Calpers

What is CalPERS’s job? There’s actually an answer: it’s to “Provide responsible and efficient stewardship of the System to deliver promised retirement and health benefits, while promoting wellness and retirement security for members and beneficiaries.” I suppose “the System” is defined somewhere, and blah blah blah health benefits and wellness and beneficiaries, but I prefer to stop at the capitalized abstraction: CalPERS provides responsible and efficient stewardship of the System.

“Responsible” and “efficient” can conflict, though:

The second-largest pension fund in the United States is considering a move to an all-passive portfolio while at the same time, the largest brokerage firms are falling over themselves to push passively managed exchange-traded funds. The California Public Employees’ Retirement System’s investment committee started a review of its investment beliefs last week, with the main focus on its active managers ….

CalPERS oversees about $255 billion in assets, more than half of which already is invested in passive strategies. … “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”

So: financial markets exist to allocate capital to its most productive uses.1 One use of capital that may not be all that productive is allocating capital, so it’s understandable that rich sophisticated capital-allocators like CalPERS would allocate less capital to the business of allocating capital. Why spend so much money on external active manager fees when they turn out not to be that good at active management? Just index, right?

But then, of course, if you’re not allocating capital to its most productive uses, who is? I mean, I’m not, obviously. And lots of retail investors aren’t either: the popularity of index funds is based on the very sensible assumptions that (1) not many people can reliably beat the market and (2) those who can tend to sell their services to fancy institutions like CalPERS, not retail schlubs.

Where does that leave you when CalPERS doesn’t want those services either? A thing I’ve occasionally worried about is that, in a world where everyone indexes, nobody’s watching the shop and actually figuring out where the most productive uses of capital are. Quick thought experiment: if literally everyone invested in a market-cap-weighted broad index fund, how would you do the market-cap-weighting? Or anything?

This concern will always seem a little silly as long as there are big rich long-time-horizon institutions with the desire to beat the market and the size to try. But with CalPERS pondering passivity, and with the Yale Model (of un-liquidity-constrained endowments investing heavily in alternatives) losing some of its cachet, it looks a little less silly than it used to. Though: I assume that this means CalPERS is pondering passive for its public equities portfolio, with a healthy dose of private equity and other alternatives alongside. This is not about the death of capital markets as a system for allocating capital. It’s about the death of public equity markets as a system for allocating capital.2

But also, like: CalPERS? CalPERS isn’t just a particularly giant active investor; it’s also a particularly activist one. It’s got a “director of global governance.” It’s got a website of global governance actually:

Welcome to our Global Governance website. We believe good governance leads to better performance. We seek corporate reform to protect our investments. The global governance team challenges companies and the status quo — we vote our proxies, we work closely with regulatory agencies to strengthen our financial markets, and we invest with partners that use governance strategies to earn value for our fund by turning around ailing companies.

So what happens if they move to all-index investing? Do they fire their global governancers? Or do they keep calling up the companies they’ve invested in (viz., the companies in the index, i.e., the companies that exist) and say “hey, if you don’t get rid of your poison pill, we will … well, not sell our stock or anything, I mean after all you’re in the index, but at least keep calling you to complain”? If there’s no exit, is there any voice?

In one sense it’s a very strange result: CalPERS might end up spending no time or money at all choosing what companies to invest in, while spending substantial time and money telling those companies what corporate governance provisions to adopt. From a bang-for-the-buck perspective that seems perverse, and it’s also troublingly one-size-fits-all: if CalPERS invests in every company, it will lobby for every company to have CalPERS-approved governance practices. I like the idea of a world with a diversity of share ownership structures, where some companies have “good governance” to appeal to the CalPERSes of the world, while others hang on to their high-vote stock or poison pill or whatever even if it costs them CalPERS money.3

On the other hand: if indexed, or at least broadly diversified, investing is the normal way of investing now, then I guess it makes sense for the noisiest investor voice to be an indexed voice.4 If the typical investor owns a more or less market-cap-weighted slice of the entire market, then she doesn’t want companies to do things that maximize their own value at the expense of other companies.5 She wants companies to do things that maximize the value of the market as a whole. Someone’s got to look out for the System. Seems like it’ll be CalPERS.

