ProfessorBainbridge.com

Active management loses out (again) to passive investment management

The WSJ today reported that:

A growing exodus from hedge funds extended to two of the biggest names in the industry Tuesday, Tudor Investment Corp. and Brevan Howard, as disenchanted investors increasingly shun what was once the hottest place to put money.

The funds’ problem is clear: They just aren’t performing.

Hedge funds and actively managed mutual funds have been underperforming since financial markets began their rebound in early 2009. The average hedge fund is up 3% this year through the end of July, according to researcher HFR Inc., less than half the S&P 500’s rise, including dividends.

This comes as no surprise, of course. It is well-established that you're better off, over the long haul, investing in passively-managed index funds rather than actively-managed mutual or pension funds. Over time, as numerous studies have shown, nobody meets the market once you adjust for risk and the survivor bias. Why? In part, at least, because the managers of active funds are subject to a whole slew of cognitive biases and errors that tend to adversely affect their decisionmaking.

Don't believe me? Fine. But before we talk about it go read Burton Malkiel's magisterial work A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing and then we'll talk. It lays out the evidence in favor of passive investment management "in terms so plain and firm as to command their assent."

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Explaining the cool down in the IPO market

There was an insightful letter to the editor in today's WSJ:

Regarding “IPO Market Cools As Private Deals Rise” (page one, Aug. 1): Is it really hard to understand why a company would prefer to sell shares to a private-equity firm staffed with highly educated professionals who not only will serve on the board but contribute value as opposed to going public and being second guessed by every plaintiffs’ lawyer, SEC staffer and Justice Department enforcer who has never held a job outside of the regulatory quagmire in Washington? 

The IPO is no longer the desired outcome because of litigation and burdensome and expensive regulation. The end result is that affluent investors in private-equity funds continue to hold stakes in promising upstarts while common investors get stuck with their parent’s and grandparent’s portfolio options.

I made a similar argument at length in Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Henderson on the merits of paying for early access to corporate information

My friend and coauthor Todd Henderson (Chicago law) has a really interesting op-ed in today's WSJ, in which he argues for creating a market in early access to corporate disclosures:

The SEC could mandate that corporate information be publicly released at a particular time, say, 2 p.m. Then it would permit companies to offer early peeks—say, starting at 1 p.m.—to anyone willing to pay. Firms could charge a subscription or sell early information a la carte, depending on market demand, and keep the proceeds. ...

If the data does indeed provide an advantage, then some investors, such as hedge funds and high-speed traders, would undoubtedly pay. Those looking for long-term equity returns, such as ordinary retirees and index funds, would not.

In turn, the pricing data that emerges from such a market would help answer one of the most perplexing questions of securities law: What information is material? The law defines materiality as whether there is a substantial likelihood that the reasonable investor would consider it important in making a decision. As Henderson points out, "The SEC may claim to know what shareholders want, but it can do little more than guess."

Once we know whether investors are willing to pay for information or not, SEC disclosure rules could be tailored to provide better tailored disclosures that are actually cost effective.

In addition, we could reduce the uncertainty around securities litigation. At the moment, when cases go to trial, we give jurors the definition of materiality and send them off to make an uniformed decision. It's not a pretty picture. Knowing whether or not investors would be willing to pay for the information would be a huge leap forward.

And don't come crying about ordinary investors. As Henderson points out:

The SEC worries that it would be unfair to ordinary investors to charge for early access. But creating a brief “pros-only” period would actually work to their advantage. Average Americans, who cannot compete with today’s high-speed traders, would know to stay out of the markets during these short periods. So would index funds, which try to avoid being picked off by savvy information traders.

There are also broader advantages: Laying bare the unavoidable fact that ordinary investors cannot beat the pros using corporate news would encourage a long-term perspective among corporate ownership. Making professional investors pay for early access would lower the bill for shareholders by shifting the costs of disclosure to the pros.

I think it's a great idea.

Why are public corporations disappearing and what are the consequences?

