Short sellers Here is a half-baked theory I have about index fund voting. People worry sometimes that index funds own a pretty large percentage of the stock of a lot of public companies, and that their control of those companies—by the concentrated voting power of their shares—will lead to trouble. There are different theories. One theory is that index funds are too passive, that they don't have good incentives to actually understand the companies they own and so will not do the work to vote the correct way. Another theory is that index funds are anti-competitive, that because they own all the companies they will vote to maximize overall industry revenue rather than one company's competitive position. Another theory is less of a theory and more just "boy it's weird that a handful of big fund managers control all the companies." You could have other theories. The point is just that some meaningful number of intelligent people think some form of "it is bad that index funds vote so many shares at so many public companies." When I write about this, I usually get emails saying something like "the solution is to say that index funds can't vote their shares, which will concentrate voting power among more active and less diversified investors," and indeed some index-fund critics have suggested this solution. Sometimes I get more financial-engineering-y emails saying "the solution is to let voting rights trade separately from economic ownership, so that index funds can own shares of a company but sell their voting rights to more active and engaged shareholders." You could find fault with these solutions, which probably both go too far and don't do enough to address the problems that people identify with index fund ownership. But the point is just that some meaningful number of intelligent people think some form of "it is bad that index funds get to vote so many shares at so many public companies, and the solution is for them to own shares but not vote them." My half-baked theory is that actually that already happens. The theory goes like this: - There is a way to keep economic ownership of shares while giving up the voting rights.[1]
- That way is called stock lending: Short sellers who want to bet against a stock have to borrow it first, and they borrow it from long investors who own the stock. If A owns stock and lends it to B, and then B sells it short to C, then both A and C have economic ownership of the stock (and B has, as it were, negative economic ownership), but only C—who actually holds the shares—gets to vote. A has only an entitlement to get shares back from B; this entitlement does not carry voting rights.
- Index funds are big stock lenders, collecting fees from stock lending which are shared between the fund's manager and its investors.
- So they are effectively giving up a lot of their votes.
To be clear, this is a half-baked theory. Stock lenders do not lend out all of their shares of all the companies they own all the time; in practice, even the most active stock lenders will still get to vote most of their stock. And stock lenders can, and in controversial disputes sometimes do, recall the stock that they loan out in order to vote it themselves; in theory an index fund with an active stock lending program could still vote every share of stock it owns in every corporate decision, by carefully recalling stock loans around every corporate vote. But at least some don't. BlackRock Inc. says, in disclosures for some of its funds: With regard to the relationship between securities lending and proxy voting, BlackRock's approach is driven by our clients' economic interests. The decision whether to recall securities on loan to vote is based on a formal analysis of the revenue producing value to clients of loans, against the assessed economic value of casting votes. Generally, we expect that the likely economic value to clients of casting votes would be less than the securities lending income, either because, in our assessment, the resolutions being voted on will not have significant economic consequences or because the outcome would not be affected by BlackRock recalling loaned securities in order to vote. BlackRock also may, in our discretion, determine that the value of voting outweighs the cost of recalling shares, and thus recall shares to vote in that instance. Other managers say similar things. Sometimes it matters. Here's a story from last year discussing "how borrowed shares affect pivotal corporate elections," in which a proxy solicitor mentions that "corporate leaders forget that an asset manager may not have as many available votes as their listed portfolio holdings suggest." If this theory is correct, one straightforward interpretation is that it's just a good thing. For investors in index funds, it's fine: Voting, say, 8% of a company's shares, instead of 9%, in favor of a non-binding say-on-pay resolution adds zero dollars of expected value to the fund's portfolio, while the lending fees add a little bit of performance. For people who worry about index funds being "bad" shareholder voters, for whatever reason, it's a positive: Especially in controversial (heavily shorted) companies, the index funds will have less voting power than their economic interests suggest, meaning that the voting power will be more heavily concentrated in "better" shareholder