Quasi-Indexers, Growth and Confusion
Should index funds be illegal because people are worried about stock buybacks?
One popular worry about modern financial capitalism is that companies are investing less in their future growth than they should be, because rapacious shareholders are demanding that they spend their money on stock buybacks instead. Here's a new working paper from Germán Gutiérrez and Thomas Philippon finding more or less that. Companies are investing less in their future growth than they should be:
We analyze private fixed investment in the U.S. over the past 30 years. We show that investment is weak relative to measures of profitability and valuation – particularly Tobin’s Q, and that this weakness starts in the early 2000’s.
And it's because of rapacious shareholders demanding stock buybacks. But it's a particular kind of rapacious shareholder:
We find fairly strong support for the competition and short-termism/governance hypotheses. Industries with more concentration and more common ownership invest less, even after controlling for current market conditions. Within each industry-year, the investment gap is driven by firms that are owned by quasi-indexers and located in industries with more concentration and more common ownership. These firms spend a disproportionate amount of free cash flows buying back their shares.
"Quasi-indexers," in their terminology, are funds with "diversified holdings and low portfolio turnover," including both index funds and actively managed diversified mutual funds. (This is a very useful term that I will steal from here on out.) They "account for ~60% of total institutional ownership," a number that has gone up since 2000, which "closely match[es] the timing of decreasing investments at the aggregate level." And:
Quasi-indexer institutional ownership is significant, suggesting that, within each industry-year and controlling for Q, firms with more quasi-indexer institutional ownership invest less.
Where do the excess funds go? Share buybacks. As shown in columns 4 to 6, firms with more quasi-indexer ownership do more buybacks.
You can tell a story here that fits with the theory, which we have discussed several times before, that quasi-indexers are bad because they reduce competition between companies. In that theory, as companies in the same industry all have the same set of overlapping owners, they have no real incentive to compete with each other: Their owners want high industry profits and don't care which firm earns them, so no firm has an incentive to cut prices and take market share. That same dynamic -- lazy managers shielded from competition -- might also lead those managers not to work too hard to invest in building new capacity.
Or you could tell different stories. There is a story that high quasi-indexer ownership of a company makes it easier for activist investors to influence the company, and activists, while they are good for competition, also tend to be fans of buybacks and general "short-termism."
Or there is a story that I particularly like, which is that the rise of thoughtful large institutional investors has improved corporate governance, and that "short-termism" is just an inevitable result of good corporate governance. Simply trusting managers with shareholder money indefinitely is bad governance, while monitoring their performance and demanding accountability tends to look like a focus on the short term. As Gutiérrez and Philippon write: "Improvements in governance reduce managerial entrenchment and require managers to continuously demonstrate strong performance, just as increased short-termism would."
Or a really fun story that you could tell is that "Passive Investing is Worse Than Marxism," as a Sanford C. Bernstein & Co. research note once famously argued. The idea there is that indexers (and many quasi-indexers) don't try particularly hard to allocate capital to its best uses, since they just buy everything indiscriminately. This makes capital markets less efficient, but it also makes the underlying investing decisions -- about whether to build a new factory or whatever -- less efficient, because the capital markets don't send the right price signals to managers. ("The stock market has nothing—n-o-t-h-i-n-g—to do with the allocation of capital," retorts Jack Bogle, rather persuasively!) On this story, companies' savvy long-term investments in their businesses don't do anything for their stock prices, so they just don't bother.
So I count four theories there: quasi-indexers as antitrust problem, quasi-indexers as activist enablers, quasi-indexers as governance advocates, and quasi-indexers as communists. Some people find some of those theories very silly! Perhaps they all are. Or perhaps three of them are and one of them is right. Or perhaps all of them are a little right, sometimes, in some combination. In any case there's the empirical evidence that the rise of quasi-indexing seems to coincide with weak investment. There seems to be something going on, even if you think that the theories for what it is are nutty.
You know what's really weird, though? One of corporate America's biggest advocates of long-termism (and critics of share buybacks) is Larry Fink, the chief executive officer of BlackRock Inc., which runs gigantic pools of indexed and quasi-indexed money. And as BlackRock's head of governance points out, BlackRock is "the ultimate long-term investor." She's right! If you're an index fund, you're going to hold your shares in a big company as long as that company exists (and is big). You have no incentive to book short-term gains at the cost of long-term investment.