Kevin LaCroix explores some reasons why we're seeing a decline in the number of public corporations and then looks at some of the consequences. A very good analysis of a very important issue. Recommended.

Alex Tabarrok: "The Number of Publicly Traded Firms Has Halved"

He observes that:

In the past twenty years [the] U.S. has lost almost 50% of its publicly traded firms [from 6,797 in 1997 to 3,485 in 2013, AT]. This decline has been so dramatic, that the number of firms these days is lower than it has been in the early 1970s, when the real gross domestic product in the U.S. was one third of what it is today. This phenomenon has been a general pattern that has affected over 90% of U.S. industries.

A rather stunning finding from Grullon, Larkin and Michaely.

The total number of firms has dropped far less than the number of publicly traded firms, so in part this is probably due to laws affecting publicly traded firms in particular such as Sarbanes-Oxley. But there has also been a small drop in the total number of firms (depending on year measured) and concentration ratios have increased which suggests that competition might have fallen. (I wish the authors had looked more closely at the entire size distribution). Have international firms risen to offset the decline of publicly-trade firms? The authors discuss but discount the role of globalization. I don’t see, however, how their findings of small effects on output competition are consistent with big labor market effects. Nevertheless the bottom line is that as concentration rates have increased so have profits, as a recent CEA report also argues.

Is this all the after-effects of the Great Recession? I hope so but the decline in the number of publicly traded firms is also consistent with the research on long-run declining dynamism (including my own research on regulation and dynamism) which shows that startup and reallocation rates have been trending down for thirty years.

The drop in publicly held firms reported here is consistent with other reports, so let us take it as given. And I agree with Alex that there are multiple factors at work here:

1. Lingering effects of the Great Recession, during which some estimates claim as many as 170,000 businesses failed. 
2. Consolidation. M&A activity has recovered from its 2008 lows and is resulting in a decline in the number of companies as more are combining than being created.
3. The first two factors meant that in  recent years many startups switched their exit strategy from an IPO to a sale to an established company.
4. Secular stagnation.
5. Regulation.

We all have home field biases, of course, but I tend to think the regulatory aspect has had a crushing effect on public corporations. Firms that were public went dark, while privately held firms decided to remain private or to sell to an acquirer rather than go the IPO route:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303

Should TV investment gurus be subject to Labor Department regulation? Not if I were in charge.

There was an important article in today's WSJ about the Labor Department's forthcoming rules under ERISA that will dramatically change how investment advising for IRAs and other retirement vehicles works:

The idea of the regulation, which could be released this month by the Labor Department, seems unobjectionable enough—that brokers would follow a “fiduciary” standard when making investment recommendations. Currently, brokers’ advice only has to be “suitable,” which critics say is a weaker standard that allows the sale of expensive products that eat into returns.

The rule’s opponents, including many in the brokerage industry, say it will increase their costs and make providing investment advice to small-balance retirement accounts less profitable. ...

The rule, provisions of which would be phased in over time, could add costs at industry giants such as Morgan Stanley, which has nearly 16,000 brokers, and Bank of America Corp.’s Merrill Lynch, with more than 14,000. But it is expected to weigh far more heavily on small and midsize firms, which make up the bulk of the industry. ...

Brokerage-industry executives and analysts say the rule is likely to accelerate brokerages’ shift toward fee-based accounts and away from commissions, a trend in which smaller firms generally lag behind their bigger rivals. Smaller firms also tend to have more small accounts that might be uneconomical to serve in a fee model, and they have fewer clients across whom to spread added compliance costs.

This is a classic example of federal government regulation of the stock market and financial services: It screws small business and the middle class, while benefiting the wealthy and the largest firms. (Which leads one to wonder why people like Lucian Bebchuk are so eager for federal regulation of corporate law, but that's an issue for another day.) Because the costs apparently do not scale, the largest brokerage houses will be better able to bear them and wealthy investors will not lose access to professional advice.

