Asset Pricing Competition

John Campbell's text, "Financial Decisions and Markets" is out from Princeton University Press. With some mild chagrin, I must say it's a splendid book. (Chagrin, of course, because it's an obvious major competitor to my own effort in Asset Pricing.)

It is spare, concise, and clearly written. How can I say that of a 450 page book, with wide text and tiny margins? Well, it's the concise version of the Encyclopedia Britannica, breathtakingly comprehensive and up to date in its coverage of important research topics.

The first part is a whirlwind tour of asset pricing theory. Here, John adopts the traditional organization -- expected utility, static portfolio choice, static CAPM and APT as equilibrium relations where supply meets demand, and finally we meet the discount factor and consumption-based pricing. I chose to go the other way around, and start with the basic asset pricing equation \(p_t u'(c_t) = E_t [\beta u'(c_{t+1}) x_{t+1} ]\), following Bob Lucas' insight that asset pricing is the same as in an endowment economy, and filling out the CAPM and APT and so forth as special cases. I never even got to portfolio theory -- it's in a draft chapter for the long-delayed next version. I still think that's the right organization, but most people don't want to teach it that way. John's more conventional organization, combined with clarity and concision, may be more what you want.

Even here, John's empirical taste and contributions rings through Any textbook is in many ways a summary of its authors' research journey, and John's journey has gone far and wide. You see a preview of the style on the 6th page of chapter 2 (p. 28) where you meet approximations for log returns, and the growth-optimal portfolio on the next page. On calculating minimum-variance portfolios, on p. 37, you get  graph of time-varying return correlations from Campbell Lettau Milkier and Xu (2001), a provocative fact usually ignored. After efficiently presenting the classic CAPM, we get (p. 51) an insightful application to Harvard's endowment, highlighting the difficulties of using these oft-repeated portfolio and pricing theories in practice.
This book is  infused with up to the minute empirical work and practical application even in the most basic theory sections. Starting on p. 61 John moves swiftly from the CAPM theory to empirical evidence, and implicitly, methodology. The next 16 pages cover the standard regression test approaches, swiftly show the evidence for the value and size cross sections, a nice treatment of momentum, a good yet economical coverage of the major anomalies and then a quick and digestible survey of reactions such as conditional capm, multifactor models, and behavioral finance. The coverage is comprehensive and up to date without being overwhelming.

Then the book really gets going. You would expect Chapter 5 on present value models to be excellent, and it is, somehow while also being brief. It covers not just the basics such as Campbell Shiller present value model and VARs, but includes a useful section on "Interpreting US stock market history" to bring equations alive, an excellent section on the econometrics of return forecasting, drifting steady state models, present value models in the cross section and more. Somehow in 40 pages John has distilled his own major research contributions, and several hundred papers of a still active literature, yet brought you up to date. My coverage focused only on the simplest idea, and wasn't one tenth this complete a summary of the current literature.

Chapter 6 on consumption based asset pricing is likewise elegant and comprehensive. John jumps right in to data with the equity premium, riskfree rate, and volatility puzzles (p. 164). Then he quickly outlines the huge literature of responses to the puzzles (p. 167) again in short digestible paragraphs. The big ones, time varying disasters, Epstein-Zin, long-run risk, ambiguity aversion and (nearly last but not least) habit formation and durable goods each get a few well-chosen pages, each self contained with derivations (a derivation of the Epstin-Zin SDF is not fun), but not windy. Unusually, John also includes an elegant chapter 7 on production-based asset pricing and general equilibrium. I think this approach is relatively unexplored and promising -- I'm glad to infer John agrees. In both areas, my latest survey in Macro-Finance is not nearly as economical. John spryly gets to the point.

It wold not be a John Campbell book without a chapter on fixed income, and this one does not disappoint. Affine models, empirical work on the expectations hypothesis, a strong emphasis on the link between macroeconomics and term structure - absent in most treatments -- and linking interest rates and exchange rates are strong points.

Here though, you see one limitation of the book, in scope at least. Everything, including fixed income, is done in discrete time. This fact certainly makes it more accessible to economists, and most of John's voluminous work has been in discrete time. But most of the ideas in asset pricing are much easier in continuous time, once one masters the elements of Ito's lemma manipulations.  Term structure models are commonly done in continuous time. In revising Asset Pricing and the online versions, I have moved entirely to continuous time rather than lognormal approximations. It's much simpler that way, and continuous time is a standard part of a finance PhD's toolkit. This otherwise comprehensive book doesn't have any option pricing in it, though Black-Scholes is a cornerstone of finance. Well, John hasn't worked on that, and his research is mostly presented in discrete time. Adding continuous time would add a lot of pages. It keeps the book quite self contained. But it does mean that a course in finance will need some other reference material for that important part.

