Bill Ackman Runs an Anti-Index Fund
If you run a hedge fund that loses 20 percent in a year, you have an obligation to be interesting in your annual investor letter, and Bill Ackman's Pershing Square letter for 2015 is quite interesting. 1 Though the how-did-we-lose-all-that-money stuff -- which you might expect would be the bulk of the letter -- is a bit perfunctory. It's basically: We bought stocks that we thought were good, and the market disagreed, but we still think they're good, so the market must be wrong. 2 In a subtle touch, the letter ends with a paragraph about the importance of humility. Honestly, though, if you invest in a hedge fund you have to expect something along these lines; you're not paying Bill Ackman because you believe in the unfailing wisdom of an efficient market.
No, if you believe in the unfailing wisdom of an efficient market, you are probably investing in index funds, and Ackman has lots to say about index funds. He is not precisely a fan. Part of his objection is what you might, at a stretch, call a Grossman-Stiglitz critique, or a meta-efficient-markets critique. Index funds are very popular right now -- "Last year, index funds were allocated nearly 20% of every dollar invested in the market" -- which drives up the prices of stocks held by index funds, regardless of fundamentals:
We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on. While we would not yet describe the current phenomenon as an index fund bubble, it shares similar characteristics with other market bubbles.
A footnote delightfully adds:
The recent underperformance of non-heavily indexed companies creates an opportunity for savvy index fund operators and a good long-term hedge for their businesses. Index fund managers should create index funds of under-indexed stocks.
One important point here is that the appeal of an index fund is that it tracks "the market," and so promises you the average performance of the market, minus a very small fee. Since by definition the average of all active managers also tracks "the market" -- some outperform, some underperform, but on average they have to be average -- minus a larger fee, the index funds will, in expectation, do better than the active managers. But this syllogism relies on the index being the same as "the market." But the Standard & Poor's 500 Index isn't the market; it's just a list of 500 stocks. 3 If index funds over-index index stocks and under-index non-index stocks, and if everyone piles into index funds without considering valuations, then over time the big-index stocks will become overvalued and the non-index stocks will become undervalued. Thus the market niche for the Under-Indexed Index. 4
Of course one could argue that the niche is already being filled. By hedge funds:
The fact that most of the investments that we have identified in recent years have been found outside of the S&P 500 perhaps is suggestive of the major index components’ relative unattractiveness from a valuation perspective. It also explains why the shareholder bases of these non-index companies is comprised mostly of hedge funds and other active managers who, like Pershing Square, use discount to intrinsic value as a primary investment consideration. 5
So for instance Valeant -- Pershing Square's worst holding in 2015 -- is rather notoriously a hedge fund hotel. It's easy to construct a story for why hedge funds would like Valeant: With its acquisitiveness, aggressive cost-cutting and price-raising, and focus on shareholder value, it's basically what would happen if a hedge fund took over a drug company. But there's a boring alternative (or additional) story: Valeant, being technically Canadian, isn't in the S&P 500. 6 The indexers under-index it. So the hedge funds almost necessarily over-index it. Recently, this hasn't gone well for the hedge funds.
We have talked previously (here, here) about how the rise of passive investing should affect active investors. There are various theories. One says that things should get easier for active investors: With more money being invested without regard to fundamentals, investors who do pay attention to fundamentals will have a better chance of outperforming. Another says that things should get harder: With the rise of passive funds driving out marginal active investors, the active investors who are left will be better, making it hard for any one of them to outperform. 7 Ackman is solidly in the first camp: He thinks that the "index fund bubble" creates opportunities for active investors to spot value in under-indexed stocks and outperform the market. At least in the long run. But in the short run, as people keep piling into index funds (and out of underperforming active funds), index stocks will keep going up, and non-index hedge-fund darlings will keep going down, and index funds will keep outperforming active funds, and people will keep piling into index funds, etc., in a self-perpetuating cycle. Ackman's argument for the eventual end of this cycle is one of meta-efficiency: "As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows." 8
The other part of Ackman's objection to index funds is what you might, at a stretch, call an Azar-Schmalz critique 9 :
If the index fund trend continues, and it looks likely to do so, what happens when index funds control Corporate America? Courts have often deemed shareholders to be in control of a corporation with as little as 20% of the ownership of a company. At current rates of asset inflows, it will not be long before index funds effectively control Corporate America and the corporations of many foreign countries. The Japanese system of cross corporate ownership, the keiretsu, has been blamed for decades of Japanese corporate underperformance and economic malaise. Large passive ownership of Corporate America by index funds risks a similar outcome without the counterbalancing force of large active investors and improvements in the governance oversight implemented by passive index fund managers.