voters. But you can always find fault. There is a competing theory that index funds are good shareholder voters, that their long-term commitment to every company (they can never sell!) and their broad perspective (they own everything!) makes them better stewards of companies than regular investors are. This theory is particularly popular among index fund managers, who love to talk about their stewardship and to think about solving big societal problems through corporate activism. And if that's your pitch then it won't do to give up your votes for a few extra basis points of returns. Anyway here's the news hook: Japan's public pension fund has struck a blow against short-sellers, declaring that it will no longer allow overseas shares to be loaned out from its ¥80tn ($733bn) global equity portfolio. The move by the Government Pension Investment Fund, the world's largest, will affect shares in its $370bn overseas equity portfolio and could prove hugely disruptive to equity markets if others follow its lead. The decision is part of GPIF's efforts to establish itself as an environmental, social and governance-focused investor. … The GPIF said it was concerned that lending stocks out stopped it exercising proper stewardship over the underlying investments. … There are numerous aspects of securities lending that can present issues for ESG-minded investors. For example, if a stock is out on loan, the voting rights go with it, which means the asset owner cannot engage with its portfolio companies. GPIF is not an index fund—and in fact "the administration of the fund's equity holdings is entrusted to a broad range of outside asset managers"—but the basic rationale still applies.[2] If you're a huge passive-ish indiscriminate holder of equities, you can get a little extra performance by lending out your shares. But if you are also a big believer in stewardship and environmental, social and governance investing, then choosing extra performance over voting control can be awkward.[3] Diversification The most obvious appeal of mutual funds is that they let small investors pool their money to diversify their investments. If you have $10,000 to invest, stocks cost $40 each and a round lot is 100 shares, then you can buy two stocks (two $4,000 round lots) and have some cash left over. It is not ideal, and you'd better pick the right stocks. But if you pool your money with thousands of other people and give it to a professional manager, she can efficiently buy lots of different stocks with it. Obviously it would be good for you if she buys stocks that go up and not stocks that go down. But two fundamental tenets of financial theory are that (1) it is hard for her to do that but (2) if she buys a bunch of different stocks then that will give you a better risk-adjusted return than you'd get by buying only a few stocks. So it is rational for you to invest in mutual funds even if you don't expect that the managers will be great at stock picking. (As long as you're not great at it either.) If they are, that's great, and if you are picking a mutual fund you might as well pick one that you expect to be good at stock picking. But that's all a bonus. Picking one mutual fund out of a hat is better than picking two stocks out of a hat. Or that is the traditional reasoning. But diversification technology has improved since mutual funds were invented. Most notably, index funds will let you get efficient diversification without paying managers fees to try to pick the right stocks. If the managers' odds of picking the right stocks were no better than chance, then this is a pure improvement for you: You get the same expected performance with lower fees. By removing the stock-picking element—which was always theoretically suspect—from mutual funds, you can make them cheaper and maximize the diversification benefit. (Also, if you want to diversify for yourself, it's way easier than it used to be: Brokerage commissions are zero, "round lots" are not so much of a thing anymore, and you can even buy fractional shares of stock, meaning that even if you don't have very much money to invest you can pretty cheaply invest it in dozens or hundreds of stocks without using a mutual fund.) Where does that leave active managers? I don't know, maybe rejecting those two fundamental tenets of financial theory? "We can beat the market," they might say, "and also diversification is bad": The growth of passive investing has motivated an increasing number of active fund managers to shun diversification and focus on portfolios of fewer stocks. Part of the idea is to differentiate themselves from the low cost, index-tracking exchange-traded funds that have done so well during the 10-year bull market. The number of active U.S. stock funds holding fewer than 35 stocks has nearly doubled since the start of 2009, while the assets under management in such funds have almost tripled, standing at around $161 billion at the end of October, according to Morningstar Direct. More than 9% of active U.S. stock funds are now concentrated by that definition, up from 7.6% 10 years ago, the data show. Now, empirically, those fundamental tenets of financial theory are mostly right and the active managers are mostly wrong, but what are you gonna do: The broad performance of these concentrated bets hasn't been great. Since the start of 2009, equity