Passive Investing is Changing Everything, at a Price

By Roy C. Smith

Eight years into a bull market in which the S&P 500 has tripled, investors seem to have given up on active managers, preferring index funds and ETFs instead. Survey after survey have shown that the overwhelming majority of active managers have failed to beat their benchmarks over 1, 3 and 5 year periods. Passive investing now accounts for nearly 40% of all US equity assets-under-management, more than twice the level in 2005. Passive funds together now hold about 13% of the S&P 500, up from 9% in early 2013, and account for about 25% of trading reported on the consolidated tape.

In the last two years, according to Morningstar, over $500 billion of funds were withdrawn from active managers and nearly $1 trillion found its way into passive funds tied to market indices. Hedge funds, too, have suffered as investors have withdrawn funds after years of paying high fees for low returns.

This trend is having a devastating effect on Wall Street sell-side research, the production of which is now well below historical norms. A recent Sanford Bernstein report referred to passive investing as “worse than Marxism.”

The principal explanation for the massive migration into passive funds over the last decade is the difference in fees and expenses charged by active managers, especially mutual funds, as compared to the exceedingly low cost of index funds.  This is a theme first expressed by Jack Bogle, former Vanguard Chairman and passive advocate, thirty years ago, but recent events have accelerated the move to passive investing.

Some observers say this new market dynamic is because of the $12-15 trillion of central bank intervention in fixed income markets in the US, Europe and Japan that have made stock investments of all types relatively more attractive than bonds. This unintended consequence of Quantitative Easing has led to mindless notions of “risk-on,” risk-off” investing that ignores individual company performance. Though these QE programs are being wound down, there is no assurance that they won’t be reinstituted during the next downturn.

QE is thought to have raised correlations of stocks with the market as a whole -- to a level of 70%-90% since 2009 from much lower levels before. Low correlations suggest good opportunities for expensive, research-driven stock pickers, and high correlations suggest any stock will do.  

All this confirms that the 2009-2017 bull market has had a substantial synthetic component to it. Continuous market appreciation during a period of unusually low economic growth and an unusual amount of political uncertainty in the US, Europe, China, Russia and the Middle East is hard to explain. These uncertainties have led many active managers to hold unusually large cash positions, but they would probably have been better off if they had been fully invested. They did not participate in the market upside as fully as index funds with no cash holdings did, widening the performance gap.

A recent Goldman Sachs report points also to a new dilemma faced by corporate directors because of the rise of passive investing. Boards can no longer trust the market to value their corporations appropriately, both absolutely and relative to the performance of its peers. Incentive compensation tied to stock prices may no longer be the best way to reward corporate managers – the compensation provided by the market may be completely out of synch with what directors want. Stock prices may also be sending the wrong valuation messages to potential corporate predators, making companies more vulnerable to takeovers.  How boards should respond to these challenges opens a whole new chapter in corporate governance.

Indeed, the surge in passive investing also tends to diminish the effect of the voting power of institutional investors in corporate governance. Long looked upon as a reasonable defender of basic shareholder interests, institutional investors have been the market’s enforcement arm. Passive investors, however, have little concern for governance issues and tend to outsource their voting decisions to firms like Institutional Shareholder Services, concentrating their power in governance issues to an all-time high.

Wall Street has claimed for years that passive investing is useful and has a place as long as it doesn’t “become the market.” Well, are we there yet?

When QE programs began, concerns about market distortions they would cause were brushed aside as less important that rescuing crisis-ridden economies from high unemployment and low growth. It is hard to see, eight years later, that these programs helped growth very much (yes, it might have been worse) though at least nominal unemployment came down significantly in the US.

Future programs, however, will have to recognize that the many long-term effects of distortion of the equity markets can be a high price to pay for their benefits.

   

Getting Serious About Private Investment in Infrastructure Finance

Getting Serious About Private Investment in Infrastructure

Ingo Walter

Back on 9th November, after his victory in the American Presidential election, Donald Trump declared, “We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none.”

His eye-catching, pledge for the nation to spend one trillion dollars on infrastructure projects over ten years has raised an important issue: How will all this be financed? Trump has proposed ideas such as public-private partnerships and a “deficit-neutral system of infrastructure tax credits” to encourage private investment in infrastructure. House Democratic leader Nancy Pelosi has signaled her support for major infrastructure investment, but she has also noted that, “on Capitol Hill, the divide is always over how to pay for it.”