We've talked several times before (here, here, here, etc.), about the Azar-Schmalz theory, which is basically that index funds, and other diversified mutual funds, somehow discourage the managers of their companies from competing hard, because competition within an industry reduces aggregate returns in that industry, and if you own every firm in the industry you will lose more than you'll gain from fierce competition among them. There are reasons to be skeptical of this theory. One is that it seems to lack a mechanism: No one really thinks that index-fund managers meet with corporate executives and encourage them to chill out about the whole competition thing. But Ackman's letter suggests a mechanism: They don't meet with executives at all.
Imagine having to read 20,000 proxy statements which arrive in February and March and having to vote them by May when you have not likely read the annual report, spent little time, if any, with the management or board members, and haven’t been schooled in the industries which comprise the index. Consider how difficult this job would be when even the largest index funds have a hierarchy of only 20 or so people (one per ~1,000 companies) in their governance departments which determine how proxies for these companies should be voted.
The index funds' focus on cost, and desire to win business from corporate pensions, 10 encourage them to do nothing and leave managers alone. Managers who are left alone tend not to slash costs and compete with the bitter efficiency of managers who are constantly bothered by investors like Bill Ackman.
The evidence for this is a bit mixed: "The research finds that ownership by passively managed mutual funds is associated with significant governance changes such as more independent directors on corporate boards, removal of takeover defenses and more equal voting rights," say some researchers, and there are hedge-fund favorites with their own awkward governance records. Valeant itself gives the impression of having been a bit undermonitored by its hedge-fund investors; when you find yourself calling up the chief executive officer of one of your biggest holdings and asking "Mike, is there any fraud going on at the company?" you probably can't avoid wishing that you already knew the answer. Nor is Valeant's strategy of acquiring drugs and raising their prices necessarily the precise form of competition that one wants to encourage.
Still, Ackman's argument has an appeal: "The cost of investing is tumbling toward zero," and zero doesn't pay for a lot of proxy fights. A fund that owns a little bit of every stock, and charges as little as possible for its work, can't justify the same level of active monitoring as a fund with a few concentrated positions and a 2-and-20 fee structure. 11 Index funds will almost necessarily free-ride off the governance work done by more engaged and concentrated investors. Sometimes the index funds will actually oppose that governance work for reasons of their own -- corporate pension conflicts, anticompetitive preferences -- but for the most part you'd expect index funds to appreciate the engaged investors' efforts to keep management honest, though you can't expect them to share much in those efforts. Ackman says as much, noting that "there are important long-term economic incentives for index fund managers to take governance more seriously," which in context means something like "vote with Bill Ackman in his activist fights."
The letter's tone about index funds is fairly unfriendly; the very top of the letter -- the part about how Pershing Square Holdings was down 9.1 percent in the fourth quarter, while the S&P 500 was up 7 percent -- might provide a clue as to why. Despite that tone, though, there's an obvious symbiosis between index funds and Pershing Square, which is sort of an anti-index fund. Index funds free-ride off concentrated fundamental investors' valuation work, buying stocks at the market price with no view of their own on valuation; in exchange, though, they push valuations away from fundamentals and give the fundamental investors more opportunities to find value. And they free-ride off concentrated activist investors' governance work, owning companies without bothering to supervise those companies' managers; in exchange, though, they encourage managerial complacency and give the activist investors more opportunities to lead activist campaigns. Index funds rely on market efficiency, and Pershing Square helps create it; Pershing Square relies on market inefficiency, and index funds help create it.
