Should index funds be illegal?Back in 2019, I wrote about "a half-baked theory I have about index fund voting." The theory is: - Some people think it is bad that big diversified institutional investors—index funds and quasi-indexers[1]—have so much control over public companies. There are various versions of this complaint, but the basic problem is that index funds own every company, so they do not care about any one company in the way that traditional shareholders would, so they will sometimes vote their shares in a way that is not in the company's specific interests. The most fun version is that index funds and quasi-indexers create an antitrust problem: If you own every company in a sector, you will not want those companies to compete against each other on price, so rising index fund ownership will lead to less competition. But there are other versions: Index funds will lead to inefficient allocation of capital, they will be too deferential to corporate managers, they will be too short-termist, they will concentrate too much power in the hands of index-fund managers, they will vote for their managers' social and political preferences rather than to maximize value, etc.
- Some people think that a solution to this problem is to prevent index funds from voting their stock, or to create some system by which voting rights and economic ownership can trade separately, so that the index funds can still own stock but sell their voting rights to someone who will do a better job.
- This already happens, quietly, through the share lending mechanism.
When people want to bet against a stock by selling it short, they have to borrow the stock. Short sellers borrow stocks from brokers; brokers, in turn, borrow it from big institutional long holders. Some holders are more willing to lend stock than others, and index funds are particularly willing lenders. Short sellers pay a fee to borrow stock, brokers pass the fees along to the lenders, and index funds pass them along to their investors, in the form of slightly better performance and/or slightly lower management fees. Stock-lending revenue is crucial to index funds because their basic business is about giving investors index performance at the lowest possible cost, and stock-lending revenue is one of the only ways to subsidize the cost of running an index fund. When you lend out stock, you don't get to vote that stock. The person who borrows it sells it short to someone else, and that buyer gets the vote. Stock lending is usually done on an overnight basis; if you are a lender you can recall your stock ahead of a big shareholder vote, so that you can vote on the important matters. But if you are a big index fund, you might not care that much about your vote—you own all the companies, so picking the board of any particular company might not matter that much to you, etc.—while you will care about getting every penny of stock lending revenue. So my half-baked theory was that index funds do not really vote their shares, but instead effectively keep economic ownership of all the companies while selling their votes to people who care more about individual companies' performance. That was overstating it: Obviously index funds vote some, perhaps most, of their shares, etc.; my point was just that index funds are less influential corporate voters than you'd think if you just counted up how many shares they own. I had no real empirical evidence for this, though; it was just a theory about the structure of how index funds and corporate voting and share lending work. Here is some empirical evidence! It's from a recent paper and blog post titled "The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff," by Edwin Hu, Joshua Mitts and Haley Sylvester. From the paper's abstract: We show that, after the SEC clarified funds' power to lend shares rather than vote them at shareholder meetings, institutions supplied 58% more shares for lending immediately prior to those meetings. The change is concentrated in stocks with high index fund ownership; a difference-in-differences approach shows that supply increases from 15.6% to 22.3% in those stocks. Even when it comes to proxy fights, we show, stocks with high index ownership see a marked increase in shares available for lending immediately prior to the meeting.
And from the blog post: We examine funds' incentives through an empirical study of the lending-voting tradeoff after the Securities and Exchange Commission's 2019 guidance on funds' fiduciary duties. The guidance departed from prior practice by encouraging funds to take into account "opportunity costs" of share lending when making their voting decisions. In the past, SEC staff guidance required that funds recall shares they loaned when material items were on the ballot to ensure that voting would occur. ... More share lending means less voting – regardless of whether the shares are borrowed in the end. Because shares can be borrowed at-will from the lending agent or broker, and then voted by the ultimate holder as of the record date, shares put on loan do not carry voting instructions. Hence, shares made available for loan but not borrowed are not voted – making share lending a significant contributor to non-voting. By one estimate, in 2010 alone, 60 billion shares went unvoted, with 15 billion shares on loan. With no fiduciary constraint on share lending, corporate elections can have surprising results. Most notably, in June of 2020, a proxy fight at GameStop surprised the investor and corporate community when activists with only 7.3 percent of shares won board seats despite opposition from large institutional investors that collectively owned around 40 percent of shares. This was possible because nearly 40 percent of GameStop shares (nearly all the shares held by institutions) were on loan, most of which were presumably borrowed by short sellers and other investors with goals contrary to the funds and similar long-term investors.
