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Letter to the Editor
June 24, 2008

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But his conclusion makes you wonder…If we all invested passively, markets wouldn’t function. If every dollar flowed through, say, Barclays Global Investors (BGI) into the stock market on a cap-weighted basis - relative market caps of different companies would never change.  The whole purpose of markets - to allocate capital to the most constructive business opportunities - would remain unfulfilled (unless a non-market-cap weighted index such as fundamental indexation was used).  There would be a sort of self-fulfilling inertia to market values.

There seems to be little question that in aggregate active management has a net cost.  But then again, so does sales and marketing.  I am always amazed at the amount of resources that are spent on sales and marketing activities (conventions, advertising, direct sales, commissions etc.).  In fact, according to the US Bureau of Labor Statistics, well over 10% of the American workforce can be categorized as being in “Sales and Related Occupations.”  Their salary alone is nearly 5% of US GDP. 

Now imagine a world without such waste.  No salespeople or marketing budgets.  No one to undertake wasteful and time consumer competition.  No costly “getting the message out” about a certain product.  Imagine how much we’d all save by simply having a central authority plan the economy - say, in 5-year increments.  We could call this central authority the Bureau of Global Investing or “BGI” for short.   

Of course, that’s been tried by some countries under different names, and as counterintuitive as it seems, it never really panned out as expected.  Functions that initially seemed wasteful and inefficient actually had the indirect effect of channeling resources toward the better, more efficient products and services.   
.  I’m not suggesting French is an advocate of central planning or anything. (He’s actually in the AllAboutAlpha.com Hall of Fame).  But passive management only really works if active management also exists.  In a sense, passive management is a free ride on the “wasted” resources of active management.   

In fairness, French explicitly recognizes the value of “price discovery” resulting from active management, but he appears to side-step the issue a little in the interview.

Advisor Perspectives: …Without active management, there would be no marketplace for companies to raise capital. The whole economics of the stock market would stop working if there was no active management. Doesn’t the benefit of active management (to society) go beyond price discovery?

French: I don’t include the cost of marketing securities; I only include the cost of trading them. Since I do not include the cost of road shows to convince people to invest in initial public offerings, it does not make sense to include the benefit of this process in my analysis either.

IPOs aside, active management benefits go “beyond price discovery” by keeping the marketplace alive.  That benefit can’t possibly be excluded from such an analysis. So while we agree with French’s straightforward and elegant analysis, we might not be so quick to dismiss the aggregate benefits of active management.

Others, notably active managers, may want to change the name of the french-fries in their cafeteria back to “freedom fries” in protest.

Yours truly,

Christopher Holt

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