Index Funds and Chicken Indexes
Programming note: Money Stuff will be off tomorrow and Friday for the holiday. Happy Thanksgiving!
Which index funds should be illegal?
We talked yesterday about the theory that ownership of multiple firms in the same industry by diversified mutual funds is an antitrust problem. I said: "I sometimes shorthand this theory as 'index funds are illegal,' which seems to rub its proponents the wrong way." This rubbed one of its proponents, E. Glen Weyl, the wrong way. He pointed out that the proposed solution we discussed yesterday would not strictly ban index funds. That proposal would allow fund companies to choose between (1) owning less than 1 percent of any "oligopolistic" industry or (2) owning shares of only one firm (more or less) in that industry. So it would allow index funds as long as they (and their fund companies) hold less than 1 percent of each industry. Vanguard and iShares would be out, probably, but providers like PowerShares would still be allowed. And of course the industry could restructure and more small firms could spring up. Or, alternatively, the proposal would allow larger index-ish funds that attempt to track the index by sampling one firm in each oligopolistic industry, but introduce some tracking error by not owning the full index.
So, fine. Those who think that diversified stock ownership is an antitrust problem -- that cross-ownership of multiple firms in the same industry by big diversified investors really pushes up prices and harms consumers, as those investors care only about high overall industry profits and don't want competition within the industry -- also think that it's a bigger economic problem than the problem of restructuring index funds to be smaller. There's something a bit weird to me about thinking that a company that is 20 percent owned by three index funds will be less competitive than one that is 20 percent owned by 30 index funds -- those funds all have the same preferences! -- but the point is that if you take the theory seriously, you should be willing to at least tinker with the index-fund industry.
Meanwhile, a couple of readers suggested a simpler solution: Allow all the index funds you want, or diversified mutual funds generally, but don't let them vote. If cross-ownership within an industry encourages managers to be less competitive, taking away votes from cross-owners -- and letting only single-firm owners vote -- might fix the problem. I guess that works? It's kind of weird, though. A basic feature of index funds, for instance, is that they can't "vote with their feet": They have to own every company in the index. Voting is the only way they can monitor the managers who work for them, and not all of what they want from managers is an antitrust problem. Some of it is just good governance.
Weyl and his co-authors sort of address this point in their paper. They mention alternatives to their proposed rule, including a "no talking rule" that would forbid cross-owners from talking to management of companies whose competitors they also own. But they say:
Institutional investors engage in valuable corporate governance with product market firms. A very real cost of the no talking rule may be to reduce the level of corporate governance of the largest firms in the economy. In fact, absent such governance, there may be no one left to monitor the management of most public corporations. This would lead to soft competition across corporations being replaced by the entire absence of control of corporations. In terms of benefits, if managers of all the firms in the oligopoly understand that they have a common owner, will it matter that the institutional investor cannot talk to the managers about the strategy? Managers may be able to work out what the institutional investor prefers without any talking, and render the rule ineffective.
Those things are sort of true of a no-voting rule too.
But one reader e-mailed to suggest a much more fun approach:
Instead of voting their shares, index funds should sell their votes. The mechanism for a vote sale is that they sell the actual stock and go long an equivalent total return swap. The counterparty to this trade is someone who buys the stock and shorts the swap, i.e. they have the right to vote but don't have economic exposure.
So you just start, like, the S&P 500 Swap Fund, and it buys all of its shares on swap (or at least all of its "oligopolistic" shares), and it can't vote. But someone can. Usually you buy shares on swap from a bank, so some bank (or banks) would have voting ownership of the shares that the mutual funds own economically. (How would the banks vote?) But of course they could do further swaps, and voting ownership could end up with some other non-economic owner:
It allows activists to corral more votes than they can afford, which makes activist campaigns against bigger companies possible.
As a consequence of this, it creates a new pricing signal: the price of a vote should correlate to the expected value of kicking out the current management team.
Obviously there are problems. The proposed rules on mutual fund derivatives might limit the fund's swaps use, to take one boring objection. And buying up votes in a company where you have no economic interest is generally thought of as bad. You could short the stock, buy a lot of votes, and vote for the company to do something dumb. Still, I like it, as a triumph of the spirit of financial engineering if nothing else.