Basically before 2019, index funds had to recall their shares to vote on "material items"; after the 2019 guidance, they could conclude that the stock-lending revenues were more important than voting. So index funds started lending out more shares, leaving them on loan during big votes, and voting fewer shares—occasionally with the result that companies made decisions that the index funds opposed, because small concentrated shareholders voted for it and big indexers didn't vote.[2] Obviously you could say this is bad. Hu et al. do say it's bad. Quasi-indexers are the big long-term investors who own most of the stock market as fiduciaries for their clients. They are supposed to be good stewards of their clients' money and good overseers of corporate behavior. If they give up their voting rights, in exchange for a tiny bit of money, then they are—arguably—not doing their jobs right. But, again, there are popular theories that if they do vote they are doing something wrong, reducing competition or whatever. Your theory might be "index funds have weird incentives when they vote their stock, and perhaps someone should pay them to stop." Perhaps someone does. Perhaps the market has just solved the problem efficiently. Voting rights aren't worth that much to quasi-indexers, so they sell them to someone who wants them. The result is that companies are mostly owned by quasi-indexers, who own the whole economy and have weird incentives when it comes to any one company, but when it comes time to vote the companies are mostly controlled by smaller and more concentrated investors, who have the time and incentive to pay attention to particular companies and vote for what's best for them. Shareholder politics"Everything is securities fraud," I like to say. If a company does a bad thing, you can always pretend that the company did the bad thing to its shareholders. If you are moderately creative, you can take any political controversy and contort it into a problem for public-company shareholders; then you can buy some shares in some public companies and sue them to stop the problem. Will it work? Well, work, probably not, but it will keep you busy for a while. It's something to do. You don't have to sue, even; you can do proxy proposals. Here's this: Shareholders in Home Depot and the advertising giant Omnicom have filed resolutions asking the companies to investigate whether the money they spent on advertisements may have helped spread hate speech and misinformation. The resolutions were filed in November but were not made public until Monday. They were coordinated by Open MIC, a nonprofit group that works with shareholders at media and technology companies. The two shareholder resolutions, which used similar language, asked Home Depot and Omnicom to commission independent investigations into whether their advertising policies "contribute to the spread of hate speech, disinformation, white supremacist activity, or voter suppression efforts."
Are the main victims of political misinformation the shareholders of publicly traded ad agencies and, um, Home Depot? Ha, no. Will Home Depot's shareholders vote in favor of this nonbinding resolution, and will Home Depot then conduct this investigation, and will this investigation lead it to change its advertising policies, and will those changes lead to less political misinformation and hate speech and a better political climate? I mean, also no, probably. But at the margin making it more annoying for corporations to fund misinformation might lead to fewer corporations funding misinformation. And a well-established way to make stuff more annoying for corporations is by enlisting their shareholders—via lawsuits or just proxy proposals—to annoy them. Stimmy markets hypothesisI don't know, man: Here's what happened in the market around the time the government sent people $600 earlier this month. Penny share volume mushroomed. A company that sounds like a word Elon Musk tweeted rose 1,100%. Tesla added $130 billion, IPOs doubled and options trading exploded. Coincidence? Maybe -- though a lot of people doubt it. They can't help notice how tiny traders with money to spend keep turning up in the vicinity of almost every market spectacle these days. Now, more federal aid may be on the way, and Wall Street pros are bracing for what comes next. "If the additional $1,400 goes to the same income levels it did before, we are highly likely to see additional speculation in stocks, which could continue to inflate an already-existing bubble," Peter Cecchini, founder and chief strategist of AlphaOmega Advisors LLC, said in an interview. … The sums would be hitting bank accounts at a time of full-blown mania in the market. Volume in penny stocks regularly tops 40 billion shares a day lately, up sixfold from a year ago, with day traders venturing off-exchanges and into the speculative over-the-counter markets. The options market saw the second-busiest day ever for bullish equity calls this week. Meanwhile, Goldman Sachs data show that a basket of retail-favored stocks has surged 10% since the end of December, beating both the S&P 500 and returns on hedge-fund favorites by more than 9 percentage points.
