What are we paying Indexers to be passive? Part 3

Rampant indexing has weakened the rest of the ecosystem designed to discipline companies including short sellers, sell side analysts and activists. Should index makers impose governance filters before they insert a firm into the index?

3.0 Do the Big Three actually have a disincentive to engage?

Thus far, I have considered the idea that the Big Three Indexers do not have an incentive to engage and govern firms. What, if there is an explicit disincentive? Most large companies have 401K plans for their employees. These plans need to be administered by an asset manager. BlackRock, Vanguard and State Street obviously offer such services. How does the plan administration nexus affect the decisions of the Big Three to engage with management?

Let’s stick with IBM as a running theme to illustrate this point. IBM’s 401k plan administrators are SSGA, State Street, Fidelity, and Vanguard, as per the form 11-K for the year 2020 for the plan filed with the SEC. The 11-K states that $34 million is paid by the fund as administrative expenses. They don’t seem to disclose how much of that goes to each of these asset managers. In September 2019, IBM appointed the ex-CEO of Vanguard, Bill McNabb to its board.

All this may be a complete coincidence. But one has to at least entertain the hypothesis that the plan administration related conflicts of interest potentially prevent the Big Three from pushing companies harder on governance matters. Having said this, the SEC in its 2019 proxy voting guidance clearly states, “an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest.” Are such disclosures being made?

4.0 Why can’t short sellers, activist funds and long-term active fill these governance and valuation gaps that indexing might cause?

These criticisms will open the inevitable arbitrage question: if indexing causes so many problems, why doesn’t someone jump in to make money? I have written numerous times in the past that shorts, long term active and activists are perhaps the only forces left to keep managements honest in today’s markets. What stops these players from fully participating?

4.1 Shorts

I hypothesize that shorting stock has likely become less profitable since indexing took off. Why? If the shorted stock is in the index, the CEO of the shorted firm is assured of demand for the stock. Consider my Tesla case study from my previous piece.

A skeptic will counter that Tesla got very big before it got admitted to the S&P 500 index. And there is a different narrative floating around that S&P missed the boat by not adding Tesla much sooner to the index. Both claims may be right without contradicting my point that indexing and the stock price hikes it causes, on the margin, makes shorting difficult.

Tesla’s market capitalization on November 17, 2020, when S&P announced the addition of Tesla to the index, was $390 billion. At the end of 2020, its market cap had risen to $669 billion! Short interest in Tesla today is barely at 2.7%. Well, go back to the short interest in October 2020, a month before Tesla was added to the S&P 500. Short interest then was around 7%, at least two times higher.

You could always counter that this is a convenient data point that does not generalize. In the past, Tesla had a capital structure that was very heavy on convertible bonds. This is no longer the case. Capital stacks with lots of convertibles of the typically high delta kind that are in the money can witness dramatic fluctuations in short interest. Fair enough.

Let me try another data point. Over the last 5 years, IBM’s dividend adjusted returns are 15.96%. The S&P 500 meanwhile has returned 55.56%. Any stock that has underperformed at roughly 8% per annum would be a candidate for shorting. However, IBM’s short interest stood at 2.8% when I checked S&P CAP IQ on May 3, 2023.

You could then come back and say, “Shorts always look bad in bull markets! And zero interest rates are a key driver as well, given how shorting works. Besides, how attractive were shorts’ returns the prior several decades? Were they ever so great? If so, then why didn’t shorts have a lot more investors ever in the history of shorting? “

There is older evidence spanning 1990s-2015 that shorts systematically made excess returns (see Desai et al 2002 and Boehmer et al. 2008 and Xue et al. 2020). The performance of shorts may well have deteriorated after 2015 considering the zero-interest rate environment we have been under, as seen by negative returns to the HFR Short Bias Index in recent years. The recent time period is confounded somewhat by the takeoff of indexing.

4.2 Activists

What about activists such as Elliott and Trian? Shouldn’t they have access to more arbitrage opportunities since indexing took off, if my thesis is true? Typically, activists target under-valued firms where the CEO or the board has not allocated capital efficiently. If the number of index zombies has indeed increased, activists should be having a field day.