Oh in other index fund news, Steven A. Cohen's early-stage venture fund invested $2 million in a millennial investing app company? And, you know, fine; millennial investing apps are all the rage in early-stage ventures. This one, like most of them, puts the millennials' money in "a basket of exchange-traded index funds." I don't ... think ... that means ... that Cohen has decided that Passive Is Good and Active Is Bad? It's just an app, you know. If there was an app that put the millennials' money in Cohen's hedge fund -- and if Cohen wasn't barred, both by general-solicitation rules and also by a Securities and Exchange Commission temporary supervisory ban, from accepting that money -- then he'd probably invest in that instead.
We talked a couple of weeks ago about the Georgia Dock index, a chicken price index constructed by calling up some chicken producers and asking them how much chickens cost. The problem with that sort of index -- as opposed to one based on actual market pricing data -- is that the producers can lie. If they give a number that is too high, and if the index is used in actual pricing formulas, then they can artificially raise the price of chicken. There were some hints that that was happening; the Georgia Dock has been considerably higher than other major chicken indexes. (Obviously there are multiple chicken-price indexes.)
So the Georgia Department of Agriculture, which runs the index, is fixing the problem. The new approach is apparently to call up some chicken producers and ask them:
- how much do chickens cost; and
- are you lying?
The producers "will be required to submit documents verifying the accuracy of information," but "the state agency said it won’t independently verify the prices." "We trust the companies we deal with, so this is our way of saying we have their validation that the information they provide is truthful," says a regulator.
This is progress! In a perfectly rational world, if you are going to lie about the price of chickens, you should also be willing to lie about the fact that you lied about the price of chickens. But in the world we live in, people who fudge their submissions to price indexes don't necessarily think of themselves as evil people. The price index starts to look like a game, and your ethical standards during the game are different from the standards in the rest of your life. A piece of paper reminding you that the price index is real life, and that you're not supposed to lie on it, might be just as effective as actually checking the prices.
I missed this earlier, but last week two former White House ethics lawyers argued that the only solution for Donald Trump's conflicts of interest between his business and being president is for him to sell the business and put the proceeds in a blind trust. And by "sell the business" they mean that "Trump should appoint an independent, professional trustee to take charge of liquidating and converting to cash Trump business holdings through an initial public offering or leveraged buyout."
This seems unlikely to happen, but that won't stop me from fantasizing about it from now through Trump's inauguration. Imagine a Trump IPO! Imagine a president who refused to release his tax returns, releasing the audited financial statements of all of his businesses. Imagine underwriting an IPO in which the founder and chief executive officer is (1) selling 100 percent of his stake and (2) quitting as CEO, so he has no further alignment of interest with the buyers. Imagine further that that founder has a history of fraud allegations, and, at his previous public company, "ran the company into the ground, immiserating shareholders while walking away with enormous bags of cash for himself." Imagine the risk factors. Imagine finally that you have to get this very odd IPO done between now and January, and that this founder has a long history of not paying people who do work for him. Wouldn't that be the most fun deal ever?
The LBO idea is fine, whatever, but doesn't spark the imagination in the same way.
Obviously he's not going to do any of this. "Donald Trump indicated Tuesday he was unlikely to disentangle himself from his business empire as fully as he previously suggested, raising questions about potential conflicts of interest while president." And: "Trump Would Have a Hard Time Divesting His Businesses—Even If He Wanted To." And: The Trump Foundation engaged in self-dealing.
A big boutique.
As banks are restricted by capital requirements and limitations on proprietary trading, I keep wondering when someone will start up a new full-service investment bank. There are trading firms that replicate many of the market-making functions of the big banks, and advisory boutiques that replicate many of the investment-banking functions, but full commitment to both is pretty rare. But now "former Credit Suisse Group AG Chief Executive Brady Dougan plans to launch a merchant bank in early 2017 and has lined up a $3 billion investment to seed the venture," and he has big ambitions:
At the new firm, Mr. Dougan aims to compete with Wall Street firms in core, capital-intensive businesses. His ambitions reflect challenges facing big banks and the opportunities for upstarts. That his money comes from sovereign-wealth funds also shows that these investors, which have long used traditional banks and private-equity firms as intermediaries to financial activities, want to flex their muscles in new ways.
I wonder if he has top-ticked the market for this sort of thing: If the new Republican administration in the U.S. just repeals all the restrictions on banks, he's going to have a harder time competing with them.