And: Given the number of Americans eligible to receive the payments, some of the $1,400 checks will inevitably land in the pockets of people who will either save it or invest it, rather than spend it on essentials. Such was the case with 23-year-old Ava Frankel of Boston, who works in the financial services sector. "I told my friends, if you're going to spend your stimulus check on shoes, you might as well just put it in Robinhood instead," Frankel said in an interview. "The $600 check was just something extra I didn't need so I just threw it in the stock market." Frankel latched onto a trend that's become emblematic of the euphoria in markets: special purpose acquisition companies. She put the entirety of her stimulus payment into Churchill Capital Corp IV, a blank-check company said to be in talks with electric vehicle maker Lucid Motors Inc.
I feel like there used to be a view to the effect that traditional monetary policy (giving banks money in exchange for Treasuries) was inefficient because a lot of the money went to inflating asset bubbles, and that more direct fiscal policy (giving money to people to spend on stuff) was a better way to stimulate the economy. Now it's like "if you give people money directly they will just spend it on SPACs and Tesla," and professional investors are terrified. It is possible that this is a version of the boredom market hypothesis. This is my theory that people will trade stocks to the extent that (1) trading stocks is fun and (2) other things are less fun; it suggests that stocks have gone up a lot in a pandemic because it's now hard to see friends or do stuff, so trading stocks on Robinhood is now relatively more entertaining. You don't need shoes if you never leave the house, so a lot of people who would otherwise spend their stimulus money on goods and services are spending it on penny stocks instead. In a pandemic, perhaps, a lot of fiscal stimulus goes to inflating asset bubbles, but not in the assets that professional investors like. The combination of economic stimulus and having nothing to do means that people are spending their stimulus checks on the experiences that are still available, specifically the experience of buying SPACs. Corporate BitcoinsIf you are the chief financial officer of a public company, responsible for managing the company's cash reserves, should you put them all into Bitcoin? Should you go out and raise more money to buy Bitcoin? You can answer that question at various levels of theory. The simplest answer is that you should put your corporate cash in Bitcoin if Bitcoin is going to go up (because then you'll have more cash), but not if it's going to go down (because then you'll have less cash). Bitcoin has gone up a lot, so this theory suggests that, yes, corporate CFOs should have bought Bitcoins. (It gives no clear answer about what they should do now.) If you put your corporate cash in Bitcoin in mid-2020, when it was trading in the $10,000 neighborhood, you look like a genius now that it's trading above $37,000. Or if you sold a convertible bond in December and used the proceeds to buy Bitcoins at around $20,000, that was good. Having more cash is better than having less cash. Bitcoin went up a lot last year. Other things, including a lot of regular old operating businesses, did worse. If you were the CFO of, say, a mall retailer, and you borrowed a bunch of money to buy Bitcoin, you did much better for your shareholders than if you spent money keeping up stores that were closed for months due to a pandemic. That is not a very … good … answer? You could have an answer that is a bit better grounded in corporate finance and, therefore, more boring. Your theory could be that a corporation is in the business of doing a particular thing—mall retail or whatever—and should stick to doing that thing. It should keep enough money on hand to have a cushion for its foreseeable expenses, and it should keep the money in simple low-volatility cash products (bank accounts, money-market funds) so that it will always be available to cover those expenses. Any money that isn't needed to keep the business afloat should either be reinvested in the core business or returned to shareholders, so that they can invest it in what they want. This theory suggests that no of course CFOs should not be buying Bitcoins:[3] Chief financial officers, not generally known as a risk-loving bunch, watched Bitcoin sink more than 25% in a 24-hour period starting [last] Sunday. Burning a hole of that size in the corporate rainy day fund would amount to a career-ending wipeout at virtually any S&P 500 firm. Yet the cryptocurrency's 300% rally last year was hard to ignore, and a few companies dived in. MicroStrategy Inc. invested $425 million of its $500 million cash into Bitcoin. In October Square Inc., headed by longtime crypto advocate Jack Dorsey, announced that it converted about $50 million of its total assets as of the second quarter of 2020 into the token. Proselytizers like Bill Miller of Miller Value Partners said this was just the start of what was sure to be a trend across Main Street. Now that Bitcoin's famed volatility has reared again, the prospects that the cryptocurrency would become a regular part of corporate treasuries -- never very good -- look all but dead. "It would be a red flag for investors if a corporation bought financial assets for speculation purposes unrelated to their core business," said Michael O'Rourke, chief market strategist at JonesTrading.
