Executive Pay and Blood Trouble
Should mutual funds be illegal?
There is a strain of fundamentalist corporate-finance thought that holds that executives should be paid exclusively for performance, and that "performance" should mean only things within the executives' control. If your stock goes up, but everyone's stocks are going up, you shouldn't get credit; if you run an oil company, you shouldn't get paid more just because the price of oil went up. It is a well-known puzzle that this is mostly not how executive compensation works in the real world, though it's not that much of a puzzle; executives have lots of influence over their own pay, and no one wants to have to work too hard for their money.
But here is a new paper with another explanation of the puzzle: The mutual funds that own large chunks of most companies prefer to pay managers for their industry's performance, rather than for their own company's performance, because the mutual funds own companies across the industry and want to maximize their overall returns.
We propose common ownership of natural competitors by the same investors as an explanation. We show theoretically and empirically that executives are paid less for own performance and more for rivals' performance when the industry is more commonly owned. The growth of common ownership also helps explain the increase in CEO pay over the past decades.
This is of course part of a broader theory, that the rise in cross-ownership of many companies by the same large passive mutual-fund complexes has reduced the competitiveness of American industry, to the detriment of consumers and the benefit of investors and executives. (One of the authors of the new paper is Martin Schmalz of the University of Michigan, who was also a co-author of the original paper on "Anti-Competitive Effects of Common Ownership.") The idea is that the big mutual funds act sort of like the old "trusts" (which were broken up by, you know, anti-trust law), owning many companies in the same industry and discouraging cutthroat competition between those companies. One objection to this theory has been that there's no obvious mechanism by which the mutual funds' influence can operate: It's not like Fidelity or Vanguard meet with United Continental managers and tell them not to cut fares because it would hurt Delta's business. But compensation could be that mechanism: If shareholders pay their managers based mostly on industry-wide returns, as opposed to the managers' individual performance, then that would discourage aggressive competition.
This only pushes the question back a bit, because it's not like shareholders really decide how to compensate managers. (Boards, and compensation consultants, and managers themselves, do that.) But "say-on-pay" rules mean that shareholders get at least some formal approval rights over compensation, and I guess the boards and consultants and managers have to design pay packages that will appeal to investors. And if those investors are mostly diversified, then they won't have much demand for pay packages that encourage one of their companies to crush another.
What I like about the mutual-funds-as-antitrust-violation theory is that it is both crazy in its implications -- that diversification, the cornerstone of modern investing theory and of most of our retirement planning, is (or should be) illegal -- and totally conventional in its premises. Big companies are in large part owned by diversified mutual funds. Those mutual funds do have incentives that are different from those of concentrated owners; if you think that incentives matter, then you would expect mutual funds to prefer that the companies they own not compete against each other too vigorously. And if you think that companies are run for the benefit of shareholders, then you should expect that preference to have the effect of reducing competition. Those premises -- that managers do what shareholders want, and that shareholders want what is in their own economic interests -- are quite standard, even obvious, though I suspect that no one entirely believes them. But if you take them seriously, then you are left in sort of an uncomfortable position; you might even believe that diversified mutual funds should be illegal.
The impressive thing about the controversy at Theranos, the Blood Unicorn (Elasmotherium haimatos), is that:
- Every news article about it is worse than the one before, and
- The controversy started with an article last October about how its product doesn't work.
You'd think there wouldn't be that much room for things to keep getting worse. And yet. The big Theranos news last week was that "Theranos Inc. Chief Executive Officer Elizabeth Holmes was banned by U.S. regulators from owning or operating laboratories for two years, a devastating blow for the blood-testing startup that’s come under scrutiny for risking harm to patients with unreliable tests." Which for most, you know, blood-testing companies, would be the ultimate bad news. But this morning's front-page Wall Street Journal article is somehow even worse:
Asked about a surprise inspection by the Food and Drug Administration that had occurred in August and September, Ms. Holmes insisted that Theranos’s withdrawal from commercial use of tiny tubes it used to collect blood from patients’ fingers had been voluntary.
However, FDA records obtained by the Journal under the Freedom of Information Act show that the withdrawal of the tubes, which Theranos calls “nanotainers,” was imposed by the agency over the company’s strenuous objections.