But then it gets worse. Forbes reports that:

Popular financial radio show host Dave Ramsey caused a firestorm on Twitter last week when he weighed in against the “fiduciary rule”—the controversial pending Department of Labor regulation that would impose new restrictions on a vast swath of financial professionals who handle IRAs and 401(k) accounts. Yet, Ramsey was only echoing concerns about the costs of the rule already expressed by Members of Congress from both parties. ...

Fittingly, even before Ramsey came out against the rule, one of his critics called for using the rule against Ramsey, supposedly for providing advice said critic deemed harmful to savers. In an October article in LifeHealthPro, an online trade journal for insurance agents and financial advisers, Michael Markey, an insurance agent and owner of Legacy Financial Network, called for Ramsey to “be regulated and to be held accountable” by the government for the opinions he gives to listeners. Markey hailed the Labor Department rule as ushering a new era in which “entertainers like Dave Ramsey can no longer evade the pursuit of regulatory oversight.”

Classic. Markey wants to use regulation to shut down a competitor, which is a primary function of the DC bureaucracy these days.

Experts both for and against the rule I have talked to agree its broad reach could extend to financial media personalities who offer tips to individual audience members, a group that includes not just Ramsey but TV hosts like Suze Orman and Jim Cramer, as well as many other broadcasters who opine on business and investment matters. They would be ensnared by the rule’s broad redefinition of a vast swath of financial professionals as “fiduciaries” and its mandate that these “fiduciaries” only serve the “best interest” of IRA and 401(k) holders.

I admit that I am not an expert on First Amendment law--especially the complexities of commercial speech regulation--but this strikes me as a classic infringement on free speech. But as Forbes notes:

Such limits on financial discussion may seem to violate the First Amendment on its face. But a lawsuit against such restrictions would not be a slam dunk, as this is largely uncharted legal territory. Courts have tread lightly on financial regulation that may harm free speech. In Lowe v. SEC, 472 U.S. 181 (1985), the Supreme Court did strike down a ban by the Securities and Exchange Commission on an investment newsletter published by a convicted felon. But the opinion did not touch upon constitutional issues, as the Court ruled that the law itself – different from the Employee Retirement Income Security Act that governs the Labor Department – applied only to person-to-person, rather than general, advice.

It's these sort of issues that make it so essential to have judges and justices committed to liberty as opposed to being enablers of the nanny state.

The case against divesting from fossil fuel companies

Here at PB.com we oppose divestment campaigns (even in those rare cases when we agree with the proponents about the issue at hand), so we were glad to see our friend Todd Henderson take on the issue in the Chicago student newspaper:

No matter what your views are on the climate change debate, no rational person should support divestment. There is no evidence to demonstrate it will do anything to help the climate, and it will ultimately cost the University hundreds of millions of dollars—Swarthmore estimates it would cost their endowment $200 million over 10 years to divest. This is money that could be spent on research, scholarships, or perhaps best of all for the cause, reducing the University’s carbon footprint.

Here is why divestment won’t work: A central tenet of corporate finance is that demand curves for individual stocks are approximately horizontal. For most things we buy, demand curves slope downward. This means if we demand less, less will be supplied and at lower prices, but stocks are not like other products. The stock price is merely an estimate of the cash flows that ownership of the stock will produce in the future, and therefore is not determined by a “demand” for the stock. Unless the sale of stock conveys information to the market about the future cash flows, no individual sale can move the price.

If the Office of Investments, which manages the University’s nearly $9 billion endowment, sells all of the shares it owns in ExxonMobil, the stock price of ExxonMobil should not change. Others will stand ready to buy the shares at the current market price, meaning supply and demand aren’t helpful ways to think about stock prices. Unless the money that ExxonMobil is expected to earn in the future goes down, the stock price will stay the same. And nothing about the decision of a few university endowments to sell the shares provides the market information about how much oil or coal will be sold at what prices tomorrow. Undervalued shares in the near term will be bought up until their price more or less reflects the expected gain from holding those shares. In an extreme case, ExxonMobil could simply go private, removing any need to rely on public markets for funding or valuation.

