Every now and then, the argument surfaces that "passive management" represents the investment method that best reflects the principles espoused by champions of economic liberty such as Friedrich Hayek and Adam Smith, and that "only the North Koreans, the Cubans, and active investment managers" have yet to come around to the position that "markets work." This particular usage of the insights of Hayek and Smith was first articulated in 1995 by Rex Sinquefield in a debate and has been recycled endlessly in the fifteen years since. In fact, we received a mailing earlier this year from a group whose opinions we generally respect, reproducing the transcript of Sinquefield's 1995 remarks and using them to promote their brand of "passive investing."
We presented a detailed rebuttal to Sinquefield's points two years ago, in a post published in May 2008, but we believe that there are several reasons why the topic is worth revisiting.
Perhaps most important is to dispel the attempt to co-opt the brilliant work of Friedrich Hayek into an argument for indexing, and the attempt to argue that anyone who doesn't acquiesce that indexing is the only way to invest capital has gone over "to the dark side of the force" (Sinquefield's phrase) and aligned themselves with brutal communist dictatorships such as those still oppressing North Korea and Cuba.
Well, we are active managers, and have made it quite clear in numerous previous posts (such as this one and this one) that we disagree with the tenets of "passive investing" or "indexing" or even the "efficient market hypothesis" that Sinquefield says is "simply an extension of Hayek's fundamental assertion: markets work," and yet we yield to no one in our admiration of and agreement with Friedrich Hayek and his arguments.
The egregious mistake that over-eager proponents of "passive investing" make when they claim that indexing is the logical extension of the insights of Friedrich Hayek or Adam Smith is their failure to make the crucial distinction between what we call "free markets" and "free enterprise."
Free markets are a necessary precondition for free enterprise, but they are not the same thing.
By free markets, we mean the conditions of predictability brought about when the rule of law is enforced, the medium of exchange is reasonably stable and predictable, and citizens are free to manage their property (including businesses which they form with other individuals) in ways that they see fit, without undue interference from the government, as long as they do no violence in the process.
In fact, these conditions are remarkably like what Thomas Jefferson articulated in his formula "the equal right of every citizen in his person and property and in their management."
While both Hayek and Adam Smith wrote about the critical importance of establishing these conditions, it does not follow that investing should be the process of trusting these conditions to the extent of allocating your capital equally to every company operating in an economy marked by those conditions. Nor does it stand to reason that Hayek would advocate such a course of action.
When we say that the distinction between "free markets" and "free enterprise" is important for investors to understand, we mean that free markets are important, but that they are only a means to an end. What we mean to indicate with the expression "free enterprise" are those innovative businesses which, in the course of trying to add value to their customers, advance the conditions of human existence, by creating new technologies, new products, new services, new and more efficient ways of growing crops or manufacturing goods, and all the other countless innovations that have enhanced human living standards over the past centuries in almost unbelievable ways.
In fact, the Austrian economists -- including the big three of Hayek, Mises, and Schumpeter -- were the most articulate champions of the centrality of entrepreneurial innovation, and if anyone had to hazard a guess as to what their position on the "active vs. passive debate" would be, a very strong case could be made that they would advocate allocation of investment capital towards the most innovative and well-run businesses, rather than the mindless allocation of capital equally towards any business that lists itself on an exchange, regardless of whether it is operating in a dying industry or whether its management has shown itself to be incompetent.
In fact, in an enlightening 1960 essay entitled "Why I am not a conservative," Friedrich Hayek touches on the subject, in the course of making a much larger argument about the distinction between the position of the classical liberal and the continuum between the radical and the conservative.
In that essay, Hayek says, "It would seem to the liberal, indeed, that what is most urgently needed in most parts of the world is a thorough sweeping away of the obstacles to free growth. [. . .] But the admiration of the conservatives for free growth generally applies only to the past. They typically lack the courage to welcome the same undesigned change from which new tools of human endeavors will emerge."
Here, Hayek seems to be reinforcing this important distinction between free markets and free enterprise, because he sees the goal of "the thorough sweeping away of the obstacles" as being the promotion of conditions which enable "free growth."
We would argue that the position of the advocate of "passive investing" or "indexing" is more akin to the position Hayek describes as that of "the conservatives" -- trusting in the growth of the past, lacking the courage to seek out and welcome those disruptive innovators, which Hayek calls the agents of "undesigned change."
We believe this is a timely moment to discuss this supremely important subject, because so many investors have given up on "active management" and stopped looking for innovative companies, in a sort of mass despair and doubt that such things even matter anymore.
It is our conviction that looking for innovation has never mattered more, and we point out that this conviction has served us and our investors well, including during the turbulent past three years (as our investment performance records demonstrate).
We recommend that all investors take the time to consider these important subjects, and to get to know the arguments of Friedrich Hayek for themselves.
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For later posts on this same subject, see also:
- "The political winds are swirling" 09/15/2010.
- "The ideology of modern finance" 01/12/2011.
- "The growth theory of investment works" 01/14/2011.