And yet ... somehow ... it seems to happen? One possibility is that this reduced investment is efficient, at least for shareholders; quasi-indexers are maximizing their own returns by investing less in factories and workers. (Gutiérrez and Philippon essentially reject that theory; low investment despite high Tobin's Q suggests that firms are not maximizing their value.) Another possibility is that the quasi-indexers really want companies to invest for the long term, but somehow can't make that happen. Their quasi-index buying pressure, their commitment to governance standards, something prevents them from signaling to the companies they invest in that they really want to see investments in long-term future growth. So they write letters and talk about it instead.
Should there be index funds that worry about stock buybacks?
Meanwhile! We talked a little yesterday about the McKinsey Global Institute study finding that there are identifiable companies that (1) have a long-term focus and (2) perform better because of it. John Authers points out: "It is a good bet that exchange traded funds based on such approaches will be available before long, and they should make an interesting opportunity." I guess that is right? Why aren't there more "long-termism-focused" investment funds? There seems to be revealed preference, among investors, for ... well, whatever the normal thing is, "short-termism" I guess.
Anyway, it is fun to think about Authers's point in light of the discussion above. If there is just something about index funds (and quasi-indexers) that leads to less long-term investment at the companies they own, even though the index funds' own managers genuinely want more long-term investment, then what would be the effect of a Long-Term Investment Index Fund? Would it just buy all the companies identified by McKinsey as investing for the long term, and then subtly and unconsciously push them to stop doing that?
Oh, markets, will you never learn?
Did you know that no U.S. public company has the stock ticker UBER? That seems like a missed opportunity. A really good business plan would be:
- Start, like, a t-shirt company.
- Name it Universal Basic Equipment Retailer, or something. The name doesn't have to be good, but it should acronym to UBER.
- Do an initial public offering for a very small amount of money, and try to acquire the ticker UBER.
- Wait until there's news about Uber Technologies Inc. going public, or introducing self-driving cars, or whatever really.
- Watch UBER stock shoot up as random dopes confuse it with Uber.
- Sell your UBER stock to the dopes.
That is not legal or investing advice, and something could go wrong at pretty much any of those steps. (I feel like Nasdaq is not giving you that ticker.) But not step 5! The efficient markets hypothesis may be "the best established fact in all of social sciences," but the best established fact in all of financial markets is that, when there is news about a big famous private company going public or being acquired, the shares of a tiny obscure public company with a similar name will shoot up. I don't know what that tells you about the efficient markets hypothesis, but it happened to Nestor, Inc., and to Tweeter Home Entertainment, and to Oculus VisionTech Inc., and now it has happened to SNAP Interactive Inc.:
In what is almost surely a case of mistaken identity, investors sent shares in a little known startup called SNAP Interactive Inc., ticker STVI, surging 164 percent in the four days since Snap Inc. filed for a $3 billion initial public offering. The $69 million SNAP Interactive makes mobile dating apps, while the IPO aspirant is the parent of the popular Snapchat photo-sharing app.
These stories are always less impressive when expressed in dollar terms than they are in percentages. In the four trading days since Snap Inc. filed its S-1, SNAP Interactive has traded 19,963 shares, worth less than $200,000, according to Bloomberg data. If you had a cunning plan to buy up SNAP shares and sell them for a quick profit when Snap filed to go public, it might have worked, but not in particularly huge size. Still, I have high hopes for UBER.
There are companies that make telephone systems for big companies. And the way they work is that a salesperson goes to a company and says "our phone systems are good, you should buy some." And the company says "sounds great, we'll take 100." And the salesperson goes back to his factory and says "I sold 100!" And then people in the factory build 100 phones. And then an installation technician goes out and installs the 100 phones at the company. And then, when they break, the company calls customer support to get them fixed. The salesman's own company employs lots of different people to do various parts of the telephone-systems business. The salesman does the selling part of that business. Other people do the, you know, phone-building parts.
Obviously not every business works like this. Lots of small businesses are run by CEO-entrepreneurs who design the product, build it themselves, and then go out and pitch it. Still the investment banking business is a little weird in that it is so big, and so lucrative, and so institutional, and operates at such global scale, and is always just a little uneasy about the division of labor between the people who make the product and the people who sell the product. Like, if you are a senior mergers-and-acquisitions banker, your job is:
- To go out and sell your merger-ing services to big companies, and
- To do the merger-ing.
In practice, the bulk of the merger-ing -- the financial modeling and due diligence and document drafting and so forth -- is done by other people. But you do some of the most sensitive parts (the board meetings, the high-level strategic and negotiation advice). And the people doing the grunt work are mostly your associates and analysts, who aspire (you hope!) to one day be senior M&A bankers just like you. (And who spend much of their time preparing pitchbooks to support your sales efforts.) It is a bit of an anomalous business, where every salesperson spends some time in the factory, and every factory worker plans to one day end up as a salesperson.