Passive investing: If it’s good enough for CalPERS … [Investment News]

CalPERS committee rethinking active management [P&I]

[Update: related, The supply and demand for (belief in) EMH, by Nick Rowe (via Twitter)]

1. This is a fun interview with Cathy O’Neil, former D.E. Shaw quant, current Mathbabe blogger, and Occupy Wall Street Alternative Banking Group organizer:

[O'Neil] So, when you first go to a hedge fund, you might suspect–if you are really naive–that a hedge fund is actually supposed to find the correct price for the market. That we actually provide a service, and the reason we make so much money is that we are providing a service and of course we should make money if we are doing something good. Or, we’re helping–another thing that you hear is we’re helping–it’s usually some of the same things–we’re helping money where it should go.

[Interviewer] Allocate capital to its highest use.

[O'Neil] Yeah. Thanks. I spent four years in finance altogether. In the two years I spent at the hedge fund I don’t think I ever heard someone say: Let’s allocate this capital better. It was all about: let’s anticipate what dumb people are going to do so that we can make money off of them. And there was this dichotomy, like dumb versus smart money. We’re smart money; they’re dumb money. We are so smart that we deserve their money. It was essentially kind of an entitlement. And it was really unattractive to me. I spent a lot of time at lunch trying to understand the mindset of, like, how does being good at math give us the right to do this?

So that’s not entirely fair? Like, read your Hayek. Still. The invisible hand works in mysterious ways, and is a dick.

2. I suppose it’s just a coincidence that CalPERS, the benchmark defined-benefit-pension-plan investor, is considering getting out of the, like, investing business at the same time that Carlyle is offering private equity funds, with 3.7-and-20 fees, to retail investors in their 401(k)s. I blithely hypothesize that in twenty years all the giant institutions will be in index funds and all the retail money will be in “alternatives.” That will end well.

3. I guess in an indexed-CalPERS world, it wouldn’t really cost them CalPERS’s money. Just its, like, votes at the shareholder meeting or whatever.

4. Here I link to The Shareholder Value Myth  without necessarily a blanket endorsement. But yeah the notion that the representative shareholder of Company X wants to maximize the value of Company X is sort of suspect in the age of indexing.

5. “This merger is underpriced, but whatever, go ahead, I own the acquirer too.”

The Chanos Sotheby's Indicator flashes a warning

Last week, hedge fund manager Jim Chanos appeared on CNBC and pointed to the price action of Sotheby's as a warning of an overheated market (emphasis added):

Closely watched hedge fund manager Jim Chanos says he has the best barometer for gauging where 1 percenters are putting their money, given the Federal Reserve's easy money policies that have been fueling their portfolios to record highs. During an interview Thursday on CNBC's "Squawk Box," he pointed to the stock chart of Sotheby's.

"That's what people are buying," Chanos said.

The chart shows that shares of Sotheby's have peaked before every major financial bubble since 1987, starting with the leveraged-buyout spree that fueled the stock market before the Black Monday crash that year.

As the price of Sotheby's (BID) appeared to have peaked, Chanos' comment was an intriguing observation. But how good is this Sotheby's Indicator? Just for fun, I charted the BID against SPX. True enough, BID (in purple below) generally peaked out before the stock market (in black) did, but the lags were uncertain. While BID appears to be rolling over now, the mildness of the pullback of BID may not necessarily constitute a definitive sell signal for the equity market.

As an alternative, the BID/SPX ratio worked well in the post-NASDAQ peak period as timing indicator. As well, the decline from the most recent peak is more pronounced. However, the ratio was in decline for much of the late 1990`s during the Tech Bubble and thus made it a poor standalone market timing model.

I did find a better fit by de-trending  the BID/SPX ratio by comparing it to its own 1 year moving average. As the chart below shows (SPX in black, left scale, de-trended BID/SPX ratio in blue, right scale), whenever the BID/SPX ratio was above its long-term moving average and then fell below its 1 year moving average, it usually marked a significant top in the stock market.