Observers of the global economy have often commented that investment in infrastructure —from airports in the U.S. to power plants in Nigeria — could help boost sluggish growth throughout the world and address challenges in both advanced and emerging economies by raising productivity, prospective returns on a variety of capital investments, and expectations about the future. And there can be political dividends as well. Populism and extremism thrive when people are generally testy, feeding global instability. But while the estimated requirement for global infrastructure investment to sustain “acceptable” growth is about $4 trillion annually (pretty much a guesstimate), less than $3 trillion is actually taking place.

New ideas to transform this gap from a challenge into an opportunity to create value for the global economy, and society more generally, are the focus of a new study by key members of the faculty at NYU’s Stern School of Business, just published.

The premise is that dissolving “clogs” in the global financial plumbing will be required to turbocharge infrastructure investment.  The focus is to better harness large pools of institutional capital such as pension funds and insurance reserves (whose managers owe duty of care and loyalty to their beneficiaries in creating investment portfolios) to sponsors of infrastructure projects (who need to optimize their capital structures) through better global financial allocation.

A key issue In the US is that the main source of infrastructure finance (state and localities and special districts created by them) are budget-constrained (in particular by public employee pension obligations) and have limited borrowing capacity, while the Federal role has historically been fairly muted. With the exception of the Eisenhower interstate highway system in the 1950s there have been few big infrastructure ideas since the end of World War II.

Trump wants to greatly expand the Federal role predominantly as a catalyst, harnessing both private capital and market discipline as to what gets done, when, how and where. The subtext is getting significant infrastructure finance off the public balance sheet and avoiding the waste of capital associated with politics overriding economics in infrastructure development. The two ultimately need to strike a sustainable balance, which the Trump plan wants to move in the direction of economics.

Where is that capital going to come from, and who is going to bear the risk? Trump may be exaggerating the appetite of investors in very long-term infrastructure debt and the inevitable political exposure (e.g., limits on fees that infrastructure projects can charge and difficulties in avoiding “free-riders”) without some form of Federal guarantees.

Serious financial innovation can dissolve some of the clogs in the financial plumbing and move infrastructure finance to a different level, harvesting real gains for the public interest - alongside gains for debt and equity investors. So far Trump's remain are “huge” but fuzzy. Still, if the political and financial momentum is there, that’s half the battle.

Infrastructure Could be Trump's Key to Tax Reform

Infrastructure Could be Trump's Key to Tax Reform

Ingo Walter

Getting close to the end of his first 100 days in office, President Trump badly needs a win on domestic policy, and he’s selected tax reform. Tax reform is almost as complicated as health care reform, but most people believe good tax policy can benefit things they care about - incomes, employment and growth - so the political underpinnings are there to bust the bunker of special interests entrenched in the current US tax system. A promising approach: Use infrastructure as a powerful wedge to meaningful reengineering of the tax system. 

Like a ship that collects lots of barnacles after a long time at sea, the federal tax code affects economic performance at all levels. Don’t believe it? Read it. Or at least do your own taxes this year to better understand what’s inside the box. It’s a disgrace.

There are plenty of connections between the two worlds that could make this work.The fact that the last significant tax reform in the US took place over 30 years ago - in 1986 under Ronald Reagan - shows how hard it is to make meaningful improvements. Riddled with loopholes, carve-outs for special interests, attempts at social engineering, conflicts with state and local governments, and pitting stockholders against bondholders, foreign against domestic tax residents - the list goes on and the lawyers and lobbyists keep circling.

If the tax system is widely regarded as an open sore, that opinion seems in line with many people’s opinion about US infrastructure as well. In both cases the issues are not abstractions. Voters experience them “up close and personal” - with the next head-scratcher of a tax worksheet or the next tire-shredding pothole.

Much of the infrastructure focus in the US is on transportation facilities, widely associated with words like decrepit, rotten, obsolete and third world. Financially strapped local governments, saddled with much of the cost and beset by other fiscal priorities, have skimped on depreciation and maintenance. Everyone wants the benefits of good infrastructure and nobody wants to pay, so things are allowed to deteriorate to a point where “crumbling” becomes the right word.

Everybody on the Trump team knows that making a run at tax reform will stir up a political hornet’s nest and possibly create a second political setback for the Administration after health care. So it’s smart for Trump to couple tax reform to his (and Hillary Clinton’s) widely supported campaign promises on infrastructure. But Trump first has to answer a simple question: What’s the plan?

