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Marxist finance - Synthesizing active and passive investing

/ 8 min read

finance, non-technical, philosophy

Apparently a contradictio in terminis, “Marxist finance” here is not referring to using Marx’s economic theory as it’s commonly discussed, but rather taking some of his analytical tools to review the different ways in which one can approach the preservation or accumulation of capital. Hopefully, this can serve as a nice example of how philosophy can provide thinking schemas that turn out useful way beyond their original field of application, be it theology, more broadly metaphysics, or political economy as it’s now the case.

Je ne suis pas marxiste. — Karl Marx

Our relevant categories - Proletariat and bourgeoisie

The main feature of Marx’s dialectical understanding of the modern economy is the opposition between capital and labor (the two factors of production in Marx’s view) and this will be our inspiration for building our perspective on finance.

Proletariat comes from the latin proles for “offspring”, and was initially used to refer to the lower classes of Rome whose children were their only “property” and hence contribution to the state. The name faded out over time and was recuperated centuries later when the drastic changes introduced by the Industrial Revolution required reconsidering sociological categories. In this time, the basic characteristic of proletarians was still being property less, but now the source of their value (in sociological terms) as their labor, which constituted their only source of income.

On the opposite side of the society, the owners of the capital (capitalists), could extract sufficient rent from their capital and did not need to work1.

In summary, the two classes can be split as to respect what’s the source of their primary income, either work or return on their assets. The core of Marx’s theory has to do with the fact that each company’s profits have to be split between labor and capital, creating a dialectical tension that was supposed to eventually bring down capitalism, something that doesn’t seem to be happening any time soon (and it’s been 250 years already)2.

His proposed synthesis was to make workers their own capitalists (by owning their means of production). This has resulted too constraining and difficult to implement but, curiously, on the other side of the political spectrum, the libertarians of the Cato Institute proposed the “ownership society”, which could be understood as another attempt at synthesizing the dialectical tension along similar lines (although with clearly different implications) since each worker is expected to be a capitalist as well: they need not own their own means of production, but they will own someone else’s effectively netting each other out.

This line of thought was endorsed by George W. Bush, and could be traced back to Margaret Thatcher.

But enough with the politics, let’s see how we can apply the above to our field of interest: finance.

Bringing Marx’s categories to modern finance

Who are the proletarians and bourgeoise of modern finance?

Capitalists would be passive investors, participants that just buy shares of an indexed fund (a fund that tracks the greatest American companies like the SP500, or its global equivalent the MSCI World) and forget about it, thus earning income without the need to work3.

The drawback of this approach is that it’s precisely capital intensive, this is: the expected rate of return is somewhat limited meaning that a very significant notional is required to obtain a reasonable income.

Proletarians would be active investors, as their work involves substantial amounts of research and monitorization of markets. In fact, we could call these market participants, rather than investors (arbitrageurs could be included too), something like market guards, since we could argue that a significant amount of their profits come, not from their invested assets (capital), but from the time (labor) they spend ensuring that market prices incorporate all available information.

The upside of this approach is that it allows for higher rates of return, perhaps the most notorious example (and quite an outlier) being Renaissance’s Medallion Fund. The downside is that it’s labor intensive, anyone already working will hardly have the time to acquire the necessary knowledge to be competitive and then participate actively in markets. Of course one can just buy participations in funds already conducting this activity, but they suffer from issues of scalability, as shown by Renaissance’s open fund performances (the Medallion Fund is closed, and that seems key to its success).

In summary, on the one hand we have excessive capital requirements, on the other excessive labor requirements.

Synthesizing capital and labor

In Aristotelian fashion, we suggest the optimal might be in between. Opting for the middle way is generally a good default for staying away from the curse of diminishing returns that plague the extremes4.

This is where factor investing comes in, which we categorize as semi-passive or semi-active investing. Factor investing consists in exploiting other risk premia apart from the equity premium. These premia have varying degrees of empirical and theoretical support meaning that a certain degree of understanding and monitorization is required. Research on these matters is relatively recent (one of the foundational works on this regard, by Fama & French is from 1992, and most of the existing knowledge has been developed over the last two decades) and hence to some extent provisional and subject to revisions5.

For instance, the causal foundations of trend-following (not cross-sectional momentum which seems to be better understood) have not been clearly identified [Jusselin et al., 2017], apart from some behavioural hypotheses which can be argued have limited explanatory power6.

Also there are issues with explaining the time variability of risk factors, which even lead to people doubting the existence of the value premium in the 2010-2020 decade [Israel & Richardson, 2020]. It may well be that risk premia do not vary that much, but the risk profile of strategies aimed at exploiting these premia does, which again calls for a deeper understanding and monitorization of such strategies.

In summary, the developmental stage of the factor investing field calls for caution and the need for greater understanding, which could be seen as labor costs with respect to passive investing; but this comes with an increase in the rates of return that allow for the reduction of capital requirements in an amount that makes it worth it.

One last note

This post is the second part of a trilogy based on the application of dialectics, and more specifically the hegelian (perhaps more hegelian in attribution than in actuality) schema of thesis, antithesis and synthesis, to finance. The first post was inspired by German Idealism (thesis), this one by Dialectical Materialism (antithesis, as materialism is at odds with idealism7) and the last one by Postmodernism (as its rejection of meta-narratives synthesizes via negation both the idealist and materialist conception of history, but more on that later).

References

Santos, T. and Veronesi, P., 2006. Labor income and predictable stock returns. The Review of Financial Studies, 19(1), pp.1-44.

Jusselin, P., Lezmi, E., Malongo, H., Masselin, C., Roncalli, T. and Dao, T.L., 2017. Understanding the momentum risk premium: An in-depth journey through trend-following strategies. Available at SSRN 3042173.

Israel, R., Laursen, K. and Richardson, S., 2020. Is (systematic) value investing dead?. The Journal of Portfolio Management, 47(2), pp.38-62.

Footnotes

  1. Interestingly, from this point of view the CEO of a company, if he owns very limited property, is closer to a proletarian, as he is earning his livelihood through his labor, than to a capitalist (the owners of the company, which here we are assuming they are not involved in the running of the business). This point is very intelligently raised in the series Halt and Catch Fire through the character of John Bosworth. Whether this classification makes sense from a sociological or political point is up for debate, here we are only concerned on how we can make it useful elsewhere. ↩

  2. Tensions do exist nonetheless, and they bring about instability, not only in politics but finance as well. In [Santos & Veronesi, 2006], part of the equity return variability is explained by variations on the labor share on profits; in plain terms, higher salaries, lower equity returns —this also suggests that earning a wage is a hedge against poor long-term equity returns (albeit a very poor one due to individual salaries being potentially not representative at all)—. ↩

  3. The whole FIRE movement (Financial Independence, Retire Early) is built around this. ↩

  4. Of course a good default is sometimes suboptimal; clearly, diminishing returns are not ubiquitous as shown by the economies of scale. ↩

  5. As is any scientific knowledge in the limit one could say, although well established fields are less prone to significant changes in understanding. ↩

  6. The fact that there are irrational market participants is more less a consensus view, but it’s hard to believe why more rational participants such as Renaissance Technologies and the like (i.e., quantitative firms) are not completely arbitraging away these apparently (if one buys the behavioral argument) free opportunities for profit. ↩

  7. Marx in fact wrote “The German Ideology” precisely to criticize the hegelian (and therefore idealists) thinkers of the time. ↩