The fact that the stock price of divested companies will not fall means that these firms will not experience a higher cost of capital, and therefore nothing about their capital raising activities, project choice, or other decisions will be affected by divestment. Managers with stock-based compensation won’t be affected either nor will other shareholders of these firms. In short, the economic impact of the SJSF demands on the targets of their ire would be nearly zero.

Making matters worse, universities—or rather their employees and students—would bear large costs to achieve no benefits. The endowments already have to spend money defending their investment decisions, and, if it comes to it, will spend more selling shares and accepting lower returns than would otherwise be available. Taking profitable investments off the table also means lower returns for endowments. This means taking money out of the universities’ pockets and putting it into the hands of other people, all without actually imposing any cost on the alleged bad actors.

Indeed.

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Dupont shareholders vote for management, Dupont investors dump stock. Huh?

Marc Kodak offers an explanation.

In 2014, index funds beat hedge funds ... for 6th year running

NY Times via Greg Mankiw:

The top 25 hedge fund managers reaped $11.62 billion in compensation in 2014, according to an annual rankingpublished on Tuesday by Institutional Investor’s Alpha magazine. 

That collective payday came even as hedge funds, once high-octane money makers, returned on average low-single digits. In comparison, the benchmark Standard & Poor’s 500-stock index posted a gain of 13.68 percent last year when reinvested dividends were included.... 

For investors, 2014 was the sixth consecutive year that hedge funds have fallen short of stock market performance, returning only 3 percent on average.

Warren Buffett & Charlie Munger Shareholder Letter Annotated by Experts in Wall Street Journal

Larry Cunningham reports that:

Warren Buffett’s latest letter to Berkshire Hathaway shareholders is annotated in The Wall Street Journal by 30 professors, authors, and investors.  

The post also has a good discussion of the state of Buffett's succession plans.

Active fund management doesn't work

More evidence for indexing.

The agency cost problem with public pension fund activism

In my book, Corporate Governance after the Financial Crisis, I argued that:

... the costs of institutional investor activism likely outweigh any benefits such activism may confer with respect to redressing the principal-agent problem. Even if one assumes that the cost-benefit analysis comes out the other way around, however, institutional investor activism does not solve the principal-agent problem but rather merely relocates its locus.

The vast majority of large institutional investors manage the pooled savings of small individual investors. From a governance perspective, there is little to distinguish such institutions from corporations. The holders of investment company shares, for example, have no more control over the election of company trustees than do retail investors over the election of corporate directors. Accordingly, fund shareholders exhibit the same rational apathy as corporate shareholders. ...  Nor do the holders of such shares have any greater access to information about their holdings, or ability to monitor those who manage their holdings, than do corporate shareholders. Although an individual investor can always abide by the Wall Street Rule with respect to corporate stock, moreover, he cannot do so with respect to such investments as an involuntary, contributory pension plan.

For beneficiaries of union and state and local government employee pension funds, the problem is particularly pronounced. As we have seen, those who manage such funds may often put their personal or political agendas ahead of the interests of the fund’s beneficiaries. Accordingly, it is not particularly surprising that pension funds subject to direct political control tend to have poor financial results. 

As an op-ed by Andrew Biggs in today's WSJ makes clear, public pension funds suffer from agency cost problems that are at least as severe as those of the corporations excoriated by activist funds:

State and local pension plans invest roughly twice as much in risky assets as would a prudent individual saving for retirement. ...

... Calpers holds about 75% of its portfolio in stocks and other risky assets, such as real estate, private equity and, until recently, hedge funds, despite offering benefits that, unlike IRAs or 401(k)s, it guarantees against market risk. Most other states are little different: Illinois holds 75% in risky assets; the Texas teachers’ plan holds 81%; the New York state and local plan 72%; Pennsylvania 82%; New Mexico 85%. ...

Public pensions are addicted to risk and, because they are effectively “too big to fail,” require an intervention.