(click chart to enlarge)

In the chart, the dates of the BID/SPX ratio peaks are shown in red while the dates of the subsequent SPX peaks are shown in black. Peaks in the de-trended BID/SPX ratio led the actual market peak by between 0 months (1990) to 11 months (2000).

What about Chano's warning on CNBC last week?

My modified Sotheby's Indicator peaked out in October 2013, though the highs it reached was not as high as levels seen in previous significant market peaks. However, the chart shows that this indicator is not very useful as a tactical timing model as the lags between the peaks in the Sotheby's Indicator are uncertain. Nevertheless, it does provide a warning of the investment environment.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.” 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

French economist Thomas Piketty’s new book Capital in the Twenty-First Century is getting him compared to Alexis de Tocqueville by his admirers and to Karl Marx by his right-wing detractors. But he doesn’t suffer from the German economist’s disapproval of popular entertainment. Rather than seeing pop culture as a mechanism enforcing capitalist ideology, Piketty’s book uses cultural references to explain capitalism’s flaws.

+

The book’s central point is that in capitalist economies, wealth naturally concentrates in the hands of a few. Why? Because the return on capital investments typically exceeds economic growth. As he writes, “novelists depicted the effects of inequality with a verisimilitude and evocative power that neither statistical or theoretical analysis can match.”

Among many things I learned reading Piketty’s book was how to understand the class dynamics of 19th century literature. The characters are always talking about their incomes, but never seem to be doing any work. Turns out that “in the novels of Jane Austen and Honoré de Balzac, the fact that land (like government bonds) yields roughly 5 percent of the amount of capital invested is so taken for granted that it often goes unmentioned. Contemporary readers were well aware that it took capital on the order of 1 million francs to produce an annual rent of 50,000 francs.”

One reason that they could be so certain about these numbers is because inflation wasn’t really part of the picture. Monetary stability lasted from the 18th century through World War I, when massive government borrowing combined with massive physical destruction to upend economic affairs. That’s the reason, Piketty says, that novelists aren’t specific about money any more: He cites the Turkish author Orhan Pamuk, whose novelist protagonist in Snow says “there is nothing more tiresome for a novelist than to speak about money or discuss last year’s prices and incomes.”

The Balzac novel that Piketty draws on most is the tale of an entrepreneur who makes a fortune in the lucrative pasta business in revolutionary France, before cashing out—”much in the manner of a twenty-first-century startup founder exercising his stock options”—to invest his wealth and give his daughters a substantial enough inheritance that they can marry well.

Was this obsession with inherited wealth just a byproduct of writerly envy from from Balzac, who was perpetually in debt from failed business ventures? Not necessarily—Piketty’s data shows that inherited wealth was about 20% of national income in the France of that time. This created a nasty situation where it was impossible to work enough to match what one could earn with inheritance. InLe Père Goriot, this is made explicit through an ambitious young man, Rastignac, who comes to understand that no matter how long he works as a lawyer, he will never have the fortune he could gain by marrying a wealthy heiress.

+

What does that mean in practice? A society where the main standard of success is earning 20, 50, or even 100 times the average annual income. Similar standards are found in the pages of Britain’s Jane Austen, but also in the US: In Henry James’s 1880 novel Washington Square, a key plot point revolves around an engagement broken off when the dowry is only 20 times the average income, rather than 60. “It was perfectly obvious,” Piketty writes, “that without a fortune it was impossible to live a dignified life.”

+

The 1970 Disney film about class warfare and cats, set in 1910 France, is used to illustrate the results of Piketty’s fundamental law of capitalism. As the return on investment continues to exceed economic growth, the rich keep getting richer:

+

    The size of the old’s lady’s fortune is not mentioned, but to judge by the splendor of her residence and by the zeal of her butler Edgar to get rid of Duchesse and her three kittens, it must have been considerable. The Aristocats calls attention to the problem: Adelaïde de Bonnefamille obviously enjoys a handsome income, which she lavishes on piano lessons and painting classes for [cats] Duchesse, Mari, Toulouse, and Berlioz, who are somewhat bored by it all. This kind of behavior explains quite well the rising concentration of wealth in France, and particularly in Paris, in the Belle Époque: the largest fortunes increasingly belonged to the elderly, who saved a large fraction of their capital income, so that their capital grew significantly faster than the economy.