portfolios with fewer than 35 stockholdings have lagged behind both the S&P 500 and their more diversified peers. Even more highly concentrated portfolios—those holding 20 stocks or fewer—have underperformed by a wider margin, returning 133 percentage points less on average than the total return of the S&P 500, according to Morningstar Direct data. Oh well. The better argument for these concentrated funds is not really "stock-picking is easy and diversification is bad" but something more like "you can get your diversification cheaply elsewhere, so you should come to us for something else": Mr. Davidowitz said that while some institutional investors are assigning a greater share of their assets to passive funds, they want their diminished active allocation to differ as much as possible from that passive holdings. It is a story of specialization, of division of labor. In the olden days, active fund managers sold you a package of diversification and stock-picking, and you paid one fee for both benefits. Now you can get really high-quality diversification practically for free; an active manager who is selling you diversification is overcharging you for it. All that they've really got left to sell you is stock-picking, and if that's what they're selling they might as well focus on picking only the stocks they really like. Not everything everywhere is securities fraud We have talked a few times about the Mozambique/Privinvest case. Basically a shipbuilding company called Privinvest Group won some contracts to build projects for the government of Mozambique, and got a lot of international financing for those projects led by Credit Suisse Group AG, and some of that financing defaulted, and U.S. prosecutors claimed that there were a lot of bribes all around. Three former Credit Suisse bankers pleaded guilty to taking a lot of bribes, but one central figure, a Privinvest salesman named Jean Boustani, went to trial in Brooklyn and "told jurors during his three days on the witness stand that these were merely 'success fees' for access to Mozambican officials to win business for Privinvest," ah.[4] And yesterday he was acquitted, not necessarily because the jury didn't think he did bribes, but because they were pretty sure he didn't do bribes in Brooklyn: The verdict came down to the venue, three jurors, including the foreman, said in interviews afterward. All three, who declined to give their names, said the panel didn't see how federal prosecutors in Brooklyn had the authority to prosecute crimes that hadn't occurred in their jurisdiction. The jury deliberated for about four hours on Wednesday, before a Thanksgiving break, and 40 minutes on Monday. Here is the prosecutors' argument for why he totally did bribes in Brooklyn: Prosecutors tried to show during the six-week trial that Boustani had defrauded U.S. investors by helping organize and conceal bribes for loans marketed and sold to Americans in New York and Los Angeles. Prosecutors told the jury that some of the bribes, even those paid via banks in Abu Dhabi, had passed through the U.S. financial system via correspondent banks such as JPMorgan Chase & Co. and Bank of New York Mellon. They also argued that Brooklyn was an appropriate venue because some payments went through JPMorgan accounts there and because even transactions with Manhattan banks went through the contiguous waterways the Eastern District shares with the Southern District. Look, I will say that as a former lawyer who often reads and writes about U.S. extraterritorial regulation of financial crime, I totally get what they're saying. I once drew a map explaining that, from a U.S. financial power perspective, everywhere in the world is actually in New York. If I were giving legal advice to international financial criminals, which I am definitely not, I would tell them "if you do any international financial crimes using dollars then they might drag you to court in Manhattan or Brooklyn." But if you are just a regular human then this all sounds absolutely insane! It sounds made up! Oh sure, bribes in Abu Dhabi actually take place in Brooklyn because there is a contiguous waterborne path between Abu Dhabi and Brooklyn, come on. Yes, sure, there is a series of legal fictions and electronic semi-realities that link all dollar transactions back to New York, and yes absolutely U.S. lawyers and judges tend to believe those fictions, but you don't have to. A jury doesn't have to. This jury didn't. Happy 'Pedo Guy' Trial Day! Oh yeah great super: Elon Musk is going on trial Tuesday for his troublesome tweets in a defamation case pitting the billionaire against a British diver he allegedly branded a pedophile. The Tesla CEO will be called to testify early in the case in Los Angeles federal court to explain what he meant when he called Vernon Unsworth, who helped rescue youth soccer players trapped underwater in a Thailand cave, "pedo guy" in a Twitter spat more than year ago. … "'Pedo guy' was a common insult used in South Africa when I was growing up," Musk said in a court declaration. "It is synonymous with 'creepy old man' and is used to insult a person's appearance and demeanor." Unsworth's lawyers have laughed off that explanation and said his claim was undercut by a subsequent tweet when he said, "Bet ya a signed dollar it's true" in response to a question about whether he had accused Unsworth of being a pedophile. What were the implied odds of that proposed bet? That tweet has been deleted, but let's assume that Musk was proposing a notionally even-money bet of one signed dollar bill with a random Twitter user. If Musk won—if he proved Unsworth was a pedophile I guess?