In addition to holding excessively risky portfoloios, of course, public pension funds notoriously are too optomistic in their actuarial assumptions:

While Americans are typically earning less than 1 percent interest on their savings accounts and watching their 401(k) balances yo-yo along with the stock market, most public pension funds are still betting they will earn annual returns of 7 to 8 percent over the long haul, a practice that Mayor Michael R. Bloomberg recently called “indefensible.” ...

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

It's long past time that publc pension funds take a lead from Matthew 7:3-5, and remove the log from their own eyes before going after corporate splinters.

The JOBS Act apparently has not solved the problems with the American capital markets

In my essay Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010), available at SSRN: http://ssrn.com/abstract=1696303, I explained that:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

If you believed the Obama administration and the Democrats' hyoe, the JOBS Act was going to solve the problem. They were wrong, according to a new study by some economists (which I'm more inclined to accept that ones done by law professors masquerading as quants):

We examine the effects of Title I of the Jumpstart Our Business Startups Act (JOBS) for a sample of 213 EGC IPOs issued between April 5, 2012 and April 30, 2014. We show no reduction in the direct costs of issuance, accounting, legal, or underwriting fees, for EGC IPOs. Further, the indirect cost of issuance, underpricing, is significantly higher for EGCs than other IPOs. More importantly, greater underpricing is present only for larger firms that were not previously eligible for scaled disclosure under Regulation S-K. EGCs that are more definitive about their intentions to use the provisions of the Act have lower underpricing than those that are ambiguous. Finally, we find no increase in IPO volume after the Act. Overall, we find little evidence that the Act has initially been effective in achieving its main objectives and conclude that there are significant consequences to extending scaled disclosure to larger issuers.

Interestingly, one of the authors - Kathleen Weiss Hanley - was until very recently an economist at the SEC,

Will CalPERS kill hedge funds?

Timothy Spangler teaches the Hedge Funds and Private Equity Funds course and the Investment Companies and Investment Advisors course at the UCLA School of Law.  He is the author of several books on private funds, a frequent commentator in domestic and foreign press, and the Director of Research for the Lowell Milken Institute for Business Law and Policy. In today's LA Times, he has an insightful article on the future of hedge funds in the wake of CalPERS' decision to pull its hedge fund investments:

Clearly, it is too soon to write the obituary for hedge funds. These highly entrepreneurial firms will certainly need to evolve in the coming years to ensure that they meet the expectations of their investors for high returns. And the question of fees is one that cannot be dismissed out of hand. ...

The most provactive part of the op-ed is his argument in favor of active fund management:

... the state of the hedge fund industry is better grasped by looking at the top quartile of hedge fund managers and seeing how their performance varies over time. All hedge fund managers are not created equal. Simply calling yourself a hedge fund manager is no guarantee that you will actually produce eye-wateringly high returns for your investors.

The most successful investors are backing the most successful managers. Simply put, the case for backing proven investment talent remains strong.

I'm not convinced that's right. There does seem to be some evidence that top returners do persist at least over the medium term (say three years). The trouble, of course, is identifying them ex ante and backing them before their hot streak ends.

Related articles

Your Lesson From CalPERS' Dumping of Hedge Funds

Hedge funds: Lousy returns and dumped by CalPERS. What does that say about shareholder activism?

Investment Bombshell: CalPERS Exiting Hedge Funds

'Red Flags' Surround CalPERS Costly Hedge Fund Gamble

Lowell Milken Institute Law Teaching Fellowship

Hedge funds: Lousy returns and dumped by CalPERS. What does that say about shareholder activism?

The NYT reports that:

The California Public Employees’ Retirement System, the nation’s largest pension fund, will eliminate all of its hedge fund investments over the next year on concerns that investments are too complicated and expensive.

Granted, CalPERS itself engages in activism, but it's still an interesting point. As is this bit of news:

Through August, activist investors returned an average 5.9% for the year, according to HFR, compared with a 3.9% gain for hedge funds in general. Still, both trailed the S&P 500's 9.9% gain.

So you'd be better off stashing your money in an S&P 500 index that giving it to activist shareholders. Someone alert Lucian!