Market Mutations

I recently described markets as biology not physics in recognition of how players adapt. Let’s discover 2 more opaque examples and their causes.

1) Structured products

Historically your bank would happily sell you an investment note which guarantees your principle (insofar as you are ok with your bank’s credit risk) and earns you a return which is linked to return of an equity index. To manufacture this investment product the bank would invest in bonds and a portion of the interest income would be directed to buy call options on the index. There are more shortcuts they use to create the product (for example, the investor typically doesn’t capture the dividends which are a significant portion of the expected return), but the important thing to understand is these notes require enough interest income to finance the call options. With interest rates near zero in most of the world, banks have had to get more…creative.

To keep these notes promising attractive rates of return, the issuers buy insurance against a sell-off from the investors. Not explicitly of course. Instead they embed a feature that “knocks” your note out and exposes you to the losses if the reference index falls far enough. Yes, the prospectus spells this out. But for whatever reason, retail investors fail to wonder why an investment product can offer seemingly attractive returns in a low risk-free rate environment. They continue to gobble them up, not realizing they are self-financing these returns by underwriting catastrophic risk.

Here’s where it gets interesting. Since interest rates have never been this low and the aging developed nations have never been this large, there is unprecedented demand for these notes. These products are intensely popular in Asia and Europe (a friend once quipped you could buy them at a 7-11 in Italy. I want to believe this because it sounds so ridiculous so I refuse to fact-check it). The issuing banks, who are not in the business of taking directional or outright volatility risk, must recycle the optionality that these notes spit off. The associated option flows from these popular products are correspondingly massive.

From a “market is biology” perspective, it’s useful to remember that anybody using historical data to make their case may not be fully appreciating that our current landscape includes a bunch of dormant, non-linear payoffs that kick in only when the market has already made a large down move. An extreme analogy would be like comparing NFL wide receivers through time without noticing that they got rid of pass interference rules.

Although the bulk of these notes have historically been tied to Asian indices like Korea, they are becoming increasingly linked to the SP500. Will the tail wag the dog? Let options fund manager Benn Eifert explain on his latest appearance on the Bloomberg Odd Lots episode titled How To Create Havoc In The U.S. Options Market. (Link)

2) How corporate governance responds to the age of passive indexing
Consider these points taken from Farnum Street Investment’s latest letter. (Link)

• In 1965, the CEO-to-worker pay ratio was 20-to-1. By 2018, it had jumped to 278-to-1. How did pay structures get so lopsided? Shouldn’t someone have stepped in? Yes, someone should have stepped in: the owners of the companies. But if you’re a passive index holder, you abdicated that responsibility to Vanguard, Blackrock, State Street or Fidelity. It wasn’t a custodian like Vanguard’s job to mind the henhouse. It was the job of the owners of the company.

Hard Truth: If you own an index fund, you waive your right to complain about CEO compensation.

• In 2019, Lyft went public. With the increased transparency of SEC filing, it was discovered the company had 46 million restricted stock units (RSU) outstanding. RSUs are a way to incentivize employees, but they can become a big bill for owners. In the case of Lyft, the RSUs would cost owners $2-4 billion, depending on the IPO price. This represented a 20-25% ownership stake of the company being granted to employees. Corporations who grant extravagant stock options do so at the expense of the owners. There are no free lunches.

Hard Truth: If you own an index fund, you waive your right to complain about option dilution.

• From 2008-2017, the pharmaceutical giant Merck distributed 133% of profits back to shareholders via dividends and share buybacks. Yes, they paid out more than they took in. Those resources could have gone toward research, saving lives, and the next blockbuster drug. The strategy seems obviously shortsighted. How come no one stepped up to tell them to think long term? Analysis initiated by SEC Commissioner Robert Jackson Jr. revealed that in the eight days following a buyback announcement, executives on average sold five times as much stock as they had on an ordinary day. Management is effectively cashing out at the owners’ expense when they know the price will be supported by internal buybacks. How come no one is stopping them?

Hard Truth: If you own an index fund, you waive the right to complain about myopic corporate strategy and share buybacks.

• Sir Winston Churchill once said, “Capitalism is the worst economic system, except for all the others.” That remains true, but proper capitalism requires thoughtful stewards, meritocratic outcomes, and engaged owners. If we all abdicate our responsibilities, we risk perversion of the system that’s created more positive effects for humanity than arguably any other single phenomenon. Hope is not lost as history tends to move in cycles. We’re in need of the pendulum to change direction.

Hard Truth: This too shall pass.

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