Money management is based on price discovery, Chris Kerlow and Craig Basinger point out in a Richardson GMP market note. We buy and sell in an attempt to profit from a stock’s return to intrinsic value.
“But there is a new big player in the market that doesn’t care about price discovery: the exchange-traded fund (ETF),” says the note. ETFs aim to buy quickly, minimizing tracking error and giving investors the exposure they seek.
Because fewer market participants are engaged in price discovery, it takes longer to reach intrinsic value. Paraphrasing Warren Buffett, this means “investors will need to wait longer for the tide to go out and show who is swimming naked,” the note says.
Does a weaker price discovery mechanism mean active managers should change their approaches?
No, say the authors, but they should get savvy to human behaviour, because active managers add the most value when markets are inefficient, which is often attributable to human foibles.
For example, investors overreact to information, slamming a high-quality company’s share price after a negative earnings report. But such companies tend to make back those price losses quickly.
To avoid this type of typical human behaviour, managers and investors must take a contrarian view, says the note. And that means stepping outside their comfort zones.
Read the full market note.