The next three chapters reflect again many of John's wide-ranging contributions.  It is a crime that we still use static mean-variance optimization -- and by "we" I include the entire industry as well as academia -- when we know state variables are moving around all the time. John has made some great strides in trying to make intertemporal portfolio allocation and inter temporal asset pricing come alive. There is a lot left to do here, but if you want to get started Chapter 9 on inter temporal risk brings you up to date (or at least faster than trying to read all of John's papers!)

Chapter 10 on household finance is a great example of a topic that is new to the asset pricing canon. How do we understand what portfolios people actually hold?  You get a great summary of that work. It's followed by an excellent Chapter 11 on the economics of risk sharing and speculation and Chapter 12 on asymmetric information and liquidity. This too is not yet part of the textbook canon but soon will be, as these issues are central to current research.  The classic theory of finance, the joke goes, is perfectly mirrored in the market for senior faculty: Prices change, there is no volume. There is a recent explosion in understanding the mechanics of trading, and these spare chapters will send students on their way.

Like continuous time, the book also does not have a chapter on the recent explosion of models in asset pricing with financial frictions. Perhaps John just hasn't written in that area yet! But an author (me) whose finance book omitted a chapter on portfolio theory can hardly complain, and knowing John's evident mania for scholarship, it will likely be there in the revision.

In sum, this is a must-read book for any Ph. D. student in finance or financial economics, and must-have book for any serious scholar of finance. It is not organized, as I tried to do in Asset Pricing around a Big Idea, trying to move how we do research in a particular direction. That is likely an advantage. Instead, it shines in a crystal-clear, nearly encyclopedic summary of current ideas in the macroeconomics and finance literature, complete with an equally encyclopedic citation list for those wanting to go further. It is distilled like fine scotch. Barrels of fine scotch.

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Bitcoin and Bubbles

Source: Wall Street Journal

So, what's up with Bitcoin? Is it a "bubble?'' A mania of irrational crowds?

It strikes me as a fairly pure instance of a regularly occurring phenomenon in financial markets, one that encompasses some "excess valuations" in stock markets, gold and commodities, and money itself.

Let's put the pieces together. The first equation of asset pricing is that price = expected present value of dividends. Bitcoin has no cash dividends, and never will. So right off the bat we have a problem -- and a case that suggests how other assets might have value above and beyond their cash dividends.

Well, if the price is greater than zero, either people see some "dividend," some value in holding the asset, beyond its cash payments; equivalently they are willing to hold the asset despite a lower expected return going forward, or they think the price will keep going up forever, so that price appreciation alone provides a competitive return. The first two are called "convenience yield," the latter is a "rational bubble."

"Rational bubbles" are intriguing, but I think fundamentally flawed. If a price goes up forever, eventually the value of bitcoin must exceed all of US wealth, then all of world wealth, then all of interplanetary wealth, then all of the atoms in the universe. The "greater fool" or Ponzi scheme theory must break down at some point, or rely on an irrational belief in the next fool. The rational bubbles theory also does not account for the association of price surges with high volatility and high trading volume.

So, let's think about "convenience yield." Why might someone be willing to hold bitcoins even though their price is above "fundamental value" -- equivalently even though their expected return over a decently long horizon is lower than that of stocks and bonds? Even though we know pretty much for sure that within our lifetimes bitcoin will become worthless? (If you're not sure on that, more later)


Well, dollar bills have the same feature. They don't pay interest, and they don't pay dividends. By holding dollar bills, you are holding an asset whose fundamental value is zero, and whose expected return is demonstrably lower than that of, say, one-year treasuries. One year Treasuries are completely risk free, and over a year will give you about 1.5% more than holding dollar bills. This is a pure arbitrage opportunity, which isn't supposed to happen in financial markets!

It's pretty clear why you still hold some dollar bills, or their equivalent in non-interest-bearing accounts. They are more convenient when you want to buy things. Dollar bills have an obvious "convenience yield" that makes up for the 1.5% loss in financial rate of return.

