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Don't Do It, CalPERS!

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What is CalPERS's job? There's actually an answer: it's to "Provide responsible and efficient stewardship of the System to deliver promised retirement and health benefits, while promoting wellness and retirement security for members and beneficiaries." I suppose "the System" is defined somewhere, and blah blah blah health benefits and wellness and beneficiaries, but I prefer to stop at the capitalized abstraction: CalPERS provides responsible and efficient stewardship of the System.

"Responsible" and "efficient" can conflict, though:

The second-largest pension fund in the United States is considering a move to an all-passive portfolio while at the same time, the largest brokerage firms are falling over themselves to push passively managed exchange-traded funds. The California Public Employees' Retirement System's investment committee started a review of its investment beliefs last week, with the main focus on its active managers ....

CalPERS oversees about $255 billion in assets, more than half of which already is invested in passive strategies. ... “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”

So: financial markets exist to allocate capital to its most productive uses.1 One use of capital that may not be all that productive is allocating capital, so it's understandable that rich sophisticated capital-allocators like CalPERS would allocate less capital to the business of allocating capital. Why spend so much money on external active manager fees when they turn out not to be that good at active management? Just index, right?

But then, of course, if you're not allocating capital to its most productive uses, who is? I mean, I'm not, obviously. And lots of retail investors aren't either: the popularity of index funds is based on the very sensible assumptions that (1) not many people can reliably beat the market and (2) those who can tend to sell their services to fancy institutions like CalPERS, not retail schlubs.

Where does that leave you when CalPERS doesn't want those services either? A thing I've occasionallyworriedabout is that, in a world where everyone indexes, nobody's watching the shop and actually figuring out where the most productive uses of capital are. Quick thought experiment: if literally everyone invested in a market-cap-weighted broad index fund, how would you do the market-cap-weighting? Or anything?

This concern will always seem a little silly as long as there are big rich long-time-horizon institutions with the desire to beat the market and the size to try. But with CalPERS pondering passivity, and with the Yale Model (of un-liquidity-constrained endowments investing heavily in alternatives) losing some of its cachet, it looks a little less silly than it used to. Though: I assume that this means CalPERS is pondering passive for its public equities portfolio, with a healthy dose of private equity and other alternatives alongside. This is not about the death of capital markets as a system for allocating capital. It's about the death of public equity markets as a system for allocating capital.2

But also, like: CalPERS? CalPERS isn't just a particularly giant active investor; it's also a particularly activist one. It's got a "director of global governance." It's got a website of global governance actually:

Welcome to our Global Governance website. We believe good governance leads to better performance. We seek corporate reform to protect our investments. The global governance team challenges companies and the status quo — we vote our proxies, we work closely with regulatory agencies to strengthen our financial markets, and we invest with partners that use governance strategies to earn value for our fund by turning around ailing companies.

So what happens if they move to all-index investing? Do they fire their global governancers? Or do they keep calling up the companies they've invested in (viz., the companies in the index, i.e., the companies that exist) and say "hey, if you don't get rid of your poison pill, we will ... well, not sell our stock or anything, I mean after all you're in the index, but at least keep calling you to complain"? If there's no exit, is there any voice?

In one sense it's a very strange result: CalPERS might end up spending no time or money at all choosing what companies to invest in, while spending substantial time and money telling those companies what corporate governance provisions to adopt. From a bang-for-the-buck perspective that seems perverse, and it's also troublingly one-size-fits-all: if CalPERS invests in every company, it will lobby for every company to have CalPERS-approved governance practices. I like the idea of a world with a diversity of share ownership structures, where some companies have "good governance" to appeal to the CalPERSes of the world, while others hang on to their high-vote stock or poison pill or whatever even if it costs them CalPERS money.3

On the other hand: if indexed, or at least broadly diversified, investing is the normal way of investing now, then I guess it makes sense for the noisiest investor voice to be an indexed voice.4 If the typical investor owns a more or less market-cap-weighted slice of the entire market, then she doesn't want companies to do things that maximize their own value at the expense of other companies.5 She wants companies to do things that maximize the value of the market as a whole. Someone's got to look out for the System. Seems like it'll be CalPERS.

Passive investing: If it's good enough for CalPERS ... [Investment News]
CalPERS committee rethinking active management [P&I]
[Update: related, The supply and demand for (belief in) EMH, by Nick Rowe (via Twitter)]

1.This is a fun interview with Cathy O'Neil, former D.E. Shaw quant, current Mathbabe blogger, and Occupy Wall Street Alternative Banking Group organizer:

[O'Neil] So, when you first go to a hedge fund, you might suspect--if you are really naive--that a hedge fund is actually supposed to find the correct price for the market. That we actually provide a service, and the reason we make so much money is that we are providing a service and of course we should make money if we are doing something good. Or, we're helping--another thing that you hear is we're helping--it's usually some of the same things--we're helping money where it should go.