We talked a bit yesterday about how Moelis & Company, the boutique investment bank run by Ken Moelis, won a mandate to be the lead adviser in Saudi Arabian Oil Co.'s initial public offering. Here is some grousing:
“What do they [Moelis] know about oil and gas privatisations? . . . Ken Moelis is a fantastic pitcher for business,” says a rival banker close to the process. “There’s probably no one better anywhere. But Moelis’s equity people have never done anything like this before.”
Moelis is known as an M&A and restructuring advisory boutique, not an equity underwriting firm (which usually requires equity salespeople). Ken Moelis knows the M&A factory well, but neither he nor his grunt workers spend much time in the equity underwriting factory. I suppose the grousing is fair, though as someone who spent four years in the equity underwriting factory, I will tell you in the tiniest whisper: It's not that hard. Anyway, I guess the point is, if you are a senior investment banker, and someone is going to say "there's probably no one better anywhere" about one of your skills, which skill would you want it to be? Pitching business, or executing that business? I don't know the right answer, but I know the lucrative one.
Oh, JPMorgan, will you never learn?
There's that famous scheme in "Office Space," and I guess in "Superman III," in which a computer programmer steals a lot of money from his company by taking amounts that are too small to notice, over and over again. Sometimes it feels like three-quarters of modern finance is descended from that scheme. Anyway JPMorgan Chase & Co. is being sued over the prepaid debit cards that it issues as jury-duty pay in some jurisdictions:
In addition to the juror pay, the cards also come loaded with fees -- for balance inquiries, for inactivity, for using non-Chase ATMs, for charges with insufficient funds and for cash or check issuance. The funds become impossible to withdraw from an ATM once the balance falls below $20, and in at least one jurisdiction -- Washington, D.C. -- there are no Chase branches or ATMs within 90 miles (145 kilometers), ensuring the funds will eventually be frittered away to the bank.
I live in New York, and the biggest revelation in this story for me was that there are places on this planet that are more than 100 feet from a Chase ATM. The debit-card-fees stuff is not so much news. JPMorgan has already settled a similar lawsuit about prison-release prepaid cards, and "announced in 2014 that it would exit the pre-paid card business," but not fast enough. It does not seem like a great business. You basically get the float on all those funds from the time the cards are distributed until the time you settle the lawsuit to pay them back.
The Italian banking crisis.
The weird thing about Banca Monte dei Paschi di Siena, the world's oldest bank, whose slow-motion collapse led to a takeover by Italian taxpayers, is that its crisis sounds so much more pleasant than pretty much anything that ever happens to me. I mean here is a story about how all of Monte Paschi's bad loans led to it owning a bunch of picturesque vineyards in Tuscany. There are photographs. I have made a lot of mistakes in my time, but none of them have ever resulted in me owning a vineyard in Tuscany. What am I doing wrong?
Elsewhere: "Worries Grow Over Euro’s Fate as Debts Smolder in Italy and Greece."
People are worried about unicorns.
I am worried about the extreme aptonym of London social-media startup Fling, whose chief executive officer, Marco Nardone, apparently ... likes ... to ... fling things?
In addition to throwing a Pret a Manger baguette at his father in the board room, Nardone also threw a cup of miso soup at his head of design in front of the whole office, one employee said, while another said that he threw chairs around the office as well.
That is just so many things! That he flung! (Allegedly.) Do you think he named the company after his proclivity to fling things, or did he start flinging things to live up to the company name? Elsewhere, Beyoncé apparently found Magic Leap's augmented-reality technology boring. Everyone wants to invest in cybersecurity startups. And: "Can the Snap IPO Push L.A. Tech Ahead of NYC and Boston?"
People are worried about stock buybacks.
So worried! See supra.
People are worried about bond market liquidity.
They're not really, but Moody's Investors Service is worried about the wall of maturities:
An all-time record $2 trillion of US corporate debt comes due in the next five years, Moody's Investors Service says in its new published reports. Both speculative-grade corporations with over $1 trillion and Investment-grade firms with close to $1 trillion are facing record amount of debt maturities. Meanwhile, the rating agency's one- and three-year refunding indices are currently below their historical norm, indicating that the market's capacity to absorb upcoming maturities is below average.
I feel like I have been reading that story for a long time? Some simple math suggests that if companies issue more debt each year than they did the year before, and if maturities at issuance don't change all that much, then the wall of maturities will get bigger every year forever. So if you are going to worry about the wall of maturities, you can worry about it forever.
Elsewhere: "Rising interest-rate expectations are fueling the biggest corporate-refinancing boom in years."
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