That is the classic, traditional answer: "It would be a red flag for investors if a corporation bought financial assets for speculation purposes unrelated to their core business." It is an answer grounded in financial theory about how efficient markets work. Investors, in this theory, buy a stock because they want exposure to a particular business; if they want diversification it is more efficient for them to diversify directly (by buying different stocks, or by buying Bitcoin) than for companies to do it for them (by becoming conglomerates, or by buying Bitcoin). If your company's proposition is "we make widgets and also own Bitcoin," people who like widgets and hate Bitcoin will stay away; if it's "we just make widgets," people who like widgets and love Bitcoin can buy your stock and also buy Bitcoin. Also: "A basket of options is worth more than an option on a basket"; a company is more valuable to the extent it's a specific bet rather than a jumble of unrelated things. Now, this is in part a theory about what investors should prefer: They can probably diversify more efficiently than corporations can, so they should do their own Bitcoin buying. But you could also express it as a theory about what investors do prefer: Public companies are owned by big sophisticated institutions who can do their own diversification and have internalized this theory, and who want companies to do what it says on the tin. If corporate managers go off and make crazy side bets, their big institutional shareholders will be upset. They will call the managers up and yell at them and maybe vote them out. Also they will sell the stock, the stock will go down, the managers' options will be worth less and everyone will be sad. What if that version of the theory is wrong? What if you start, not from the efficient markets hypothesis, but from the boredom markets hypothesis? What if you are a corporate CFO and you say: "Look, my marginal investor is not a sophisticated institution looking for a specific combination of pure exposures, but a bored 23-year-old putting her $600 stimulus check to work on Robinhood"? Surely the way to appeal to her is to put your money into as many weird fun trendy things as possible, and talk about them all the time. "We are going to put a quarter of our corporate cash into Bitcoin, a quarter into Tesla stock, a quarter into SPACs and a quarter into daily fantasy sports." Do whatever you can to attract the attention of the Robinhood traders, they'll buy your stock, it will go up, your options will be worth more, and your big sophisticated institutional investors will be like "well this is dumb but the stock is up so whatever."[4] When MicroStrategy Inc., a publicly traded business intelligence company, announced in August that it was putting its corporate cash into Bitcoin, its stock went up 9% in a day. Since the announcement, it is up 368%.[5] Bitcoin is up less than that over the same period. If you like Bitcoin, not as a decentralized store of value or the future of money or whatever but just as a volatile fun trendy thing to bet on, you should like MicroStrategy more; it is more volatile and has gone up more. Also MicroStrategy's proposal is kind of "we provide Bitcoin exposure, but in an amusing way." Why wouldn't people looking for entertainment in the stock market pay a premium for that? I bet if some semi-anonymous mid-cap company announced tomorrow "we are going to raise a $500 million convertible bond and invest the proceeds in Tesla stock," the stock would go up. This makes no sense, there's no corporate or financial logic to it, it's just a matter of having your name next to a buzzword.[6] "Amalgamated Widgets something something something Tesla," Amalgamated Widgets stock goes up, that is how finance works now, I'm sorry.[7] Garbage BitcoinsWe talked on Friday about a guy who threw away a hard drive with 7,500 Bitcoins and now has hedge-fund backing to dig up a Welsh garbage dump to try to find it. We had some laughs. I wrote that "in another decade, when Bitcoin has become the world's main store of value and 90% of it has been misplaced, this will be a trillion-dollar rubbish dump and Wales's main industry will be combing through it looking for that hard drive." But I somehow forgot that, in Chapter 10 of the "General Theory," Keynes wrote about exactly this: If the Treasury were to fill up old bottles with banknotes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and then leave it to private enterprise on well-tried principles of laissez-faire to dig up the notes again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.