The records also show that the inspectors initially were barred entry to Theranos’s Newark, Calif., facility when they arrived there on Aug. 25. After being asked to wait several hours in a conference room, they were finally allowed to access part of the facility under the escort of “a couple of security guards,” the records show.
There is more, about how Holmes "has continued to put a positive spin on her embattled blood-testing company—while broadly keeping employees in the dark on many issues—even as Theranos’s regulatory and legal troubles mount." (Elsewhere, here is a claim that "The company’s biggest achievements were in sales, marketing, and deregulation—rather than in medical technology," sort of an Uber but for consumer-driven blood testing.) I guess you don't drop out of college to build a $9 billion startup without a certain amount of optimism and shamelessness, but, like, how much worse can the Theranos stories get? We talked last month about Theranos vampire fan fiction; what if it turns out to be real?
Here is a website called "Blockchain Graveyard" that tracks "cryptocurrency institutions" that "have suffered intrusions resulting in stolen financials, or shutdown of the product." There are 38 blockchain hacks in the database so far. So when you read that the blockchain is the hot new way to make financial transactions more secure, remember: 38!
Of course old-school financial institutions get hacked too; blockchains have some features (good cryptography, distributed ledgers) that make them harder to hack, and some features (anonymity, irreversibility) that make them easier to hack. But I've said before that the main advantage of the blockchain over other ways to store financial information is not so much technological as sociological: It's not that it was technologically impossible to quickly settle financial transactions using shared computer databases before; it's that no one cared enough to do the work of coordinating a bunch of banks to set up the databases. The word "blockchain" has managed to make that boring back-office coordination work sexy, which means that it might actually get done.
On the other hand, while the word "blockchain" has a vague but compelling emotional resonance for bankers, its effect on anarchist cryptographer-hacker types seems to be even stronger. So, you know, sociologically, blockchains seem like they'd be fun to hack.
Berkshire Hathaway’s unique managerial model is lauded for its great value; this article highlights its costs. Most costs stem from the same features that yield such great value, which boil down, ironically, to Berkshire trying to be something it isn’t: it is a massive industrial conglomerate run as an old-fashioned investment partnership. An advisory board gives unchecked power to a single manager (Warren Buffett); Buffett makes huge capital allocations and pivotal executive hiring-and-firing decisions with modest investigation and scant oversight; Berkshire’s autonomous and decentralized structure grants operating managers enormous discretion with limited second-guessing; its trust-based culture relies on a cultivated vision of integrity more than internal controls; and its thrifty anti-bureaucracy means no central departments, such as public relations or general counsel.
Wouldn't it be fun to be Elon Musk's lawyer? Like, here is how a normal conversation might go between a normal securities lawyer and a normal chief executive officer:
CEO: What if I tweeted that I am working on a top secret master plan?
Lawyer: What? No.
CEO: But what if I did?
Lawyer: It just seems weird to hype our business without giving any specifics.
CEO: Weird, or actually illegal?
Lawyer: Well, weird anyway. At least attach this 500-word disclaimer about forward-looking statements to your tweet.
Social Media Manager: I don't think Twitter works that way.
Lawyer: Also we need to prepare an 8-K laying out the details of your top secret master plan that we can file as soon as you tweet your tweet.
CEO: But it is a top secret master plan.
Lawyer: Then why are you tweeting about it.
CEO: Fine never mind.
Lawyer: Thank you.
Here is how it apparently goes at Tesla:
Elon Musk: [tweets "Working on Top Secret Tesla Masterplan, Part 2. Hoping to publish later this week."]
Lawyer: Hmm yes this is fine.
The practice of securities-disclosure law can be pretty boring and conventional; it is nice of Musk to keep his lawyers on their toes. It's like his plan to have one of his companies (Tesla) buy another one (SolarCity): Normal CEOs don't do stuff like that, but if you work for Musk, every day is an exciting new adventure at furthest edges of securities law. Anyway I guess stay tuned for part 2 of the master plan?
Here is a grim sentence:
In my experience, the misogyny often comes from bosses; denigrating women is the mechanism through which they connect with their subordinates.