I don’t know how to show that activists are doing even better in the post indexing world. But we do know that the nature of activist investing has changed since indexing took off. Activists like Elliot need to earn the support of the big three indexers because there is virtually no way to influence management if 20% of the votes are not with the activist. The long-term gains from activism, if any, are shared by the indexers. In fact, the very existence of such cooperation is prima facie evidence that the Big Three do not have the resources to spot and correct material mismanagement of corporate resources, on average, although they are forced to hold the stock and can’t sell if the stock is in the index.

In a perverse way, rampant indexing both enables and hurts activists. It enables them by opening more cases of managers disconnected from shareholders. On top of that, the activist can commit minimal capital if she can convince one or more of the Big Three to vote with her. But, indexing hurts activists if you buy my thesis that indexing promotes over-valuation of firms. It is always harder for the activist to make a case against a company that has generated reasonable absolute returns in the stock market. I am not sure how these forces net out, on average.

But I suspect that activists believe that the Big Three is deferential to management and will not go for radical solutions such as firing the CEO or replacing the whole board. Knowing this, activists are likely to propose incremental, not radical, restructuring, if they were to go after an index zombie.

You can always ask, “why has IBM not attracted an activist?” My guess: its too hard to generate value within a year or two! IBM is a complex company that employs a quarter million people and has 2-3 sub-divisions that perhaps need to be all broken up. Business transformation, to generate value, will take years. Do activists have the time and expertise and patience to guide IBM through that transition? May be not. Does any capital market player have that kind of time, expertise, or patience?

4.3 Long term active

Long term active managers who engage with management could play a stronger role than “activists.” They focus on supporting a long-term strategy that could have short term headwinds to growth but better long-term outcomes for the business and stakeholders. Activists are sometimes accused of putting short term pressure on management to make change too quickly for immediate financial gain. Having said that, long-term active is struggling for survival, as detailed in my prior piece.

When I showed my piece to someone quite senior in the Big Three, the person came back saying, “there is a premise that active managers have truly engaged a lot on corporate governance of the companies whose stocks they invest in. I fundamentally challenge that assertion for most active managers. If you ask most companies if they are doing more on corporate governance today, as indexing as grown, than they did 20-30 years ago, they will acknowledge that it’s much more today. So, for every activist, there are a lot of ‘active’ managers who simply buy and sell, rather than truly engage in corporate governance. Your narrative paints a fake view of some halcyon former time of golden corporate governance engagement.”

I agree fully with the above statement. My claim is not that governance was perfect pre indexing. A vast majority of active in the past were free riders who did not generate enough returns for their investors, after taxes and expenses. All I am saying is that the Grossman-Stiglitz paradox highlighted earlier has only gotten worse, post indexing.

It is also worth noting that active investors express their distaste for bad governance (or low faith in management) by selling the stock or holding it without buying more at a comparatively lower valuation multiples. A non-owner would not push for changes on something she doesn't own. Management teams that look to have long term partnerships with their investors (which matters in moments of volatility or strategic pivots) view governance as a conversation (not a “one size fits all”) to enable the balancing of interests of all stakeholders.

5.0 What does indexing do to the sell side analysis business?

Sell side analysis has gotten hammered over the years for many reasons. I remember that at Columbia we used to place many more students as sell side analysts than we do today. What has indexing done to the sell side business? I suspect the primary culprit is Reg FD, which ironically leveled the playing field between analysts and the rest of the market. Others have blamed MIFID II, an arcane rule in Europe, that requires investment banks to clearly separate how the investment bank business is subsidized by the trading business. This rule appears to have led to a fall in analyst coverage in general in Europe and in the US because most of our investment banks have a strong European footprint.

To some extent, this is like asking my school to allocate my salary to teaching, service and research and then publishes these numbers to the outside world. It is a well-meaning idea except that once you put a dollar number on research that is not immediately monetizable, such research will quickly disappear!