Boiling it down so far, the plan involves $1 trillion of additional capital spending in the near-term, with an emphasis on greater reliance on the private sector and the use of tax credits as a key policy tool. The details - What? Where? When? How? - are supposed to be forthcoming soon. Eager to get a slice of whatever is going to happen, 49 states submitted 428 “shovel ready” infrastructure projects back in February. In getting the initiative off the ground, here are a couple of things the Trump team might want to consider.

·       Transportation is the lynchpin. Electric power generation and transmission, freight rail, warehousing and logistics, pipelines and energy terminals are mostly in private ownership and doing just fine. Social infrastructure (schools, hospitals, correctional facilities, the courts) creates broad public benefits and is largely publicly financed, albeit with private competition in some areas. Same with water and sewage. So those are mainly off the table. Fixing our roads, bridges, tunnels and transportation hubs are a must and will have the biggest impact. Government tends to be pretty bad at multitasking, so Trump should narrow the immediate focus on the transport sector.

·       Public or private, or both? Done right, government involvement in infrastructure is inevitable. It is the key to the effective use of private capital in transportation. It provides operating concessions, eminent domain, rate-setting, engineering and safety standards, and in some cases financial partnerships with the private sector (public-private partnerships). There always has to be a coincidence of interest between the private and government sectors that is carefully anchored in durable and robust project agreements, and everyone has to be able to claim victory.

The key issue is to identify projects that generate robust future cash flows that can be turned into today’s private sector financing – attractive non-listed and listed equity investments, bank lending facilities capable of coping with construction risks supported by solid infrastructure bankers who have been around the block a couple of times, and the kinds of high-quality long-duration debt instruments backed by realized cash flows that big institutional investors like insurers and pension funds crave. Attractive projects that cannot be calibrated to meet these conditions, however valuable, will have to remain off the table for the private sector. 

Be patient about jobs. Infrastructure investments increase aggregate spending in the economy but at the same time require high-quality, specialized labor that’s in limited supply due to U.S. education and training bottlenecks. This could put the brakes on promised employment gains. The newly popular emphasis on vocational training for high-skill jobs and attractive pay that comes with it should help. A key issue is the excruciating delays that often beset US infrastructure projects in our hyper-litigious and politically testy environment. Trump has already tried to clear away some of the regulatory underbrush and should make sure it actually happens. Still, benefits that start flowing a decade or more from now aren’t worth very much today, and in any case will be harvested by governments - so they require a good dose of statesmanship.·       

OK on the private sector involvement, but what’s with the tax credit idea? It’s not obvious how private infrastructure financing can benefit from tax credits. Municipal bonds are already tax-favored - a status that may be up for negotiation as part of Trump’s tax reforms. Any additional infrastructure-specific tax benefits would probably take the form of corporate “tax subsidies” on “approved” projects, which puts the government in a position of deciding which worthy projects would count toward the promised $1 trillion in federal support. Here the U.S. can learn quickly from Europe and Asia, where good outcomes in many cases seem to have captured broad public support for public-private ventures and where creative moves, such as the European Bank for Reconstruction and Development (EBRD) by now have a track record that can teach us some valuable lessons on what works.

The devil is in the details. But the product of a good infrastructure plan is significantly higher income and output in the short term and economic growth in the long term, so that prospects are seen to improve for everyone. The product of good tax reform is much the same. The two issues are joined at the hip. Both are positive-sum games, with plenty of scope for promising gains in one domain to compromise perceived losses in the other. In politics, more degrees of freedom are good for outcomes that are in the public interest. Linking infrastructure to tax reform can make a positive contribution, so Trump should give it a shot.

Have Business Schools Ruined Capitalism?

By Roy C. Smith

Ross Sorkin’s review of The Golden Passport by Duff MacDonald raises again the question of whether Harvard Business School (and all other business schools) should be blamed for the ethical hollowing out of modern capitalism. 

Apparently MacDonald thinks so, according to the review, because in 1985 HBS hired Michael Jensen, a Chicago-trained, free-market economist from the University of Rochester, who then refocused the school’s notion of the purpose of capitalism from efficient manufacturing to maximizing shareholder value.

Michael Jensen, now an Emeritus Professor at HBS, was undoubtedly one of the more influential business school professors of his day. His seminal work on agency conflicts helped illuminate a lot of the darker niches of corporate governance in the 1970s and early 1980s when, after a decade of underperformance, American corporations attracted a tidal wave of takeovers (25% hostile) that brought the shareholder value movement to light.

It began with the “rogues” of corporate finance (hostile activists, “asset-strippers,” “greenmailers,” leveraged buyout firms, and financial entrepreneurs generally) threatening large, long established corporations with takeover offers made directly to their shareholders, bypassing management.

At first these aggressive outsiders were seen to be disruptive influences, driven only by greed to make trouble for “great American corporations,” whose management, it was assumed of course, had the best interests of shareholders at heart.

The rogues, however, explained their actions by saying that management had destroyed shareholder value through a series of mistaken actions authorized by Boards of Directors that were unchallenged by shareholders. Whenever a challenge did arise, they added, CEOs and their captive boards of directors, were able to squash it with impunity.

It didn’t take long for institutional investors that cumulatively owned controlling positions in the targeted companies to work out that the rogues had a point. In too many cases, so-called great American corporations had fallen into economic disrepair by failing to remain competitive and adapting to changes in their markets. The market capitalization of US corporations slumped in the 1970s (to less than that of Japanese corporations). It became clear that US corporations needed to be revitalized and restructured, but so did the mechanism of corporate governance of public companies with widely distributed shareholdings.

HBS in the 1980s was closely tied to many great American corporations through its case method of teaching (requiring cases to be written with the cooperation of the corporations), executive training, job-placement and fund raising.  But it was also expanding its notion of business education to include financial services and investing institutions, and Jensen’s arrival helped to create a platform for scholarly examination of some of the issues that emerged with the takeover boom.

One of these issues, in which Jensen specialized, was agency conflict, i.e., the conflicts of interest that are inherently present in relations between shareholders (owners) and managers (agents). Owners, of course want to see the maximization of value of their investment over time and after taking business risks and obligations into account. Owners are represented by Boards of Directors, but boards could be dominated by CEOs. CEOs, however, are not owners but agents hired to run the company on behalf of owners. Some agents see their role as maximizing the stock price over relatively short periods of time, regardless of risks and obligations, so as to profit from incentive compensation arrangements. 

Throughout the 1980s (and ever since), agency conflicts involving takeovers and control issues have been litigated extensively in the Delaware Chancery Court, resulting in a well illuminated but continuously updated pathway of what is permissible and what was not in launching and defending against unwanted takeover efforts.

At the same time, a different form of corporate organization was emerging to improve operational efficiency and to maximize returns to investors. This was the leveraged buyout in which an investor group would acquire control of a corporation, leverage its balance sheet to increase shareholder returns and then manage the enterprise to maximize value and minimize risks. There was very little agency conflict in these organizations – the ownership was concentrated into a powerful, knowledgeable group that hired managers but watched them very closely and made all the important decisions. 

Jensen was certainly important in bringing attention to these issues in corporate governance, and bringing HBS into the field.  But he was by no means alone.  At Stern, a number of finance professors, including Yakov Amihud, Edward Altman, William Allen, David Yermack, Aswath Damodaran, Ingo Walter and myself, authored books and papers on various aspects of these issues, contributing to a wider national effort to better understand and balance-out the roles of Boards and managers.  

The Golden Passport, aims to persuade readers that despite its great success in recruiting great students and faculty, and in maintaining important working relationships with corporations, it has lost its soul to corporate greed and recklessness epitomized by an overwhelming emphasis on maximizing shareholder value above all else. This is absurd - neither Harvard not any other business school has done that.

On the contrary, business schools such as HBS and Stern have contributed knowledge and insight into how corporations maintain their competitiveness, the pros and cons of takeovers, how leveraged buyouts should be structured to work best, and how corporate boards and their critics can agree on practical ways to minimize agency conflicts going forward.

These are important contributions and we should be proud on them.

Note: The author is a graduate of HBS.

The Re-Birth of Citigroup

by Roy C. Smith

The Economist recently observed that “Citigroup’s decade of agony is almost over,” and now all it needs to is be able to demonstrate that it can grow again. That will not be so easy. After a decade of focusing on just surviving, it now has to select a business model that can succeed in the decade to come.