—then he would get a dollar bill signed by a random Twitter user, which would be worth $1. If the random Twitter user won, then that user would get a dollar bill signed by Elon Musk. I assume that Elon Musk's signature on a dollar bill increases its value a little bit, but a dollar bill signed by Elon Musk that is the centerpiece of his dumb "pedo guy" trial has to be worth at least, I don't know, I'd give you a hundred bucks for it? More? I'd need a certificate of authenticity explaining the context. ("This dollar bill was signed by Elon Musk as the stakes of a Twitter bet related to the 'pedo guy' tweet that got him sued," etc.) But I feel like if you collect Elon Musk Bad Decision Memorabilia you'd want to frame that dollar bill next to your Not-A-Flamethrower. Also it sure seems like Musk did lose that bet—he "provided no evidence" for the accusation, and now "claims he wasn't making a factual statement and no one reading his tweet would take it seriously"—so if I were that random Twitter user I'd be contacting him to collect. It's Elon Musk, he sent a box of shorts to David Einhorn once, he'll totally send you the signed dollar bill. Obviously we are all dumber for having read, never mind typed, that, but also I think it's true? One way that Elon Musk destroys value for his companies is by spending a lot of time getting in dumb Twitter fights and Twitter-related lawsuits, but one way that he creates value for his companies is just by sort of waving his Elon-Musk-ness over everything. People will pay a premium for things—dollar bills, cars, shares of stock—that are connected with Elon Musk, not only because he is good at certain stuff but also because he is so consistently so over-the-top. Who knows, maybe even the pedo guy stuff helps the brand. Things happen 'Peak' Private-Equity Fears Are Spreading Across Pension World. Dyal Capital Hauls in Record $9 Billion to Buy Stakes in Alternative Asset Managers. Trump Puts Tariffs on Brazil, Argentina, Citing Currencies. Analyst coverage shrinks after fee shake-up. U.S. Dominance in Global Services Economy Weakens. Two China Firms Miss $526 Million Bond Payments as Woes Grow. The rise of Abu Dhabi power broker Khaldoon al-Mubarak. Softbank to Face Valuation Cut in OneConnect IPO. Restructuring Argentina's Sovereign Debt: Navigating the Legal Labyrinth. Strategic Liquidity Mismatch and Financial Sector Stability. Facebook Gives Workers a Chatbot to Appease That Prying Uncle. Jason Blum, 'Big Short' Writer Tackling WeWork Drama. "A French celebrity chef has been branded a 'diva' for taking the Michelin guide to court Wednesday for suggesting he used cheddar cheese in a soufflé." If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] I mean, there are several. Total return swaps are a way to get economic ownership without voting rights. In practice you do not see a lot of index funds investing via swap (for reasons of tradition as well as regulatory skepticism of mutual fund derivative use), while you do fairly often see *activist hedge funds* investing via swap (to get around antitrust and securities-law ownership limits). This is kind of backwards. The activist funds really want a lot of votes; the index funds don't care so much. Really what should happen is that activist funds should buy like 30% of their portfolio companies and then sell 20% back to index funds on swap, but that probably doesn't work for anyone's regulatory situation. [2] Also, let's be clear, a lot of what I say in the text is not really about index funds. Some of it is—unlike active funds, index funds really don't analyze companies much, and they really are longer-term investors than most active funds—but much of it is really about broadly diversified institutional investors, of which index funds are one important type. [3] There is a more conventional reason for long-only investors not to lend out their shares to short sellers, and that reason is that evil short sellers are betting against the companies the long investors invest in, so why should the long investors facilitate that? Elon Musk applauded GPIF's move. ("'Bravo, right thing to do! Short selling should be illegal,' he tweeted on Tuesday morning.") [4] When we first talked about this case, I noted that Boustani referred to the alleged bribes as "success fees" while his Mozambican official contacts wrote ridiculous euphemisms like "whatever numbers you have on your poultry I will add 50 million of my breed." I wrote: "If you are looking for a code word for 'bribes,' 'success fees' is almost infinitely superior to 'chickens.' Like if someone finds these emails and asks you 'isn't "success fee" just a euphemism for "bribe,"' you can just tough it out and be like 'oh no those are success fees, very standard, in every contract, you gotta pay a fee for success. Consulting! Local expertise!'" I am extremely pleased to see that Boustani did exactly that. Just success fees! Nothing wrong with that! Gotta pay a fee for success! | 
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