Every Investor is a Market-Maker
- “Informed” investors, who have a specific reason to think some asset is mispriced: if a stock is at $20 and they think it’s worth $25, they’d rather pay $20.05 than miss the opportunity.
2. Noise traders, who buy and sell basically at random.
3. Market-makers, who offer to buy or sell assets.
This broad approach is a start. But it’s a limited model, because it treats informed trading and market-making as distinct. They’re really the same behavior, on a different time scale.
So the fund manager’s value-add breaks down into two parts: provide liquidity at a profitable price when sellers demand it, and avoid adverse selection from trading with informed counterparties. This is exactly what traditional market-makers do, just on a different time scale.
So much of their portfolios exist to track the index. They can’t say that, though, because if their pitch was “I’ll 80% of your money in an index fund, and 20% in an ultra-concentrated bet on a subset of that index,” then investors a) wouldn’t want to pay active management fees for the 80% of the portfolio that’s passive, and b) would be leery of paying any fees for an active portfolio that’s so concentrated.
One way to look at VCs is that over the duration of their investment, part of their return comes from the diminishing illiquidity discount on their assets.
But the most important result of this model is that it clarifies why investors should be able to make money trading financial assets. Prices are set at the intersection of supply and demand, and informed middlemen can identify cases where supply or demand are temporarily out of whack, and can get paid to fix them.