    +

At that time, Piketty notes, the top 1% in Paris had over 70% of the wealth, despite the the French revolution, just over a century before, that up-ended the aristocracy and created more progressive laws. Only the shock of World War I would halt the progress of capital.

+

House and the temporary end of rentiers

Modern pop culture tends to portray America as a meritocracy, where people with special skills do well. Piketty illustrates this by turning to American television, citing the medical mystery-solving of House, the forensic investigators of Bones, and the brainy politicos of West Wing, with a president who has won the economics Nobel. Inheritors of fortunes, by contrast, are generally portrayed as selfish, greedy and debauched in Damages and Dirty Sexy Money. (Not that this depiction of capitalism is new: Piketty notes that Tolstoy’s Ibiscus, where a thief steals a fortune and prospers, shows that “the arbitrary return on capital can easily perpetuate the initial crime.”)

+

This meritocratic pop culture is behind the times, Piketty argues. The mid-century cataclysms, starting with World War I, made it possible for labor to gain a brief advantage over capital. If you were born between 1890 and 1970, your chances of gaining a higher standard of living were more likely to come from being a successful labor earner than an inheritor. But as decades of relative peace and globalization allowed capital to continue accumulating, Piketty’s law—that wealth tends to concentrate—has re-asserted itself. Today, he says, the economy is somewhere between Balzac and West Wing, but it’s moving in a distinctly 19th-century direction, toward a world of small rentiers. What was true for Goriot is also true for Steve Jobs: “Entrepreneurs turn into rentiers.”

+

Ok, here’s one chart

Living-standards-in-France-by-birth-cohort-as-multiple-of-the-average-income-Top-1-inheritors-Top-1-labor-earners_chartbuilder (1)

In 19th-century France, the top 1% of inheritors lived more than 25 times as well as the average laborer, while the top workers could earn perhaps 10 times as much. In the middle of the 20th century, that situation was reversed, but already inheritors are starting to gain again. Data from Germany and the United Kingdom show a similar trend, but there aren’t enough public data about US inheritance patterns to check against the US. Piketty notes, however, that estimates of inherited wealth show it plays a similarly important role in the economy.

 

The US has a unique spot in Piketty’s narrative because it began from a more egalitarian state: Land was cheap in the 19th century, immigrants were prevalent, and population growth was a real thing. Colonialism, too, largely passed the US by, and its investments abroad were largely matched by investment at home—Piketty turns to Mad Men, where a US ad agency is bought by a British competitor, for an example.

But the US did have slavery far longer than its European counterparts; at the turn of the 19th century, enslaved humans in the US were thought to be worth one and a half years of national income. The American original sin was also a manifestation of inequality, and Piketty notes, with a nod to Quentin Tarantino’s slavery revenge epic Django Unchained, that the arbitrary treatment of slaves led to wide variations in prices.

By the 20th century, the differences between Europe and the US were less pronounced. Piketty notes that in James Cameron’s film Titanic, set in 1912, wealthy Americans on the doomed ship are portrayed in the same way—prosperous and arrogant—as their European counterparts. And unlike in Europe, the shocks of World War I and II were not felt as deeply in the US. Today, the wealthiest Americans get most of their income from capital.

On to Utopia?

Piketty’s cultural references tend to illustrate things that have already happened: societies harshly stratified by wealth, with little mobility. There’s not much literature to depict his solution: Increased taxation of wealth across the globe, to protect democracy from rentiers. He calls it a “useful utopia” because he recognizes both the need to take it seriously and how hard it is to implement. Its potential, for now, is in the hands of science-fiction writers—but they’re at least as likely to be concerned with dystopia these days.