[Interviewer] Allocate capital to its highest use.

[O'Neil] Yeah. Thanks. I spent four years in finance altogether. In the two years I spent at the hedge fund I don't think I ever heard someone say: Let's allocate this capital better. It was all about: let's anticipate what dumb people are going to do so that we can make money off of them. And there was this dichotomy, like dumb versus smart money. We're smart money; they're dumb money. We are so smart that we deserve their money. It was essentially kind of an entitlement. And it was really unattractive to me. I spent a lot of time at lunch trying to understand the mindset of, like, how does being good at math give us the right to do this?

So that's not entirely fair? Like, read your Hayek. Still. The invisible hand works in mysterious ways, and is a dick.

2.I suppose it's just a coincidence that CalPERS, the benchmark defined-benefit-pension-plan investor, is considering getting out of the, like, investing business at the same time that Carlyle is offering private equity funds, with 3.7-and-20 fees, to retail investors in their 401(k)s. I blithely hypothesize that in twenty years all the giant institutions will be in index funds and all the retail money will be in "alternatives." That will end well.

3.I guess in an indexed-CalPERS world, it wouldn't really cost them CalPERS's money. Just its, like, votes at the shareholder meeting or whatever.

4.Here I link to The Shareholder Value Myth without necessarily a blanket endorsement. But yeah the notion that the representative shareholder of Company X wants to maximize the value of Company X is sort of suspect in the age of indexing.

5."This merger is underpriced, but whatever, go ahead, I own the acquirer too."


The Smart Indexes Are Even Worse Than The Dumb Ones*

You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren't even "industrial" any more.** There are alternative theories but those theories are wrong: Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow's legitimacy. If it's very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it's adding value in some kind of way. But instead what's going on is that the Dow's creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren't in the Dow and aren't doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow's creators already "know" the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result. Maybe! An alternative theory is maybe suggested by [Occam's razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length:


Passive Investing Claims Another Victim: Stock Buybacks

Rejoice, for we have one more reason to freak out about index funds.

A very dangerous man. (Screenshot)

Carlyle Group Pretty Pleased It’s Not The Vanguard Group

Especially since its investors seem just as pleased, for some reason.

Facebook Will Take Free Money From Banks But Don't Expect It To Show Any Gratitude

The Wall Street Journal today discovered that universal banks that lend money to companies for cheap tend to want investment banking business in return for that lending and I guess that's a scandal: As the market for technology IPOs revs up and the biggest banks seek to capitalize on the size of their balance sheets, the practice of selecting underwriters that also provided loans is coming under focus, spurred by Facebook's IPO process. Critics of the practice say the choices aren't accidental and reflect the "you-scratch-my-back-I-scratch-yours" way that Wall Street works. Bankers, for their part, say they aren't allowed to make loans on the condition that they receive other business, but borrowers can use the loans as a factor in choosing underwriters. Some bankers say that lending is just one of the many services they offer companies. At Facebook, the credit line played a role in the batting order for underwriters, said a banker who worked on an underwriting pitch to the company. When I was young and naive and pitching for underwriting business against banks that did lots of lending, I always thought that banks "aren't allowed to make loans on the condition that they receive other business, but borrowers can use the loans as a factor in choosing underwriters" thing was ripe for a scandal. I still sort of think that: I just do not believe that no client coverage banker has ever said "we'll be in your credit facility but only if you promise us underwriting or M&A business." (Some people agree with me!) And, as the Journal notes, that would be a criminal violation of the antitrust laws, which is unspeakably weird but there you go. But if you ask a banker who has been carefully and recently briefed on anti-tying regulations, he will probably tell you something like "we don't demand underwriting business to provide a loan. Companies demand loans to get underwriting business." And, as the Journal says, that's not illegal.

Rajat Gupta's Lawyers May Try The "Everybody Was Doing It" Defense

There is much to like in this morning's Journal article about the Rajat Gupta insider trading prosecution, including a nice illustration of how the inside information that Gupta allegedly passed to Raj Rajaratnam actually seems to have been out in the market already. But let's start with the transcript of the call between Raj Rajaratnam and his trader Ian Horowitz, which the Journal has redacted not for confidentiality but for saltiness: Just so you can see Raj Rajaratnam saying "fuck" a lot, the full transcript of that call is here. But, anyway, the Journal story: