Index Standards and Listing Standards

(Bloomberg View) -- Indexes and governance.

What stocks can you invest in? You can go buy the stocks listed on the New York Stock Exchange or the Nasdaq. We live in a global economy so you can buy the stocks listed on the London Stock Exchange or the Nigerian Stock Exchange. Listing is not a prerequisite, though; you can buy public stocks that aren't listed anywhere and trade over the counter on the "pink sheets." And even being public is not necessarily a requirement: In the U.S., exemptions to the registration requirements allow people to buy stock in private companies if they are "accredited investors" (basically: have a lot of money) or if the stock offering is small enough. If Uber Technologies Inc., or your local hardware store, or your favorite podcast, wants to raise money, and you have money, you might be able to work out a deal.

What stocks can big institutional investors invest in? Well, in the broadest sense, at least as many stocks as you can. U.S. listed stocks and foreign listed stocks and over-the-counter stocks and private stocks (big institutions are normally "accredited") and whatever. In practice, lots of institutions have restrictions on what they can buy, sometimes imposed by law but often imposed by their own charters or rules or advertising. If you run a U.S. technology mutual fund you might find yourself dabbling in private-company stock offerings, or you might not -- you might have rules against buying private-company shares -- but in any case you are unlikely to spend a lot of time on the Nigerian Stock Exchange.

What stocks can index funds invest in? The stocks in the index that they track.

The rising popularity of indexing sometimes makes it easy to conflate "the index" with "the market." If you buy a Standard & Poor's 500 index fund, you are generally doing that not because you have a carefully considered view that the companies in the S&P 500 index will outperform other companies, but because you want to invest passively -- just buy all the stocks and not worry about picking between them -- and buying an index fund is the way to do that. With broad indexes that is a reasonable assumption: If you invest in a CRSP US Total Market Index fund or a Russell 3000 Index fund, you really are getting the large bulk of publicly traded U.S. stocks. Of course you are not getting Uber, or your local hardware store, or your favorite podcast, or any U.K. or Nigerian stocks, or any bonds or gold or Bitcoins for that matter, in that portfolio. But it is passive enough; you are making the active decision to allocate some of your money to publicly traded U.S. stocks, and then refusing, as much as possible, to make any further decisions within that allocation. Just put the money in all those stocks.

Even so, index providers and index funds are making some decisions for you about exactly which stocks you will invest in. But they are not the only ones. A broad index might include only stocks listed on U.S. stock exchanges, which means that the stock exchanges are making some decisions for you: If they decline to list certain companies, even companies that want to be or are public, then your index fund won't buy them. Similarly if securities regulators won't allow companies that do certain things to go public, then your index fund won't buy companies that do those things.

Here is an interesting letter from BlacRock Inc. to MSCI, Inc., about what companies should be included in indexes. As we've discussed before, Snap Inc. went public last year by issuing non-voting shares, which created a backlash that led to several index providers announcing that they would stop including companies with dual-class shares in some of their indexes. MSCI is another index provider that considered doing that, but it asked its customers for their opinion, and BlackRock's opinion is that it mostly shouldn't:

In our view, broad market indexes should be as expansive and diverse as the underlying industries and economies whose performance they seek to capture. In constructing indexes, index providers should make every effort to reflect the investable marketplace in the broad benchmark indexes that they produce.

Instead, BlackRock proposes that MSCI offer both "(i) broad market indexes that reflect the investable universe and (ii) indexes that have alternative weightings or screen companies based on governance principles, similar to index offerings with tobacco or social screens." And while it opposes permanent dual-class shares, it thinks that someone else should stop them:

We believe that regulators in conjunction with listing exchanges should be the arbiters of corporate governance standards for publicly listed companies. Ideally, exchanges would limit the use of dual share class structures and market regulators would mandate minimum listing standards. However, we recognize that competitive pressures may discourage these stakeholders from imposing standards that would create an uneven playing field across jurisdictions. In fact, we are concerned that the current system will lead to a race to the bottom as exchanges compete for listings by lowering their standards for corporate governance. In light of this collective action problem, a global agreement is necessary to establish minimum corporate governance standards that would ensure a minimum level of investor protection.

In some ways that is an odd thing to say. There is an established mechanism to overcome the collective-action problem on governance standards. We saw that mechanism work in the backlash to Snap. The mechanism is the index providers. The index providers aggregate feedback from investors and then decide what companies get to be in indexes and, thus, get all the index-fund money. It may not be the ideal mechanism -- BlackRock proposes "a global body such as IOSCO" -- but it's the one that does something.

Still you can see BlackRock's point. The index providers' rules are important -- a lot of money follows their rules -- but they are not binding on companies. Companies can go public, and be quite big, without courting index-fund investors. And if BlackRock wants its broad index funds to invest in "the investable marketplace," then it has to invest in those companies too.

On the other hand it is only approximately true that listing standards are binding on companies. Even if every stock exchange in the world got together and said "no dual-class stock," that wouldn't prevent companies from issuing dual-class stock. It would just prevent them from issuing dual-class stock and listing on a stock exchange. In practice they wouldn't be able to go public with dual-class stock. But going public is no longer a prerequisite for raising a lot of money and being a big company and living a perfectly happy corporate life. Uber can raise as much money as it wants, often from mutual funds and asset managers and, um, BlackRock. Equating "the investable marketplace" with "publicly listed companies" is not entirely correct, even for BlackRock.

And it is becoming less correct. One irony here is that the power of index providers to police the investable universe has increased as that of stock exchanges has decreased. You no longer really need to go public to be "investable," in the sense of being able to raise a lot of money from institutional investors. But if you are going to go public -- to target a somewhat broader class of institutional (and retail) investors -- then you might as well be in the indexes, since they're where so much of the money is.

Elsewhere in gatekeepers.

Here is Felix Salmon on "Silicon Valley's Latest Revolution: Cutting Out Wall Street." The point is that things like Spotify's non-IPO IPO, Uber's ability to do a syndicated loan without banks, and the rise of private financing and initial coin offerings generally, all make traditional finance less relevant to the tech industry. But:

This is one disruption that hasn’t scaled beyond the tech industry. Why didn’t Google’s Dutch auction IPO method take off? And why is it almost certain that, outside the technology sector, we’re going to see very few Spotify-style direct listings, Uber-style bankless loans, or Telegram-style ICOs? The answer lies in the balance of power. Large companies simply can’t function without a broad array of financial services, provided by highly professional relationship managers at each of the big Wall Street firms. 

There might be another aspect to this. Traditionally the role of banks in underwriting securities offerings and syndicating loans is not just to get all the mechanical processes right; it is also, to some extent, to vouch for the company. When Amalgamated Widgets Inc. first goes public, you don't know anything about it, and you have no reason to buy its stock. But if Morgan Stanley takes it public, and Morgan Stanley bankers conduct due diligence on it and write the prospectus, and a Morgan Stanley research analyst writes a report about it, and a Morgan Stanley salesperson calls you up and asks you to buy the stock, then you might say "oh well Morgan Stanley, fine, I will buy this Amalgamated Whatever thing." This basic certification and credentialing function is traditionally important in initial public offerings. It is totally essential in bank lending. You don't go lending money to widget companies. You put your money in a deposit at a bank, and the bank lends it to widget companies, and you never even think about the widget companies. 

One obvious part of what tech companies have accomplished is that they have become more famous than the banks, often without bothering to go public. Spotify didn't need the seal of approval of a bank to go public (though it got a few anyway), because it is Spotify. Uber didn't need to go public at all to raise money, because it is Uber. 

