ProfessorBainbridge.com

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.

"The Feel-Good Folly of Fossil-Fuel Divestment"

Daniel Fischel argues in today's WSJ that the "only ones to suffer [if colleges surrender to the anti-divestment fossil fuels movement] will be colleges that earn less money for research, services and student scholarships":

A new study that I and my colleagues at Compass Lexecon are releasing on Tuesday indicates that fossil-fuel divestment could significantly harm an investment portfolio. ...

Of the 10 major industry sectors in the U.S. equity markets, energy has the lowest correlation with all others—which means it has the largest potential diversification benefit. The sector with the second-lowest correlation with others is utilities, which includes many fossil-fuel divestment targets such as Southern Company and Duke Energy .

How does divestment affect portfolio performance? To get at this question, we constructed a model to track the performance of two hypothetical investment portfolios over a 50-year period: one that included energy-related stocks, and another that did not. What we found is that the optimal portfolio, which included energy stocks, generated average returns 0.7 percentage points greater than portfolios that excluded them on an absolute basis. In other words, the “divested” portfolio lost roughly 70 basis points compared with the optimal one—70 basis points for each and every year over the 50-year period in which the portfolios were active.

They also find that management fees are higher for funds that divest from fossil fuels, presumably due to the added administrative burden of making sure the fund's portfolio really is holier than thou.

This is a damning finding. The people who manage university investment funds are fiduciaries who must consider the long run impact of their decisions. Giving in to today's fossil fuel campaigners demonstrably will reduce future returns, negatively impacting not only current but future stakeholders. And, as we now know, the folks who have caught the divestment bug are unlikely to stop with one victory. It'll just be on to the next moronic cause.

It's time for university fund managers to grow a spine and tell the divestment crowds to take a hike.

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!

Good news and bad news on the University of California's "green" investing plans

The good news is that the UC has rejected the call by ecomentalist activists to divest from fossil fuel companies, which was the right decision for all the reasons I suggested the other day. The bad news is that:

The University of California will invest $1 billion over five years in companies and researchers coming up with solutions to climate change, part of an overall UC push in sustainability. ... UC also said it will implement a framework for sustainable investment by the end of June and become the first public U.S. university to adhere to United Nations-supported principles for responsible investment.

What's wrong with that, you ask? Well, as the WSJ explained a while back:

... investors tempted by green investing need to choose funds carefully and understand that some of these sectors can be very volatile, as illustrated by the bankruptcy of multiple ethanol and biofuel producers, as well as struggles among small solar-power companies, amid a drop in oil prices over the past year. It is also important to recognize that buying into green businesses and shunning those that are harder on the Earth's resources won't benefit the environment directly.

The thought that "if you are buying stock [in] an oil company, you are somehow giving money to the oil company" is just not true, says Brian Pon, a financial planner with Financial Connections Group Inc. in the San Francisco Bay area. Whether you're investing in a traditional energy company or an alternative-energy player, you are typically buying shares from another investor and not pumping cash into the firm. Further, he says, "an individual doesn't really have the money to affect investment markets. You're buying a hundred shares when hundreds of thousands of shares trade daily."

So you're taking on considerable risk by "greening" your portfolio, as illustrated by the WSJ's summary of the performance of portfolios of alternative energy during the financial crisis:

Among the narrow and volatile green portfolios are two ETFs that focus on solar energy: Claymore/MAC Global Solar Energy Index and Market Vectors Solar Energy.KWT +0.63% They are both down 45% over the past 12 months, while the Standard & Poor's 500-stock index declined 6.9%. ...

PowerShares WilderHill Clean Energy, a somewhat broader alternative-energy portfolio, has also taken investors for a bumpy ride. The ETF gives investors exposure to areas including ethanol, solar and wind power, and energy efficiency. Over the past year, the fund—one of the larger green portfolios, with a recent $783 million in assets—returned a negative 27%. Over the past three years, it has declined an average 13.5% a year, trailing the S&P 500 by more than eight percentage points.

Ouch. And the news hasn't gotten any better. The three year annual return on S&P's Global Alternative Energy Index is 7%. Compare that to the S&P 500's three year annual return of 22.7%. The Fidelity Select Environment and Alternative Energy Portfolio has underperformed the S&P 500 consistently.

So pardon me if I can't work up much enthusiasm for this new UC policy.

The American people are finally wising up: There is no point in paying for active fund management

Interesting article in the WSJ over the weekend:

Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren't run by stock pickers or star managers. ...

The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners. ...

Traditional stock-fund managers—old-fashioned stock pickers—have been the hardest hit in the wave toward passive investment. Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds, according to Morningstar.

Even uber-active investor Warren Buffett has seen the light, recently disclosing how he wants his estate invested: "Mr. Buffett, 83 years old and with a net worth of $66 billion, wrote that he advised his trustee to 'put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.).'"