Burying money under garbage as a form of stimulus is apparently a permanent feature of economics. We talk a lot around here about how cryptocurrency enthusiasts are rediscovering all of financial history; here Bitcoin has rediscovered a joke Keynes made in 1936. Things happenGoldman Sachs Dealmakers Drive Surge in Fourth-Quarter Profit. BofA's Wall Street Unit Falls Short of Rivals During Bumper Year. Renaissance Says Losses Should Have Been Expected at Some Point. Federal agencies, states compete to be fintech regulator. Europcar Credit Insurance Debacle Sends Warning to Speculators. London Metal Exchange to Propose Closing Trading Ring for Good. The Argentine 2020 Restructuring Drama: An Insider's Perspective. "'I read in the FT what a naughty boy you are ;-)', Mr Schütz wrote to Mr Braun, adding he had bought shares in Wirecard the previous week." Competition for Attention in the ETF Space. People are worried about non-GAAP accounting. People are worried about Tether. The world now is ready for this pizza-making robot made in Seattle. British food generator. 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] "Quasi-indexer" is a useful term that I took from Germán Gutiérrez and Thomas Philippon. It refers to institutions with "diversified holdings and low portfolio turnover," including *both* index funds *and* other large diversified institutional investors. People sometimes use terms like "shadow indexers" to refer to mutual funds that charge active-management fees but closely track the index, but that is not my intent here. "Quasi-indexer" is not meant to be pejorative; it just means a big fund that owns a lot of stocks to get broad equity exposure. A mutual fund with diversified holdings that differ significantly from the index could also count. [2] To be clear, the *short sellers* don't vote either. If you borrow stock and sell it short, *you* don't get to vote the stock; whoever *buys* it does. This is not about quasi-indexers (who want good things for the company) selling their votes to short sellers (who want bad things); it's about quasi-indexers (who vaguely want good things) selling their votes to concentrated holders (who want specific good things). [3] The main long-term bull case for Bitcoin is that it is a novel decentralized digital store of value, which will have lots of uses. One of them might eventually be for holding corporate cash—a store of value is a good place to put your money—but we're not there yet. "The paradox of Bitcoin is that the process for becoming a good store of value requires a stage of being a terrible store of value but a very exciting vehicle for speculation," writes Byrne Hobart; that's where we are now. [4] Also they *won't* vote you out, because they don't vote their stock; see above. [5] It closed at $123.62 on Aug. 10, the day before its Bitcoin move; it closed at $578.07 last Friday. In between, MicroStrategy also sold $550 million of convertible bonds to buy Bitcoin last month. That had a mixed near-term effect on the stock, which went up when the deal was announced (buying Bitcoins!) but down on the day that it priced (as convertible investors shorted to hedge their stock). The stock has doubled since that deal too though. [6] Long Blockchain Corp. knows what I'm talking about. As does Eastman Kodak Co. for that matter. [7] Literally! When Tesla Inc. Chief Executive Officer Elon Musk tweeted "Use Signal," the stock of Signal Advance Inc. went up 5,100%, even though (1) Musk was probably talking about the Signal encrypted messaging app, (2) Signal Advance has nothing to do with the Signal app, and (3) the mix-up was widely reported and well known for days as the stock kept going up. If you are a smallish company and Elon Musk whispers your name, or a word that sounds a little bit like your name, your stock will double. If you are a smallish company and *you whisper Elon Musk's name*, your stock might go up too. | 
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