That's from this op-ed by Sam Polk about "How Wall Street Bro Talk Keeps Women Down," and I suppose it is true that there's no bonding experience quite like shared misbehavior. That mostly explains the Libor scandal. Still, senior investment bankers, let me tell you that saying this sort of stuff to young analysts makes you sound pathetic, not cool:
At one of the firms I worked for, a senior executive asked me, “Did you get laid last night?” When I responded no, he said: “Too bad. When I was your age, it was like shooting fish in a barrel.” I faked a smile — I felt that I had to.
Elsewhere: "Wall Street hot shot fired after throwing Hamptons rager" to which I was by some oversight not invited.
People are worried about unicorns.
Nah, things are great now:
Line, the Japanese rival to WhatsApp, priced its initial public offering at the top end of its proposed range, taking advantage of a global drought in tech listings to arm itself with $1.3bn in cash to challenge Facebook.
Its dual Tokyo-New York listing is tipped to be the world’s biggest tech listing this year, priced at ¥3,300 per share, at the top end of the ¥2,900-¥3,300 marketed range.
Line is not a unicorn -- it is "owned by South Korean portal Naver Corp." -- but still it is encouraging to see how quickly the narrative has turned from "weak demand for tech stocks has led tech unicorns to delay their IPOs" to "lack of tech IPOs has led to strong demand for tech stocks." It is the circle of life, and it works just as well in the Enchanted Forest as anywhere else. Elsewhere in tech IPOs: "Here's How Fast Internet Companies Need To Grow To Get Public."
Elsewhere in tech, Pokemon Go is a ... thing ... of some sort ... that I am not equipped to understand? I guess it's a way to walk around the world while looking at your phone, though I use Twitter for that. Anyway Nintendo "has added more than $7 billion in market value since last week’s debut of a new smartphone app for its fantasy monster character franchise." Also there are armed robberies, somehow. Elsewhere: "Microsoft: Email promising 'hella noms' to 'bae' interns at 'lit' party was 'poorly worded.'"
People are worried about stock buybacks.
Here's Gretchen Morgenson on stock buybacks as a form of executive compensation:
The average annual dilution among S.&P. 500 companies relating to executive pay was 2.5 percent of a company’s shares outstanding. Meanwhile, the costs of buying back shares to reduce that dilution equaled an average 1.6 percent of the outstanding shares. Added together, the shareholder costs of executive pay in the S.&P. 500 represented 4.1 percent of each company’s shares outstanding.
What would the right number be though?
People are worried about bond market liquidity.
I just got back from two weeks of vacation and it is nice to see that nothing has changed in bond market liquidity. Here is a U.S. Treasury blog post from last week about "Examining Corporate Bond Liquidity and Market Structure," and if you have read enough governmental discussions of bond market liquidity there will be few surprises in this one. "While some measures, such as lower trade sizes and dealer inventories, are frequently cited as evidence of declining liquidity, the available evidence, when viewed holistically and in light of recent market trends, does not suggest a broad-based deterioration in liquidity," says Treasury. (Compare the New York Fed last year: "Price-based liquidity measures—bid-ask spreads and price impact—are very low by historical standards, indicating ample liquidity in corporate bond markets.") On the other hand:
One recent study suggested that for the most active dealers the share of agency intermediated trades has roughly doubled from 7 percent to 14 percent since the pre-crisis period; another recent study looking at all dealers estimated that the share could be as high as 42 percent. Acting as an agent does not require a dealer to hold inventory and could result in tighter bid-offer spreads due to the dealer’s reduced risk. However, some customers worry that it may take longer for a dealer to find another customer interested in taking the other side of the trade than it would for a dealer to execute as a principal, exposing the customer to intervening price movements.
Meanwhile in the U.K., people are worried about real estate fund liquidity:
A prominent UK fund manager, speaking on condition of anonymity, said: “When you start getting daily trading funds-of-funds investing in daily trading funds that are invested in illiquid assets, that seems to be layering up potential liquidity risks. “[Investors need to] consider the impact on funds that are caught with material investments in the gated property funds.”
U.K. real estate funds seem to be having the liquidity crisis that everyone has been expecting from U.S. bond funds. And here is Bloomberg's Tracy Alloway on the original fund-liquidity worry, the one about open-ended equity mutual funds dumping stocks in a panic in 1962. That didn't particularly happen -- "Far from increasing the market's fluctuation, the funds actually served as a stabilizing force," wrote John Brooks -- but, in bonds and real estate, the worry remains.
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