Another part of it, though, is that the credentialing function of banks has fallen into some suspicion. Part of this is that it has genuinely become less important: Investment banking is more transactional than it used to be, research is less important, profitability standards for initial public offerings have diminished, and there is generally less of a sense, even at the banks, that the banks are vouching for the companies that they take public. (Similarly in lending, banks now do less long-term relationship-based lending where they make a whole loan and hold it to maturity, and a lot more syndication of loans to outside investors.) Part of it is, you know, financial crisis, distrust of banks, etc. etc. etc. Surely initial coin offerings are so popular in part because they cut out the banks, and the sorts of people who use their Bitcoins to invest in ICOs are the sorts of people who were disinclined to trust banks to begin with. 

Residual claims.

There's a widespread theory that the shareholders of a company are its "owners," and that the managers and employees of the company have a fiduciary duty to those shareholders to maximize their profits and share price. This is ... I think not quite an accurate view of what a company is, but it is often a useful shorthand. On the other hand, it is often useful to think of financial-services companies as Marxist collectives run for the benefit of their workers. Sometimes this is just legally true: Several important proprietary-trading firms and banking boutiques really are owned by and run for their workers, several prominent hedge funds now run mostly their managers' money, and many other hedge-fund firms are owned by their workers even if they also manage outside money. But even in the case of publicly-traded banks and private-equity firms, it is not completely apparent that the outside shareholders are the residual claimants on the company's cash flows. In good years, the workers get paid a lot; in bad years, the shareholders absorb a lot of the loss; and the employees and managers are more or less the ones making the decisions about how to allocate the gains. From first principles it would not be obvious that those firms are "owned" by their outside shareholders.

Anyway in completely other news I was tickled by this story:

“Financial services, particularly post the global crisis, had been seen to bathe itself in dishonor,” says Audette Exel, a former lawyer and banking executive in Sydney. “Many great bankers and financial-services professionals—people of great integrity—had huge concerns about that.”

Exel operates an unusual consulting company that capitalizes on that anxiety. Called Adara Partners and based in New South Wales, Australia, it’s staffed by people with day jobs at the likes of Goldman Sachs, UBS, and Deutsche Bank who contribute their time on a pro bono basis. One-hundred percent of the advisory fees paid by Adara’s clients flow into Adara Development, Exel’s charity, which she started way back in 1998 to help people living in poverty. The consultants get the benefit of good karma, while Adara gets a steady source of income.

It's a financial-services firm run not for the benefit of shareholders, and not even for the benefit of workers (who don't get paid), but for the benefit of charity. It does consulting for companies and sends out bills and collects revenue, but then that revenue just gets spent on charitable projects rather than bonuses or dividends. Most of what you read about the financial-services industry is about how to align the (financial) incentives of workers with whoever's interests (shareholders, depositors, customers, society) you want to align them with. It is fascinating to think about a financial-services firm with no financial incentives at all

Investing across the capital structure.

Speaking of residual owners, you have to admire Eddie Lampert's approach to owning Sears Holdings Corp., which he owns in as many ways as possible:

In addition to serving as Sears’s chairman and CEO, he is the company’s largest investor and among its biggest lenders. He is also chairman of, and a major investor in, Seritage, which ranks among Sears’s biggest landlords.

And now he is "proposing that his hedge fund purchase the Kenmore appliance brand and other Sears units after the struggling company was unable to find other buyers," and also offering to buy more real estate. How would you diagram his incentives? If Sears somehow turns around and becomes a wild success, he'll do well as a shareholder. If Sears muddles along fine, he'll do fine as a lender and landlord. If Sears falls apart, he'll pick up a lot of the pieces as a lender and landlord and now, perhaps, owner of a lot of the pieces. Each time he does a trade like this there is some effort to manage the local conflicts of interest ("Mr. Lampert wrote that he and ESL President Kunal Kamlani, who is also a Sears director, would recuse themselves from the board’s deliberations" about the Kenmore sale), and he may well be offering the best deal that the company is going to get for its loans, asset sales, etc., but still the accumulation of these deals seems like a broader conflict. Ideally a board of directors would prefer for its CEO's incentives to be aligned with those of shareholders. You don't want the CEO's incentives pointing in every possible direction.

