Indexers, Activists and Tax Robots
Index funds and activists.
The basic thesis of the index-funds-should-be-illegal crowd is that when most companies are mostly owned by the same overlapping group of owners -- big mutual fund complexes, particularly passive index funds -- then those companies will have less desire to compete with each other. Diversified shareholders may push managers to maximize industry-wide profit rather than to compete for market share, or more likely, they won't push managers at all, and the managers will just relax and not compete too hard. And in fact, there are "signs of declining dynamism" and increased concentration in U.S. business.
Meanwhile, the opposite of these passive investors are activist investors, hedge funds who take large concentrated positions and push their targets for changes that make them more efficient and competitive. And in fact, there is evidence that if an activist takes a position in one company's stock, its competitors' stocks go down: The activist makes its target more competitive, and that's bad for the competitors.
Those simple models suggest that concentrated activists and passive indexers would be enemies, with opposite goals (more versus less competition) and approaches, and that a company with more index holders would be relatively insulated from activism. But, nope! Here is a profile of Jim Rossman at Lazard Ltd., who advises companies on activism, and who thinks "that passive investing will help activists":
Rossman’s thesis is that activists could gain more clout as stock ownership is concentrated among fewer owners, with funds shifting to indexed strategies. “It’s become a lot easier for activists to influence the shareholder base, because they have fewer and fewer shareholders that they have to talk to,” says Rossman, who calculates that the top 25 investors hold almost 40 percent of the S&P 500. Research published in September by the National Bureau of Economic Research (NBER) outlined a finding similar to Rossman’s — that activists may become more powerful with the rise in passive investing.
Activists and passive investors complement each other; the activists provide the discipline that the passive funds don't. In a sense, some of the passive funds' governance work is outsourced to activist investors. Much like with the worry that too much indexing will make prices inefficient, the financial system has its own checks on the concentrating power of the index funds.
"I don't think there's a tax-optimization robot that understands the entire Internal Revenue Code yet," I wrote yesterday, "but they'll get there." The robots must have been listening, because now there's a tax-optimization robot that understands the entire Internal Revenue Code. As is so often the case, the robot that has swallowed a whole area of human knowledge is International Business Machines Corp.'s Watson, which is now hanging out at H&R Block Inc. waiting to do your taxes:
Watson proved to be a quick learner. Its core skill is its ability to digest and classify vast amounts of text, using what is known as natural language processing. So, among other things, it was fed the 74,000 pages of the federal tax code and thousands of tax-related questions culled from H&R Block’s data, accumulated over six decades of preparing tax returns.
Then, H&R Block tax professionals were brought in to “train” Watson. They approved when Watson suggested a smart question for a particular tax filer and corrected it when a proposed question was off base. The tax professionals were not told they were working with Watson, just a software program.
To be fair, if they didn't know it was Watson they might have thought it was ... TurboTax? I mean, there have been not-especially-smart tax robots for years. But now that Watson has had some time to ponder the entire tax code, I suppose it will be a more nuanced and helpful robot. My mention of tax-optimization robots yesterday was not about tax-return preparation, which is fairly mechanical as these things go, but about tax planning for investors; perhaps Watson could turn to that next.
By the way, humanity is doomed:
But Watson’s other task was to make visiting H&R Block a more “engaging and interactive” experience, he said. Clients will be able to watch suggestions and questions on a separate screen, as the Watson-assisted tax professional works.
It turns out that it is more "engaging and interactive" for two people to sit and look at separate screens than for them to look at or talk to each other.
Fiduciaries and funeral cannons.
To become a lawyer in the U.S., you need to prove that you are ethical by passing a test called the Multistate Professional Responsibility Exam. It's pretty easy. It's a multiple-choice test, every question has four answers, and the correct answer is always the second-most-ethical one. (This is not legal, or test-preparation, advice. It's a well-known joke.) So for instance, if your client sues you, can you disclose confidential information that you learned about him while representing him?
- No, you have a sacred duty of confidentiality to your client, and you can't violate that duty even if he sues you.
- Yes, but only to the extent necessary to defend yourself.
- Sure, he's being a jerk, you should get him back however you can.
- Wait that information was supposed to be confidential? What?
And the right answer is number 2, the second-most-ethical one. (This is not legal, or ethical, or second-most-ethical advice.)