Finding successful long-term business models is not something that Citi has been good at. Walter Wriston (CEO of Citibank from 1967- 1984) developed the bank’s widespread international franchise, but he also installed a super-competitive ethos for the bank that led it to great heights before stumbling badly in the 1980s from bad loans and write-offs.  His successor, John Reed (CEO 1984 -1999), led a technology revolution (ATMs, etc.) that installed Citi as the leader in retail banking, but also agreed to sell the bank to Travelers Corp. in a transaction that would establish the surviving enterprise as the world’s largest and most diversified financial conglomerate until that too fell apart.

Reed, who later admitted the merger was a terrible mistake, was eased out by Sandy Weill, Travelers head, who soon launched the aggressive integrated business platform that combined Citi’s lending activities and expertise with Salomon Brothers’ capital markets and trading skills. He also used further mergers to triple the assets of the conglomerate from $700 billion to a peak of $2.4 trillion, and extend its reach, complexity and risk exposures by more than that.

The effort turned out to be a painful lesson in corporate hubris. Citi was deeply tied in with Enron and WorldCom, the two poster children of the tech-wreck of 2000-2002, costing it many more billions in write-offs, fines and legal settlements than it had earned in all of its corporate finance activity since the merger.  Controversies abounded and ultimately Sandy Weill was removed as CEO after the NY Attorney General threatened to sue him and the bank for fraud in 2003.

Sandy was followed by two poorly chosen and ineffective CEOs who were unable to control the reckless, performance-driven juggernaut that Sandy’s ambitions unleashed. There were several further instances of unethical conduct, involving investigations by several foreign governments and a string of US legal encounters that led one federal judge to describe Citigroup as a “serial offender.”

The mortgage securities crisis in 2007-2008, however, proved the undoing of Citi’s voracious business model. It crashed and would have died in 2008, having written off more than 100% of its capital, but the government, fearing the bank was too big to fail, bailed it out – in a series of capital infusions and a lot of assistance from the Federal Reserve.

Since then, the present management team, in place since 2012, has devoted itself to cleaning up the mess. It sold assets, added new capital and did what it could to shore up the balances sheet and relations with its regulators. Total assets are now down to $1.8 trillion and headcount has been reduced from 357,000 at its peak, to 219,000.

But the tougher news is that Citigroup’s stock price, even after benefitting from the Trump rally, is still off 90% from its 2007 peak. And, for the past nine years, Citi’s EVA (return on equity less its cost of equity capital) has averaged -13%; though in 2016, it was only -5.13%. The bank’s price to book value ratio today is 0.80%.

The bank now has two core businesses: global consumer banking and global wholesale and investment banking. Roughly half of the bank’s revenues now come from consumer banking, about half of which comes from Asia, Mexico and other emerging markets.  The other half of the revenues is divided about equally between wholesale banking and securities transactions. Citi’s net income in 2016 was $14.3 billion vs. JPM’s $24.7 billion

In his recent shareholder letter, Citigroup CEO Michael Corbat announced that “our restructuring is over” and that he has a “deep conviction…” that Citi has “the right model, the right strategy, the right customers and clients, and the right people in the right places to meet our update targets.”

These targets include achieving a return on tangible equity of 10% in 2019 after utilizing deferred tax assets. This is a pretty low bar for judging success. (Citi’s ROTE in 2016 was 7.6%; JPM’s was 13%). Return on total equity would be about 2% less than the return on tangible equity.

Nevertheless, Citi’s cost of equity capital (using the Capital Assets Pricing Model) is presently about 12%, which means that even if it hit its target return two-years from now, it still would be earning less than its cost of equity capital more than 10 years after the financial crisis that brought it down.

Corbat is making three key assumptions that will determine the future of the bank.

One is that his choice of a global universal banking business model will pay off despite slow global growth rates and increasing costs and constraints of regulation and exposures to litigation. If the model can only generate a return on equity less than its cost, the long-term prospects can hardly be seen as viable.

Second is that the Citigroup team is capable of executing the business model effectively, despite its broad reach and complexity (e.g. trading operations in 80 countries). Citi has lost some market share in total capital market originations over the last decade, falling to 6^th from 4^th place. But now that its restructuring is over, will it attempt to catch up by re-adopting the hard-to-control aggressive business practices of the past.

And third, that investors will continue to tolerate low returns and lackluster stock prices (Citi has lagged both JPM and Bank of America over the last ten years, and in the rally since November despite the support of a $10 billion stock buyback program). If these don’t change – and the two-year targets suggest they wont - shareholders may demand yet another management change, one that finally would be willing to break the company up into two separate companies that could operate more entrepreneurially. 

From: eFinancial News, April 1,2017