This is not to say that indexing has not hurt the sell side analyst business. My guess is that analyst coverage also herds on the indexed firms. I suspect coverage increases substantially when a stock is added to the S&P 500. I would conjecture that a decline in coverage is more rapid and permanent when the stock gets kicked off the S&P 500.

What is the analysts’ job in a stock with index related demand? On the margin, it becomes harder for the analyst to question the firm’s inflated stock price with fundamentals. This may explain why more and more analysts rely on relative valuation or price-earnings multiples relative to grounding the stock price squarely in terms of fundamentals. In my classes, I am astounded by how almost every firm that I and the students choose to value looks over-valued when we try to carefully predict future revenues, costs, profits, and a reasonable cost of capital. On the flip side, management has to work that much less to impress analysts if they are assured of index related demand for their stock.

I also suspect that the workload per analyst has increased in recent times. This may or may not related to indexing, I don’t know. I ran this casual perhaps unscientific experiment to test this theory. I found 19 analysts with email addresses that follow IBM on CAP IQ. Of these, three represent credit rating agencies or mutual fund ranking firms such as Morningstar. I looked at how many other firms are covered by the other 16 analysts. The median number of firms covered by an analyst is 19.5. That sounds like quite a lot of firms.

Now compare this with the number of employees involved in engagement and corporate governance at the Big Three: 75. Of this 75, BlackRock states that in NYC, they have 15 global analysts, 14 local analysts with four in the rest of the country. So, the US focused team is 18 strong. The US has 4,266 listed stocks and I suspect BlackRock at least holds and engages with the S&P 1500. If each of the engagement employees were to work like a median Wall Street analyst, they could deeply research say 360 companies at best.

Conversation with a prominent sell side analyst does suggest that there clearly were some misalignments on incentives in the era of star analysts. Analysts and pools of juniors are just way less prevalent today. The number of deep research reports (outside of initiating coverage) is down significantly. This analyst thinks that magnitude of deep work is down by 75 percent or so in the last decade. Crunch on research dollars from declines in assets under management in active is a key reason. Moreover, investors prefer to park in mega caps. Many thoughtful analysts, outside of the conventional system, are now on Substack or Twitter.

A concrete way in which the job has changed is the rising importance of macro factors in recent times. Unsurprisingly, there is work suggesting that stocks that get added to indexes become more correlated with the market and hence are more susceptible to macro factors such as industry factors, interest rate movements, central bank intervention and the like. A good analyst today needs to understand the importance of macro and micro factors that affect stock prices of individual stocks.

6.0 Should indexers themselves factor in governance criteria?

If the Big Three don’t have an interest in governing, should we expect the index maker to weed out poorly governed firms. This is complex as well because simple “yes/no” filters are likely to not correlate well with value creation. For instance, S&P’s decision to ban dual class shares from entering the index in 2017 is a case in point. Earlier this year, S&P reversed its own rule and allowed Blackstone, Dell and Airbnb, that have multiple classes of shares, to re-enter the index. Perhaps this is an admission that multiple classes of shares are not a blanket good or bad, but context matters. But someone has to invest in researching that for individual firms. Who is that someone?

This issue is even more pressing for indexes on international stocks where governance issues are even more pressing. For instance, Hindenburg, the short seller, alleged accounting, and governance shenanigans at the Adani group in India. MSCI reduced the percentage of shares publicly floated by the group in their index, a decision that might eventually get Adani Total and Adani Transmission out of MSCI India index, which in turn is likely to cause $500 million of selling pressure.

But the bigger question to ask here is how does MSCI screen out firms that are poorly governed? Even harder, what do you do with overseas firms that are highly valued by their respective stock markets but are poorly governed? Does this mean poor governance has not been priced in yet? Should the index maker take a stand and anticipate the future negative valuation impact of poor governance? Or should they wait for the rest of the governance ecosystem, such as short sellers, to discover these problems, wait for valuations to fall and/or use the allegations as the politically convenient excuse to exclude governance laggards from the index?