Anyway Johnny Depp's business managers are not his lawyers, but they are -- were -- fiduciaries for him, and presumably had some fiduciary or contractual or just human duty to keep his weird spending habits private. But then he sued them, claiming that they cost him $25 million due to "gross mismanagement and sometimes outright fraud," and now they have hit back by just listing how he spent his money:
Former managers for the actor Johnny Depp have alleged he spent $3m firing the late author Hunter S Thompson’s ashes from a cannon.
“All I’m doing is trying to make sure his last wish comes true,” said Depp at the time. “I just want to send my pal out the way he wants to go out.”
The ceremony "involved hoisting the cannon to the top of a 47m tower on Thompson’s Colorado farm," though even so I am not sure how you get to a $3 million price tag. ("Other attendees included John Kerry, Jack Nicholson, John Cusack, Bill Murray, Benicio del Toro, Sean Penn, Josh Hartnett and Ralph Steadman.") The lesson here is: Don't sue your business manager, unless you really have to. "Other alleged spends include $18m on a 150-foot yacht, $4m on a failed record label, $30,000 a month on wine, $200,000 a month on private planes, $150,000 a month on security and $300,000 a month maintaining 40 staff." In my profession as a financial journalist, I am constantly reading about rich people who still drive their beat-up 1986 Oldsmobiles, or who spend lavishly but on weird stuff like New Zealand apocalypse compounds or young blood or golf. It is nice to see a rich person who has fun. Not so rich any more I guess.
Anyway people find the Department of Labor fiduciary rule pretty confusing! Here is a strange column from Charles Duhigg speculating on what would happen if Depp's managers were held to a fiduciary standard. But of course they are, not because they are broker-dealers who give advice on his tax-advantaged retirement accounts (the Department of Labor's standard), but because they are his business managers, and the trustees of his trusts. (According to Depp's lawsuit, anyway, which includes counts for breach of fiduciary duty.) Fiduciary duties are normally created by relationships, not statutes; you should generally expect your trusted confidential adviser-manager to be a fiduciary. (Not fiduciarying advice though!) Certainly a trustee is.
The confusion in financial advice is that salespeople aren't fiduciaries, and brokers are essentially salespeople. You come into their office to buy stocks, they offer you some stocks to buy, you buy them. It's like a car dealership; no one expects a car dealer to have their best interests at heart. But that brokerage model has evolved over time. People don't really come to stockbrokers to get arms'-length commission-based single-stock transactions any more. They go to financial advisers to get holistic financial advice, and some index funds. The industry has evolved to meet those changing needs, but it hasn't entirely evolved. Registered investment advisers are held to a fiduciary standard, but many brokers still think they're salespeople -- even if their customers think they're advisers.
In any case the fiduciary standard is not magic. Duhigg:
If the Management Group were held to the fiduciary standard, his advisers would probably have had more of an obligation to stop Mr. Depp from doing foolish things with his money, like giving it away or impulsively buying a French town.
Nah. Avoiding conflicts of interest, sure. But preventing impulsive French-town-buying isn't part of the job.
The Supreme Court.
I am not particularly a Supreme Court analyst, but I'm a former lawyer, so I feel a strange need to comment on Supreme Court nominations. Like my Bloomberg View colleague Noah Feldman, I can't help but be impressed by nominee Neil Gorsuch's snobby credentials (Columbia, Harvard, Oxford, Marshall scholarship, D.C. Circuit clerkship, Supreme Court clerkship). I worry about over-criminalization and over-imprisonment, so I like that Gorsuch seems to be skeptical of prosecutorial power. More so than former prosecutor Merrick Garland: As Radley Balko points out, on many criminal-justice issues, "Gorsuch’s record suggests that he’d actually be to the left of Garland." And here is Eugene Volokh with an excerpt from a pro-defendant Gorsuch opinion.
But most interesting might be Gorsuch's doubts about the federal administrative state. The usual shorthand about this is that he doesn't believe in "Chevron deference," the doctrine that courts should defer to administrative agencies' interpretations of the laws they enforce. Jeffrey Rosen quotes an opinion of Gorsuch's:
“Executive agencies today are permitted not only to enforce legislation but to revise and reshape it through the exercise of so-called ‘delegated’ legislative authority,” Gorsuch wrote. “[A]ll this delegated legislative activity by the executive branch raises interesting questions about the separation of powers ... [including] troubling questions about due process and fair notice—questions like whether and how people can be fairly expected to keep pace with and conform their conduct to all this churning and changing ‘law.’”