There is also a section about "The Pershing Square Correlation":
Perhaps the largest correlation in our portfolio is one that we have not previously considered; that is, the fact that we own large stakes in each of these companies. We have had the benefit of a “following” of investors who track and own many of our holdings. This has given us significantly greater clout than is reflected by our percentage ownership of these companies, and we believe that it is partially what has caused the “pop” in market price when we announce a new active investment. As a result, these active managers’ performance is often closely tied with ours. When Valeant’s stock price collapsed, our performance, and that of Pershing Square followers, were dramatically affected. Nearly all of these investment managers are subject to daily, monthly, and quarterly redemptions, and therefore, many were likely forced to liquidate substantial portions of their holdings which overlap with our own.
Other indexes might be closer to "the market" (the Russell 3000, the CRSP Total U.S. Market Index), or further away (the Dow), but even the CRSP claims only to represent "nearly 100% of the U.S. investable equity market." Cynk -- which somehow still trades! -- isn't in the CRSP index. Neither is Valeant, for different reasons (Canadian-ness).
Of course this is just defining "the market" as "U.S. listed equities," or whatever. If you want some other version of "the market" -- global equities, or U.S. stocks and bonds, or anywhere you could conceivably put your money -- then it's even harder to find a matching index.
Of course if that takes off then the same problem will occur, and you will need a Second-Order Under-Indexed Index, containing the residual stocks that aren't either in the main indexes or the main Under-Indexed Index.
An alternative explanation is, of course, that if a company is not in the major indexes, its holders won't be index funds, which means they have to be active managers. (Who else would they be? Retail?)
Despite their large market caps and business quality, which would ordinarily qualify them for inclusion in the S&P 500 index, Canadian Pacific, Valeant, and Restaurant Brands are Canadian-domiciled and therefore not eligible. Their shares have also likely suffered because they are components of Canadian market indexes that have experienced large capital outflows and substantial declines due to Canada’s large energy and commodity exposures.
A third possibility is a cyclical one in which, as Josh Brown explains, active management tends to outperform in conditions of "cash is not a drag," "international stocks doing well," and "small caps competitive with large caps." In our terms, that mostly means: Under-indexed stocks outperform over-indexed stocks.
I guess, though I don't entirely see the mechanism. The whole premise of index investing is that it is indifferent to valuation -- and thus to future returns -- and driven only by the low fees and past outperformance of index funds. The market can remain meta-irrational longer than you can etc. Perhaps the end state is my ideal world in which the only allocators of capital are index funds and corporate chief financial officers.
That is not actually the name or anything, I just made it up. The two main papers in this vein are one by José Azar, Martin Schmalz and Isabel Tecu, and another by Azar, Sahil Raina and Schmalz. Given that Azar and Schmalz are on both papers, I'm naming the thing for them. "Posner-Weyl," for two early popularizers, would also be a plausible name.
In the text, I am conflating the antitrust argument with the governance argument; they are distinct. Ackman is focused on what he calls "governance," which means basically doing right by shareholders, and you could imagine plenty of shareholder-friendly things that are also anticompetitive. (E.g. buying drugs and jacking up prices.) But they do seem related: A lot of activism is about cost-cutting, efficiency and other pro-competitive activities, and activism tends to be bad for its targets' competitors, suggesting that it is more or less pro-competitive.
Furthermore, corporate pension fund assets are one of the largest pools of capital invested in index funds. It does not help index fund managers win business from Corporate America if they have a reputation for being an activist or if they support activists. In fact, the opposite is likely true. If their reputation is more for protecting incumbent management than for supporting activists, they are much more likely to garner assets from corporate pension plans than index fund managers who are known to vote against management.
Though Pershing Square Holdings isn't 2-and-20. Its prospectus mentions a 1.5 percent annual management fee and a performance fee capped at 16 percent.
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