Also, nobody holds dollar bills for a whole year. You minimize the use of dollar bills by going to fill up at the ATM occasionally. And the higher interest rates are, the less cash you hold and the more frequently you go to the ATM. So, already we have an "overpricing" -- dollars are 1.5% higher priced than treasurys -- that is related to "short-term investors" and lots of trading -- high turnover, with more overpricing when there is more trading and higher turnover -- just like bitcoin. And 1999 tech stocks. And tulip bubbles.

Some of the convenience yield of cash is that it facilitates tax evasion, and allows for illegal voluntary transactions such as drugs and bribes. We can debate if that's good or bad. Lots of economists want to ban cash (and bitcoin) to allow the government more leverage. I'm less enthusiastic about suddenly putting out of work 11 million undocumented immigrants and about half of small businesses. The US tends to pass a lot of aspirational laws that if enforced would bring the economy to a halt. To say nothing of the civil liberties implications if the government can track every cent everyone has ever spent.

But US cash is largely stuffed in Russian mattresses. It is even less obvious that it is in our interest to enforce Russian laws on taxation or Russian control over transactions. Or Chinese, Venezuelan, Cuban, etc. control.

And more so bitcoin. This is the obvious "convenience yield" of bitcoin -- the obvious reason some people are willing to hold bitcoin for some amount of time, even though they may know it's a terrible long-term investment. It certainly facilitates ransomware. It's great for laundering money. And it's great for avoiding capital controls -- getting money out of China, say. As with dollars there is a lot of bad in that, and a lot of good as well. (See Tyler Cowen on some parallel benefits of offshore investing.)

But good or bad is beside the point here. The point here is that there is a perfectly rational demand for bitcoin as it is an excellent way to avoid both the beneficial and destructive attempts of governments to control economic activity and to grab wealth -- even if people holding it know that it's a terrible long-term investment.

On top of this "fundamental" demand, we can add a "speculative" demand. Suppose you know or you think you know that bitcoin will go up some more before its inevitable crash. In order to speculate on bitcoin, you have to buy some bitcoin. I don't know if you can short bitcoin, but if you wanted to you would have to borrow some bitcoin and sell it, and in the process you would have to hold some bitcoin. So, as we also see in high-priced stocks, houses and tulips, high prices come with volatile prices (so there is money to be made on speculation), and large trading volumes. Someone speculating on bitcoin over a week cares little about its fundamental value. Even if you told him or her that bitcoin would crash to zero for sure in three years, that would make essentially no dent in their trading profits, as you can make so much money in a volatile market over a week, if you get on the right side of volatility.

Now to support a high price, you need restricted supply as well as demand. There are only so many bitcoins, as there are only so many gold bars, at least for now.  But that will change. The Achilles' heel of bitcoin's long term value is that there is nothing to stop people from creating bitcoin substitutes -- there are already hundreds of other similar competitors. And there is nothing to stop people from creating private claims to bitcoin -- bitcoin futures -- to satisfy speculative demand. But all that takes time. And none of my demands were from people who want to hold bitcoin for very long.  Ice cream is also a fast-depreciating asset, but people hold it for a while. In this view, however, Bitcoin remains a terrible buy-and-hold asset, especially for an investor who plans to pay taxes.

In sum, what's going on with Bitcoin seems to me like a perfectly "normal" phenomenon. Intersect a convenience yield and speculative demand with a temporarily limited supply, plus temporarily limited supply of substitutes, and limits on short-selling, and you get a price surge. It helps if there is a lot of asymmetric information or opinion to spur trading, and given the shady source of bitcoin demand -- no annual reports on how much the Russian mafia wants to move offshore next week -- that's plausible too.

This view says that price surges only happen with restricted supply, and accompany price volatility, large trading volume, and short holding periods. That's a nice testable link, which seems to hold for bitcoin. And other theories, such as madness of crowds, no not explain that correlation.

Bitcoin is not a very good money. It is a pure fiat money (no backing), whose value comes from limited supply plus these demands. As such it has the huge price fluctuations we see. It's an electronic version of gold, and the price variation should be a warning to economists who long for a return to  gold. My bet is that stable-value cryptocurrencies, offering one dollar per currency unit and low transactions costs, will prosper in the role of money. At least until there is a big inflation or sovereign debt crisis and a stable-value cryptocurrency not linked to government debt emerges.

(This view is set out in more detain in a paper I wrote about the tech stock era,  Stocks as Money in William C. Hunter, George G. Kaufman and Michael Pomerleano, Eds., Asset Price Bubbles Cambridge: MIT Press 2003. Alas not available online, but the link to my last manuscript works.)

Update: Marginal Revolution also on bitcoin today.

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Online Asset Pricing is back!

The online Asset Pricing Ph.D. class is back! It died in a Coursera "upgrade," but it is now migrated over to Canvas.

Click here to go to the online class. My Asset Pricing webpage has links to the class, book, and many other useful materials.

It should be open and free to anyone, including all the quizzes, problem sets and exams.

Since it's on the Canvas system, if you are teaching at a University that uses Canvas, you should be able to integrate it with your class, assign all or part of it, and receive grades from quizzes and problem sets. Thus, you can use it as a flipped classroom, assign selected videos and quizzes in advance of a lecture.

It is also ideal for a Ph. D.  program summer school for year 0 or year 1. Again, through Canvas you should be able to assign the class, in whole or in part, and get grades.

It's also well suited to self-study. If you just want to watch the videos and read the notes, they are all here via youtube links on the Asset Pricing webpage.

Huge thanks to Emily Bembeneck and Allison Kallo at the University of Chicago, Mikhail Proshletsov, and above all to Nina Karnaukh now at Ohio State. Nina masterminded all the hard work of moving the class pages and quizzes from the Coursera system to the Canvas system, and fixing innumerable glitches along the way. Thanks also to the Booth School for paying for the transition.

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Mallaby, the Fed, and technocratic illusions.

One of the frustrations -- or perhaps challenges -- of studying monetary economics and monetary policy is howFed talk and writing on economic mechanisms, causal channels, and effects of policies is far ahead of our actual, scientific knowledge. And writers outside the Fed go leaps and bounds beyond the Fed in advocating strong policies based on the latest stories.

A good example is Sebastian Mallaby, author of "The Man Who Knew: The Life & Times of Alan Greenspan," who wrote last week in the Wall Street Journal Review, that the Fed should surprise us more.

His basic idea: the Fed should monitor asset prices; diagnose when a boom turns in to a bubble; and then actively suppress higher stock prices. And, in addition to interest rates, asset sales, "macro-prudential" regulation (telling banks to stop lending), the Fed should deliberately surprise markets more, adding volatility, in place of central banks' and governments' centuries-old quest (often illusory) to smooth asset prices.

By being less transparent—and reserving the option of deliberately ambushing investors with a shock move—the Fed could discourage them from taking too much risk. 

The painfully learned lesson from the late 1990s and mid-2000s is that excess financial serenity leads to excess risk-taking, which in turn increases the chances of a blowup.

But the equally hard lesson of 2008 hasn’t yet been absorbed: that they [the Fed] should embrace modest, short-term market instability to head off truly disruptive crashes over the horizon. Instead, the calmer markets remain, the prouder the central bankers feel.
Mr. Greenspan and his colleagues faced the danger that the interest rate that would stabilize consumer prices would also destabilize asset prices. The Fed could have escaped this dilemma by acting less predictably. Instead, it telegraphed its intentions and avoided surprises.

Rather breathtaking, no? The last paragraph adds more -- when the Fed wants to lower interest rates to stoke the economy, that causes "bubbles," and the Fed should offset the bubble with deliberate volatility. Hit the gas and the brake at the same time. Greenspan wasn't obscure enough.


What's wrong with "bubbles" anyway? There is one sensible comment,

..when risks seem modest, Wall Street borrows to make bets that look great based on the Sharpe ratio.

Financial crises are always and everywhere about debt. But if Wall Street debt is the problem, just what is the entire Dodd-Frank apparatus to monitor Wall Street debt all about? Really, if Wall Street defaults are the problem, is deliberately inducing volatility to your and my portfolio the answer? Would not a little more capital be a better idea?

Academics do not know exactly how the financial system works. What I as an academic do know, a little more than the average person, is the limits of knowledge - just how much is not known, what the holes are in stories bandied about, and which stories have no basis yet in theory, experience, or evidence. An academic knows that many stories about how the world works are wrong, and we know that many other stories might be possible but have not been written down coherently and evaluated against experience. Knowing what you don't know is knowledge.

