)!
flairjax » Giving away ideas…have been doing it for a while now wheres my props. // May 29, 2008 at 3:17 am |
[...] venture hacks made a post Free ideas . That talks about Laserlike giving away free ideas since people worry to much about protecting them and not enough time about [...]
Björn // May 29, 2008 at 7:32 am |
One problem I worry about with social investing is that the social investors could try to manipulate the market. They could have outside investments and then do the same investments as social investments, thereby influencing their outside investments to their advantage.
In general it would be nice to make something like this work, though.
Mike Speiser // May 29, 2008 at 2:36 pm |
Bjorn,
Fair point. With a large, diverse groups of investors putting their own money to work, this problem is limited. You could also tune your algorithms to look for behavior that is wildly inconsistent with the crowd — you could then decide (perhaps based on the trader’s reputation based on previous trades) whether or not to use or toss a particular trader’s “guidance.”
-Mike
Ethan Bauley // May 29, 2008 at 3:56 pm |
Mike, you will love this if you haven’t seen it already (decentralizing knowledge):
“In Quadir’s view, it’s not that centralization per se creates poverty. Poverty is the natural beginning state of all societies, east or west. Rather, decentralization is the engine which removes poverty and brings wealth.”
Kevin Kelly “Technology That Connects”
Mike Speiser // May 30, 2008 at 1:45 pm |
Excellent! Thanks Ethan. Enjoyed that post.
Blog you must add | Bronte Media // June 2, 2008 at 2:04 pm |
[...] idea that I have noodled over: a shadow market mutual fund, where the investors pick the stocks. It creates wonderful incentives: no one is going to pick bad stocks because they are putting their [...]
Town Hall: A distributed solution to managing the U.S. economy. « Laserlike // June 13, 2008 at 4:02 am |
[...] Hall: A distributed solution to managing the U.S. economy. Posted June 13, 2008 In Shadow Market: Money management by the masses, we discussed the idea of distributing the management of a mutual fund to consumer traders. The [...]
flairjax » I wonder where Ignighter got the idea? // October 16, 2008 at 1:27 am |
[...] is that VC guy who gives away ideas…. Laserlike? I think a VC should hire me to create new companies. Any incubators looking for a new [...]
Stephanie Gerson // December 3, 2008 at 5:08 pm |
a little birdie pointed me to this post. fantastic. and something tells me you’d be interested in Piqqem, a web app that applies the wisdom of crowds to stock market predictions. specifically, Piqqem captures users’ stock predictions, analyzes them, and then displays aggregate results back to the users, enabling them to see what ‘the crowd’ thinks about particular stocks.
I see you were referenced to a list of social investing sites on VentureBeat. note that Piqqem is different from other social investing sites, because it believes the crowd has more knowledge than any single individual. instead of looking for the best individual stock picker and weighting votes based on investment ability, which is what CAPS and other social investing sites do, it looks at aggregate opinion and allows everyone to vote as much as they want.
with zero shame: we’d Love to get blogged about here. please get in touch if you’re interested.