Wagging the VIX.

Here is a post from the Bank of England's Bank Underground blog called "Is the tail wagging the dog? The impact of VIX exchange traded products on equity volatility" that points out that exchange-traded products betting for or against volatility both magnify the effect of volatility:

When volatility spikes, issuers of leveraged VIX ETPs have to rebalance at the end of the day by buying large amounts of VIX futures.  Perhaps somewhat counterintuitively, rebalancing flows are procyclical regardless of whether the ETP benefits from rising or falling volatility – issuers of both types of ETPs have to rebalance in a way which amplifies initial moves in volatility. 

VIX exchange-traded products are either long or short VIX futures. When VIX futures go up -- when volatility expectations increase -- then levered long VIX ETPs make money and need to buy more VIX futures to remain properly levered; meanwhile short VIX ETPs lose money and need to reduce their short-VIX exposure by buying back futures. (We talked about how this works for short products back in February.) So both sides are buying VIX futures as they go up, which pushes them up further. And vice versa when futures go down. So the existence of VIX exchange-traded products makes the VIX -- the measure of volatility -- more volatile.

Though they also work the other way:

But in addition to making spikes in volatility sharper, VIX ETPs also have the potential to make them shorter-lived.  When volatility spikes, holders of VIX ETPs positioning for higher volatility need to quickly sell their ETP holdings in order to realise a profit.  This is because volatility spikes tend not to persist and eventually volatility falls back down to around previous averages, which erodes the profit.  At the same time, a spike in volatility tends to be seen as an opportunity to initiate trades positioning for lower volatility.  Together, these flows put downward pressure on the price of VIX futures in the days following the volatility spike.

The bank also says, though:

That said, according to the Bank’s contacts, developments in VIX ETPs tend not to spill over to the S&P 500 – or that the VIX ETP “tail” does not wag the S&P 500 “dog”.  Unlike VIX futures, there is no mechanical link between hedging flows linked to VIX ETPs and equity prices.  The universe of VIX ETPs is also relatively small.

Well, I dunno, I feel like there is a bit of a mechanical link, which is long and attenuated but still worth describing:

  1. VIX exchange-traded products buy VIX futures when the VIX goes up.
  2. Sellers of VIX futures who want to hedge do so by buying the VIX, that is, buying the underlying options on the S&P 500, further pushing up the VIX.
  3. Sellers of S&P 500 options who want to hedge do so by buying or selling the S&P 500 (that is, buying or selling S&P 500 futures, say). The way they do this is determined by option pricing formulas, but more or less what happens is that sellers of S&P 500 call options buy some of the futures underlying those options, and then buy more if the S&P 500 goes up and sell some if the S&P 500 goes down; sellers of S&P 500 put options sell some of the underlying futures, and then buy some back if it goes up and sell some more if it goes down. So the sellers of options on the S&P are buying the S&P as it goes up and selling it as it goes down, much as the levered VIX ETPs are buying VIX futures as they go up and selling them as they go down.
  4. Sellers of S&P 500 futures who want to hedge do so by buying the underlying shares of companies in the S&P 500.
  5. Etc.

You shouldn't overestimate this. ("The universe of VIX ETPs is also relatively small," points out the bank.) But the point is that bets -- even weird levered funky technical-driven exchange-traded-product bets -- that volatility will go up can go propagate back into the world and cause volatility to go up. And why not? Betting that a stock will go up makes it go up; there's an intuitive sense in which betting that volatility will go up should make it go up. The weirder part is that betting that volatility will go down can have the same result.


"Jeff Gundlach Wore A Purple Corduroy Suit To This Year’s Sohn Conference…And Thus Concludes Our Coverage Of This Year’s Sohn Conference," is the Dealbreaker headline, and you know what? That is a good amount of Sohn Conference coverage.

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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

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