It is amazing in that context how much people advocate strong public policy actions -- actions that cost a lot of money, and threaten to put a lot of people in jail -- on stories that are either demonstrably false, or as in this case have no scientific foundation beyond cocktail party speculation, and many glaring logical holes.

For example, it is commonly bandied about, as in this article, that low interest rates induce investors to "reach for yield,'' and create "bubbles'' in asset markets. This is stated as a known, scientific, fact. I know, though it may be true, that this is not yet a known fact. Known facts have to start with a mechanism. Just what is the mechanism? Borrowing at 1% and lending at 3% is exactly the same as borrowing at 5% and lending at 7%. What connection is there between the level of short-term interest rates and the risk premium reflected in the differences between prospective rates of return on different assets?

Well, there are stories about it. Many theory papers have done so in the wake of such speculation. It takes a lot of friction carpentry -- only leveraged intermediaries hold assets, and a lot of nominal illusion or accounting constraints, so that 7-5 is not equal to 3-1. Yes, past booms have involved credit in some way. But most of the time low interest rates correlate with busts, not booms. There are empirical papers,  that seem to show some effects, with all the caveats about empirical work in economics. But none of this elevates it to a known and verified fact, ready for exploitation by policy makers. [I foresee also a swarm of comments opining that yes, low interest rates cause asset booms, thereby missing the point that we shouldn't make policy on such opinion, but rather on well understood causal channels.]

Good policy waits for some sort of scientific evidence. We don't want the government jumping on every food fashion that comes out of the organic farmer's markets of Palo Alto either.

And if the idea that the Fed has the technocratic competence to understand the difference between "boom" and "bubble," the political mandate to determine the correct level of stock prices -- something that affects many voter's pocketbooks! -- and is ready to exactly offset its manipulation of  short term rate by deliberately injecting just enough volatility to hold down prices... Well, I titled the post "technocratic illusions" for a reason.

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More non-voting shares

Tim Kroencke at the University of Basel wrote a nice follow up on non-voting shares (previous posts here and here) , which I share with permission. Some of the controversy was whether companies would issue shares and whether investors would by them. It turns out, yes, and he sends a gorgeous example in which control rights and cash flow rights are priced differently and react to different events:

....

In Germany, it is quite common for large companies to issue voting shares (Stammaktien) and non-voting shares (Vorzugsaktien) and one can make nice case studies. Here is one I did a while ago,  that I have updated today, and I want to share with you:

In 2005, Porsche started to buy Volkswagen shares. In 2008, it became obvious that Porsche tried to overtake Volkswagen and the price of voting shares, and only the voting shares, skyrocked. Volkswagen became the world’s biggest company…  well, for a couple of days.

Some figures to give perspective: first, the share price of non-voting vs voting Volkswagen shares traded in Frankfurt:

The dividend yield:

 And here is how prices and yields add up to total returns:

Some observations:

First, the voting component of a share price can diverge substantially from its cash-flow related value. What is small most of the time does not need to be small all of the time. This should really worry any passive investor who simply wants to earn a factor premium. The typical broad index investor wants to earn the market premium. I really doubt that such an investor wants to be involved in the house of cards of the Wiedekings and Piëchs. There is a reason for hedge fund investors being around.

Second, voting and non-voting shares nicely move together - in the long-run. After all, they pay out a very similar cash-flow stream, as you write and as one would expect if the law is set up in a sensible way.

Third, non-voting shares outperformed the voting shares by roughly 100% over 18 years. This is the long-run picture, difference in cumulated returns come from differences in dividend yields. Cumulated over time, the premium for voting can be quite big!  Sure, this does not have to be the case in general. (For example, in 2011, die dividend yield of voting shares was slightly higher.) After all, we are looking at a failed takeover and this is just an example. However, I think one can safely make the point that non-voting shares are likely to better track the value of the cash-flow value of a company and are indeed well-suited for passive long-run investors.

Comment:

I was initially puzzled by the rate of return difference. If you start and end at the same price, but pay the same dividend, how do you achieve a different return? I think the answer is reinvestment. Dividends paid to the voting shares during the spike are reinvested at a time of terribly high prices, and so lose.

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Non-voting shares response

Todd Henderson and Dorothy Shapiro wrote me a thoughtful response to my post on non-voting shares. Todd and Dorothy:

Response to Cochrane

We are grateful for Cochrane’s thoughtful response to our op-ed in the Wall Street Journal. Space limitations prevent us from giving the necessary treatment to our ideas, but he is right to push us to be careful in our analysis, no matter the limits. We look forward to addressing his concerns and others in a forthcoming article.