If you want to know why index funds are deservedly beating the crap out of actively managed funds, read this post and then go buy Burton Malkiel's book:

Recommended reading: Jill Fisch on money market fund reform

I liked this article a lot: Fisch, Jill E., The Broken Buck Stops Here: Embracing Sponsor Support in Money Market Fund Reform (June 16, 2014). U of Penn, Inst for Law & Econ Research Paper No. 14-24. Available at SSRN: http://ssrn.com/abstract=2456255:

Abstract: Since the 2008 financial crisis, in which the Reserve Primary Fund “broke the buck,” money market funds (MMFs) have been the subject of ongoing policy debate. Many commentators view MMFs as a key contributor to the crisis, in part because widespread redemption demands during the days following the Lehman bankruptcy led to a freeze in the credit markets. The response has been to deem MMFs a component of the nefarious shadow banking industry and to target them for regulatory reform. 

Determining the appropriate approach to MMF reform has proven difficult. Banks regulators prefer a requirement that MMFs trade at a floating NAV rather than a stable $1 share price. By definition, a floating NAV would prevent future MMFs from breaking the buck, but it is unclear that it would eliminate the risk of large redemptions in a time of crisis. Other reform proposals have similar shortcomings. More fundamentally, pending reform proposals could substantially reduce the utility of MMFs for many investors, which could, in turn, dramatically reduce the availability of short term credit. 

The complexity of regulating MMFs has been exacerbated by a turf war among regulators. The Securities and Exchange Commission has battled with bank regulators both about the need for additional reforms and about the structure and timing of any such reforms. Importantly, the involvement of bank regulators has shaped the terms of the debate. To justify their demands for greater regulation, bank regulators have framed the narrative of MMF fragility using banking rhetoric. This rhetoric masks critical differences between banks and MMFs, specifically the fact that, unlike banks, MMF sponsors have assets and operations that are separate from the assets of the MMF itself. Because of this structural difference, sponsor support is not a negative for MMFs but a stability-enhancing feature. 

The difference between MMFs and banks provides the basis for a simple yet unprecedented regulatory solution: requiring sponsors of MMFs explicitly to guarantee a $1 share price. Taking sponsor support out of the shadows provides a mechanism for enhancing MMF stability that embraces rather than ignoring the advantage that MMFs offer over banks through asset partitioning.

 

I hope somebody at the SEC is reading it.

Related articles

Yet more on money market mutual fund reform

The SEC at the precipice

Money Market Fund Reforms Remains Elusive

US money market fund reform goes down

U.S. risk council to weigh money market fund reforms Tuesday

"3 views on high speed trading and securities markets"

Steven Bradford has links.

Is the stock market efficient?

An excellent analysis of the great debate.

WSJ says "Investors Return to IPOs in Force": But it's all built on a foundation of sand

Today's WSJ reports that:

Investors are stampeding into initial public offerings at the fastest clip since the financial crisis, fueling a frenzy in the shares of newly listed companies that echoes the technology-stock craze of the late 1990s.

October was the busiest month for U.S.-listed IPOs since 2007, with 33 companies raising more than $12 billion. The coming week is slated to bring a dozen more initial offerings, including Thursday's expected $1.6 billion stock sale by Twitter Inc., the biggest Internet IPO since Facebook Inc.FB -2.10% 's $16 billion sale in May 2012.

As I document in my article How American Corporate and Securities Law Drives Business Offshore, in The American Illness:

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.

In the article, I explained that how the risk of anti-fraud liability adversely affects the competitiveness of U.S. capital markets and how the federalization of key aspects of corporate governance during the last decade generated significant net regulatory costs adversely affecting those markets. None of these structural problems have been solved. Instead, the current book in IPO volume is happening despite them.

The reasons behind the IPO boom in fact make it look like an IPO bubble:

The rush to buy shares of newly public companies is the latest sign of investors' thirst for assets with potential upside, at a time when relatively safe investments are generating scant income due to tepid economic growth and Federal Reserve policies that have kept a lid on U.S. interest rates. ...

To others, however, the demand is an indication that a rally fueled primarily by abundant liquidity from the Fed, and not by earnings growth and economic expansion, is entering dangerous territory.

"When I hear intelligent investors asking me not which companies are good to invest in, but which IPOs can I get into, it scares the heck of me," said Mark Lamkin, a wealth-management adviser based in Louisville, Ky.

As well it should. Once the Fed starts to curb liquidity, the structural legal problems that beset US capital markets will quickly pop the present IPO bubble.

Related articles

"Are activist shareholders good for investors?"

Bubble Watch: Twitter Raises IPO Price By 25%

Investors return to IPOs in force