[Week 41 of 2025] Innovation, Incentives, and Inertia

Welcome back to Price and Prejudice with a few musings from Week 41 of 2025.

Implementation is the New Alpha

In the beginning, “active” meant judgment: a manager picked stocks, trimmed positions, and occasionally had to address client concerns. But in today’s ETF world, activity has been bureaucratized as this article points out. Most of the so-called “active” funds aren’t expressing conviction about companies; they’re managing exposures—rolling options, adjusting buffers, or fine-tuning volatility overlays. It’s not a stock picker’s game anymore; it’s an engineer’s.

One reason is that disclosure rules make real security selection awkward, almost self-defeating. The requirement to publish holdings daily forces transparency at the cost of secrecy—any genuine edge would be arbitraged away before the week was out. So the innovation frontier has shifted to the implementation layer: how efficiently you can deliver a return pattern rather than how cleverly you can choose one. This could explain why the industry’s creative energy now flows into structures, wrappers, and yield-manufacturing tricks.

The result is a market where complexity disguises itself as originality. Investors see new tickers and clever acronyms, but what’s really being sold is packaging that allow old exposures look new. In a world that worships transparency, secrecy has simply migrated from the holdings to the mechanics.

When Genius Fails (Again)

The classical version of Long-Term Capital Management (LTCM)’s collapse is neat and tragic: a fund run by Nobel laureates and Wall Street savants borrows 30 times its capital, bets on convergence trades, and dies when the world stops converging. Russia defaults, correlations jump, spreads blow out, and the models crack under pressure. It’s the archetypal morality play of hubris and leverage: the smartest guys in the room undone by their own equations.

This postmortem complicates that story. Yes, leverage mattered, but the fatal mechanics were endogenous: how market structure and incentives turned a funding problem into a death spiral. Once LTCM’s book leaked, its counterparties marked collateral to liquidation values, tightened haircuts, and shorted assets the fund was forced to sell. Rational self-protection at the individual level became collective predation at the system level. Governance failures—fragmented collateral streams, cross-netting gaps, and porous Chinese walls between lenders and traders—made everything worse.

It's a subtler warning that financial crises don’t just punish excess risk-taking but expose incentive alignment. Each counterparty acted rationally within its own perimeter, tightening terms and marking aggressively, and together they built a feedback loop that no model could close. Today’s markets may be better capitalized, but they’re still wired through the same human circuitry. And when we eventually hand the controls to AI, the code will only formalize what instincts already knew.

Passive Meets Retirement

People have been worrying about concentration risk for as long as there have been markets to concentrate. The story repeats with new names: once it was IBM, then Exxon, now the Magnificent Seven. Every cycle ends with charts showing the top ten stocks’ share of the index and reminders that diversification isn’t what it used to be. The market always looks dangerously lopsided—until it gets more so.

This note makes a slightly newer concern: concentration risk is no longer just a market outcome but a structural feature of the retirement system. U.S. workers contribute roughly $8,500 a year to their 401(k)s, most of it into passive equity funds. With the Magnificent Seven making up almost 40% of the S&P 500, about $2,300 a year from every saver now flows automatically into those same seven stocks.

But if that’s the problem, what’s the alternative? We could go back to active management, but that means higher fees and—empirically—worse results for most savers. We could equal-weight the index, which sounds fairer until you realize it forces constant rebalancing from winners to laggards, effectively buying what’s going down and selling what’s going up. We could design “smart beta” or factor portfolios, but those are just new flavors of rule-based passivity with different biases. The current system isn’t perfect; it’s simply the least bad way to funnel trillions in household savings through a mechanism simple enough to trust—at least until we can credibly show that concentration risk is not just an aesthetic discomfort but a genuine systemic threat.

Podcasts

• This podcast by Barry Ritholtz with Jamie Magyera at BlackRock is a good summary of the latest trends in the wealth management business. It’s a nice illustration of how the business runs on a simple service model akin to a modern money concierge.