Elliott Management’s Paul Singer is worried about the structure of financial markets. In Paul Singer’s second quarter letter to Elliot investors, a copy of which has been reviewed by VallueWalk, the billionaire contemplates how markets today are now ruled by central banks, after years of ultra-easy monetary policy.
These policies have resulted in the Swiss National Bank owning global stocks with a market value equal to 23% of the GDP of Switzerland and the Japanese central bank being a top-ten shareholder in 90% of Japanese companies.
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Central banks controlling such a large percentage of equity markets is unprecedented, “nobody knows what this pattern means, and nobody has seen anything like it. It is not capitalism. It is not communism” Singer opines. Nor does this ownership structure “resemble anything that people have contemplated when thinking about markets, the virtues of private ownership of the means of production, and the prospects of growth and prosperity for masses of citizens.”
And it’s not just central bank equity ownership that’s causing underlying issues.
Paul Singer's second quarter letter on "the passive blob"
Almost $500 billion flowed from active to passive funds in the first half of 2017 as the exodus from actively managed funds accelerated. During 2016 passive funds grew 4.5 times faster than active funds with passive assets under management expanding 18% to $6.7 trillion, more than double the growth rate of 8% experienced for 2015.
Singer argues in his letter that the rapid rise of passive investing is “in danger of devouring capitalism” as owners of index products “have no real interest in the business performance of the underlying portfolio companies, and little or no knowledge or appreciation of what those companies actually do for a living, or how well they do it or could do it.” ETFs and tracker funds automatically invest in stocks or bonds within an index, which is perfect for the average investor who is looking for a low-cost way to match the market, something many high cost active managers have failed to do. However, this approach does not disqualify between good and bad companies, and as assets flow into passive trackers, all of the rubbish is being lifted by the rising tide. As Paul Singer's second quarter letter puts it, “think about all those companies that actually lose money and would never be brought in close to the same volumes if they were not in the Index Products.”
What’s potentially more damaging is that the demand for passive trackers is clustering assets in the market’s largest companies. Low-cost ETFs need to achieve scale to be profitable and the only way to do so is to invest in the most liquid large-cap stocks. So, small companies, that may be more deserving of growth capital, are neglected.
Paul Singer's second quarter letter says the trends become self-reinforcing
The biggest problem of all with the passive/active argument is that as more and more investors turn to passive, the above trends become self-reinforcing because “they cause the assets in the index products to outperform those that are not in those products, thus confirming the theory in the minds of both adherents and frustrated non-believers” Singer notes.
Within the letter, Singer goes on to question whether passive investing “is even investing at all.” Investing in a public company means being part owner of a business, examining financial documents and trying to figure out the company's prospects. On the other hand, passive investing is a “delegation of authority to a small team of unaccountable staff at S&P or Morgan Stanley or another entity which creates and tweaks indices and Index Products,” something that does not sound much like investing at all.
The billionaire goes on to lament the declining level of accountability at the management level for companies. Even though passive investment outfits may argue that they have large corporate governance departments to make sure shareholders are well represented, Singer claims that these actions have done little to improve management accountability on “a company-specific level where "investing" is done”. With hundreds of thousands of companies to be evaluated “we venture that it is impossible to do a comprehensive look at all (or even most) of the situations that deserve scrutiny.” As a result, in the passive investing world “small shareholders have little-to-no voice and no realistic possibility of banding together” while the biggest shareholders have “no (repeat, no) skin in the game”.
This might seem like an all out attack on passive investing, but Singer is careful to note that passive assets can be a helpful part of portfolio construction. However, as passive takes over it has “grown into a blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism.”