In the meantime, here is a quick response to the thrust of Cochrane’s critique.

There is a logical inconsistency in Cochrane’s post—his “modest proposal” would require more legal change to accomplish than ours. (And we are the ones with a vested interest in more law!) For one, it’s not clear that companies would willingly issue non-voting stock in addition to voting stock (and in the right amounts)—this occurs very rarely in practice, if ever.

Second, even if the shares existed, Cochrane assumes that index funds would willingly buy them, although there’s no evidence to suggest that this would occur.

The hostile reaction from large passive institutional investors, including BlackRock and Vanguard, to the Snapchat IPO and other recent dual class stock offerings make it clear that passive funds wouldn’t buy non-voting stock willingly—institutional investors participated in those offerings under protest and have since been advocating for reforms that would prevent future non-voting offerings, even going so far as to lobby Russel FTSE to delist companies that have dual class shares.

It’s also unlikely that non-voting stock would be much cheaper than voting stock—empirical evidence has demonstrated that often, non-voting stock doesn’t trade at any discount to voting stock (such as when there's a controlling shareholder or the company is well run).

Even if passive funds could purchase non-voting shares at a small discount, it’s not obvious that they would have any incentive to do so. Index funds have the sole goal of replicating the performance of an index. Why would they want to get a different product for a lower price? This is especially true when doing so would cause them to give up power and influence over some of the companies that they invest in (for a small benefit that investors are unlikely to recognize).

So, under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them. Talk about a lot of law! (Read: coercion.) Not only would this be a more dramatic change than the one that we propose, it would surely lead to a worse world. As an example, there could be liquidity concerns—if passive funds wanted to sell en masse (as can happen when funds are tracking the same index), there would be no buyers. And, if passive funds instead wanted to buy, there would be no sellers (and in this situation, it's unlikely that the non-voting shares would really trade at a discount).

By contrast, our solution--encouraging (but not requiring) passive funds to abstain from voting—is much less intrusive. Rather than mandating the creation of a new market of non-voting shares, we advocate a voluntary legal change that would permit natural correctives to any corner solution. The concern seems to be that if index funds abstain, too much power will be vested in the hands of activists, not all of whom will be interested in long-term shareholder value. But if index funds are merely encouraged to abstain unless they have no strong interest in the outcome, then there is a natural, market-based corrective to this problem. If activists go overboard, then index funds will have a strong interest, and reenter the voting market at that time. In a sense, Cochrane’s critique is ironic: we are calling for less law. We want law to get out of the way, by letting index funds act naturally—to not vote when they have no interest in doing so, and where they have no comparative advantage in the process. (Our other alternative, a legal duty to vote in an informed matter, and not just blindly follow ISS and other proxy advisors, is a clear second best.)

***

A little response-response clarification:

I do not envision any coercion!  So I  deny "under Cochrane’s proposal, the law would have to not only require companies to issue non-voting shares, it would also need to require index funds to buy them."

Index funds need to wake up and ask for non-voting shares, and then companies will issue them. The funds get a discount and absolution from legal trouble. Or companies need to wake up and offer non-voting shares to index funds. The companies get a new source of financing.

The non-voting shares I have in mind need do need a lot of smart lawyering and contract writing by people like Todd and Dorothy.  I accept the point that current non-voting shares are not as protected as they should be, that the promise ``you get exactly as much money as the voting shares, and you can sue as bondholders do if you don't'' needs teeth.

Indeed, the market is hostile to non-voting shares because current non-voting shares are designed to concentrate control with insiders, not to create a vibrant outside market for corporate control. That's the last thing insiders want, and a reason that companies will be slow to offer such shares unless funds start demanding them.

Sometimes the world hasn't arrived by itself at the optimum, just because nobody thought of it, not because there is a market failure, and not because law has not compelled it. We live in a time of legal and financial innovation, not just gadget innovation.

And index funds not voting aggressively is not a screaming problem that can't take some time to sort out.

(How to start a fight in a libertarian bar -- "You're advocating government intervention! No, you're advocating government intervention! I probably should have left that out of the original, and there is not much need to spend time on it in further discussion. Laws and contracts and courts are all on the menu at the libertarian bar.)