This is usually considered a right-wing position, because the administrative state (think: the Environmental Protection Agency) tends to do a lot of regulating, and many regulations have left-wing aims. But political views on executive power also tend to shift based on who holds that executive power. Right now executive power seems to be exercised drastically and haphazardly by the political arm of the White House, with little input from lawyers or civil servants, and ... it might ... be nice ... to have some sort of check on that? Like, perhaps, a court? "So far I'm finding Judge Gorsuch's case for Chevron skepticism pretty persuasive," tweeted Timothy B. Lee. Right now, so am I.
The Federal Reserve.
A global wave of populist nationalism has swept over the world's democratically elected institutions and made our legislative and executive branches ... different, anyway, from what they were. So far that wave seems to have spared the judiciary: Donald Trump may have been elected to "drain the swamp" and stick it to the elites, but Neil Gorsuch has Columbia, Harvard and Oxford degrees and a Supreme Court clerkship. But for how long will the wave spare the central banks? Judging by this story about Janet Yellen's ineffective outreach to Congress to preserve the Federal Reserve's independence, not that long!
Once revered as the masterminds of the U.S. economy, Fed policy makers now face the most intense political scrutiny in a generation. The path of monetary policy, which is emerging from a decade of basement-level rates, is being debated in the political arena in a way not seen since the Paul Volcker era in the 1980s.
The person leading the institution isn’t a politician—she’s a macroeconomist who spent most of her career at the Fed and in academia. Yet the task ahead of her, now that Donald Trump is president, might require a different set of skills.
People are worried about unicorns.
People are worried about unicorns, yes, but the way you get a "people are worried about ____" section in Money Stuff is if those worries are a constant nervous drumbeat rather than a full-blown panic. Careful backtesting reveals that Money Stuff would have had a "people are worried about mortgage-backed securities" section in 2006, but not in 2008. "Worried," in 2008, was not the right word.
One upshot of this is that if you have a massive unicorn that you want to sell, now is the time. I mean maybe three years ago -- before people were worried about unicorns -- was the time, but if you missed that window there's no sense regretting it. And now might still be better: The essential reason that people are worried about unicorns is that they think that valuations seem stretched, and "valuations seem stretched" is just another way of saying "you can get a stupidly large amount of money for your unicorn right now." And also a way of saying: "That situation can't last."
So take advantage of it while you can! If the unicorn worries are right, there's going to be a tremendous first-mover advantage to being the first unicorn out of the Enchanted Forest, rather than coming with the rest of the stampede. That may be part of Snap Inc.'s thinking, as my Bloomberg Gadfly colleague Shira Ovide points out:
As a high-profile internet company hitting a stock market starved for new public companies, Snapchat becomes the hottest Christmas gift for investors who haven't had many new toys. That gives Snapchat the power to set all the rules.
Those rules include issuing non-voting stock and, perhaps, being "parsimonious about financial information." There's another advantage to Snap's initial public offering at a relatively young age:
Second, Snapchat may find being public is a healthy dose of vegetables for a still young and immature company. It's not a popular opinion in Silicon Valley, but in the long run public companies will have more access to cash and more confidence from customers and employees. And they benefit from the institutional rigors needed to be a public company. In tech land, where "fake it until you make it" sometimes bleeds into financial fudging or outright fraud, it's not a bad thing if the CEO risks prison for the same behavior tolerated from startups.
But those rigors of being public will be tempered by the non-voting stock: Snap will be sort of a public-lite company, subject to some of the good discipline of the market and disclosure obligations, while still leaving control with management. We often talk around here about how private markets are the new public markets, with private companies able to raise huge amounts of money from institutional and retail investors without formally going public. But Snap is to some extent going to make public markets the new private markets, with a formal IPO for a still-young startup company without the shareholder rights that usually come with an IPO.
Elsewhere, "Warning Signs Abound As Snap Barrels Toward IPO." And here is a profile of Snap co-founder Evan Spiegel, who is "different from most tech people because he knows what’s cool and what’s next."
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