I found this short article about how "Wall Street’s Youngest Workers Aren’t Worried Robots Will Replace Them" strangely touching:
The recruiting firm asked more than 3,200 traders, salespeople and other finance professionals how advances over the next five years will impact them. In every bracket age 26 and up, at least 8 percent of respondents predicted they will lose their livelihood.
But virtually nobody younger checked that box. Instead, their most popular answer was “better work-life balance.”
Look, I am sorry, but if you are under 26 and work on Wall Street, a robot could probably do your job. You are building Excel models and formatting pitchbooks; the deep client relationships and nuanced risk management come later. When you see a demo of a computer program that builds models and pitchbooks, does that not worry you?
And the answer, charmingly, is no. Of course the kids know that their jobs are routine and robotic. But they also understand that they are paying dues, that they spend two years building pitchbooks so that one day they can be real bankers and traders, their days full of glamour and creativity that no robot could replicate. They are doing the robotic work, but they believe that their older colleagues are doing something else, adding value beyond anything that a computer could do.
Those older colleagues, who are actually doing that work, are more skeptical.
European employment disputes.
I feel like every so often I read stories about employment disputes at banks in Europe, and the disputes -- like all human disputes -- involve some strange elements, but the stories compress those strange elements in a way that makes the whole thing sound utterly surreal. Anyway here's a dispute out of Bank of America in London:
Maurice Marco, who is still an executive on the bank’s Euro Commercial Paper team, said in a witness statement at a London court Tuesday that his boss, Anthony Dullaghan, referred to some clients as "French rats" and called a Middle Eastern customer a derogatory term involving a camel. A lawyer for the bank countered that Marco exaggerated and took his shirt off during a heated argument.
Yes, yes, those are two very normal tactics to use in a heated argument: exaggeration and stripping. I can see how an argument would escalate in exactly that way.
People are worried about unicorns.
"Silicon Valley is slowly making its way onto the farm," it says here, "with coders, analysts and entrepreneurs eager to use their skills in the agricultural sector." I imagine the unicorns are sick of hanging out in their loft-like co-working spaces in the Enchanted Forest, and yearn to get out in the fields and pull a plow. Some good artisanal unicorn labor.
People are worried about stock buybacks.
This has only a sort of vague spiritual connection to "people are worried about stock buybacks," but here is "How the Influx of Dividend-Minded Shareholders Will Impact Shareholder Activism." It's actually a pretty interesting short-term-versus-long-term question. Stereotypically, "short-termism" means demanding that companies spend all their money buying back stock, while "long-termism" means demanding that companies keep all their money and invest it in research and development. But what about companies that return money to shareholders (short-term!), but by instituting a recurring dividend (long-term!)?
An activist who promotes share buy backs and dividend increases to cause a short term increase in the price of the stock is concerned about sustainability of the dividend increases only to the extent that evidence of sustainability is necessary to translate dividend increases into a higher stock price. If the market ignores the sustainability issue, the activist can happily take advantage of the price increase generated by the stock buy backs and higher dividends, and exit the stock before the dividends are subjected to the test of time. A dividend minded investor, on the other hand, is likely to worry about sustainability whether or not the market sees an issue because this investor is buying the stock to hold it and receive dividends for an extended period.
People are worried about bond market liquidity.
Here is Alexandra Scaggs on the New York Fed's new efforts to broaden its group of primary dealers:
Broadly, though, the changes in the primary dealer requirements are another step in the government’s decades-long balancing act between liquidity and stability in its market. Liquidity is generally helped by a large, diverse group of traders, while smaller, more homogenous groups are easier to supervise.
Of course a whole lot of financial regulation is a similar balancing act. The capital requirements, Volcker Rule, etc. that were intended to make banks safer and more stable are also usually blamed for reducing bond market liquidity. Very abstractly, imagine you could just turn a dial to increase a thing called "market stability." If you started at zero, and turned the dial to increase stability, liquidity would probably go up: A fair, transparent, predictable market will probably encourage more trading than a bunch of random nonsense. But you will eventually reach a peak, after which further efforts to increase stability will reduce liquidity. A perfectly "stable" market won't trade at all.
I don't know what that tells you. There's no particular reason to think that the peak of liquidity is the right place to be at. Even when you're trading off liquidity against stability, you might want to make that trade.
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