***

Update:

This is a good point. Perhaps we just need some good intermediation/financial engineering for index funds to routinely lend out their shares around votes.

Update 2 here

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Index funds and voting shares

Todd Henderson and Dorothy Shapiro Lund have an interesting OpEd in the Wall Street Journal, "Index funds are great for investors, risky for corporate governance." In brief, index funds don't participate heavily in monitoring companies, finding information about companies, or corporate control contests.

This point echoes larger complaints that with the spread of index funds there won't be enough active money to make markets efficient, and especially to make efficient the market for corporate control. One of the most important functions of a public market is, if you think that a company is mismanaged, you can buy up a lot of shares, vote out the management, and run it better. This is an imperfect system, to be sure, but note how many nonprofits (universities) and privately held companies, immune from this pressure, are run even more inefficiently than public companies.

Todd and Dorothy, law professors, after very nicely reviewing how funds currently deal with voting issues, seem to favor more law.

So how can the law ensure that these institutions make informed decisions about corporate governance? ... The first is to encourage them to rely on third-party corporate governance experts. It may be necessary... for the law to create incentives for institutional investors ...option three: encouraging passive institutional investors to abstain from voting altogether.   

Hmmm. When "the law," not a person or people, is the subject of a sentence, I get cautious. When the law wants "to encourage" people, my hackles rise.  The law "encourages" and "creates incentives" pretty bluntly. One example, though discarded, is a bit chilling,

 This could be accomplished by providing a legal cause of action to shareholders that are harmed by uninformed or conflicted voting decisions. But this would be a blunt tool for curbing abuse. 

Indeed it would.

But this is forgiveable. They are lawyers, so more law is the answer. We are economists, and law a necessary evil when contracts and markets fail. Is there not an economic solution, a Coasean way to slice the knot?

I think so. Companies should issue, and index funds should want to buy, non-voting shares.  Non-voting shares seem to be regarded as a little infamy of internet companies, used to keep control in the hands of founders. But a split between voting and non-voting shares seems ideally suited to a mass of indexing investors, and a few active, information-based traders and active corporate control investors. In this vision, most of those voting shares are in public hands, unlike the internet companies.  In fact, most corporate stock grants and options to insiders should be in the form of non-voting shares.

Non-voting shares are treated exactly the same for all cash flow purposes. They receive the same dividends, same rights in repurchase, same treatment in any reorganization. They just do not allow the right to vote.

Since index funds don't value the option to vote, they should want non-voting shares.


Would such shares trade at a discount? Yes, likely so. And that's a benefit, not a cost, a feature not a bug. Index funds could buy the same cash flow, which is what they want, cheaper, by giving up the value of their votes, which they're not interested in. Buying the same cashflow cheaper gives you a better return.

Todd  and Dorothy actually advocate a form of this idea, that the index funds voluntarily refuse to vote.  But then the index funds pay the cost of an option they do not use. By purchasing non-voting shares they do the same thing, and reap a financial reward.

This separation between voting and non-voting shares would make the market for corporate control more efficient. It is easier for someone who wants to buy the voting rights to buy them from other active investors than from passive mutual funds. It also separates the stock market price into guesses about cash flows and guesses about corporate control events. As a long-term investor I'm interested in the former and less in the latter.

Non-voting shares become a sort of state-contingent long term debt. Rather than guarantee payment by its fixed value, as in debt, payment is guaranteed by its equality with whatever other shareholders are paid, and similar rights in court as debt-holders have to enforce their right to be paid ahead of voting shareholders.

I've asked a few of my corporate finance colleagues about this idea, and their general reaction is that it won't work, because sooner or later the investors with voting shares find ways to screw the non-voting shares out of money, not just out of votes. The ability to vote is the ultimate guarantor of payment.

I'm still not totally convinced.  (I admit I did not follow all of the shenanigans they suggested to accomplish stealing money from voting shares.) If we're bringing in law here, and if we're designing a security, it seems not impossible to create a class of non-voting shares whose equal treatment in all cashflow related events is the same as those of voting shares, and who have strong rights to sue to guarantee those rights. Long-term debt works, after all, as the voting shares don't find a way to escape interest and principal payments. The contract design for that right seems easier than the legal means to "encourage" behavior that Todd and Dorothy imagine.

Update: See Todd and Dororthy's response and more discussion.

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