Money Stuff: You Can Relax Once You’re in the Index

Money Stuff

Programming note: Money Stuff will be off tomorrow, back on Thursday.

Should index funds be illegal?

We talked last week about a paper by Lysle Boller and Fiona Scott Morton that found that, when a company joins the S&P 500 index, (1) its stock goes up and (2) the stocks of its competitors in the index also go up. We talk a lot around here about the theory that common ownership of multiple companies by the same large diversified investors reduces competition among those companies, because all the companies' profits are going to the same place anyway; if you all work for the same owners, why cut prices to gain market share? The result fits neatly with that theory: When you join the index, your common ownership with other firms in the index goes up (because a lot of index funds who already own their stock also buy your stock), so you should compete with them less, so your industry gets less competitive, so you and they both start earning fatter profits. 

Here, on the other hand, is a paper by Benjamin Bennett, René Stulz and Zexi Wang (free version here, via Tyler Cowen) finding that actually when a company joins the index its stock goes down:

We investigate the impact on firms of joining the S&P 500 index from 1997 to 2017. We find that the positive announcement effect on the stock price of index inclusion has disappeared and the long-run impact of index inclusion has become negative. Inclusion worsens stock price informativeness and some aspects of governance. Compensation, investment, and financial policies change with index inclusion. For instance, payout policies of firms joining the index become more similar to the policies of their index peers. ROA falls following inclusion. There is no evidence of an impact of inclusion on competition.

Okay? Depends on exactly what you measure. Bennett et al. find, like everyone else does, that most companies' stocks go up in the 10 days centered around when they are added to the index, but they find that this effect has gone down over time and is statistically insignificant for companies added to the index since 2008. They also find that measured over longer time periods, and on various specifications of abnormal returns, the effect of being added to the index is negative, at least in recent years.

Also other stuff. For instance, we have talked about a fun theory that index investing is "worse than Marxism": Because passive investors buy companies without evaluating their performance or valuation, they are not doing their job of allocating capital to its highest and best uses. Bennett et al. find some evidence:

Passive investors do not have to acquire information about a stock to hold it. If passive investors held all stocks, there would be no information production about stocks. We show that information production about a firm's stock falls after the firm joins the index. Another way to put this is that stock prices are less informative after a stock joins the index. It is well documented that price discovery in the stock market guides managers to make more efficient decisions (see Bond, Edmans, and Goldstein, 2012, for a review of the literature). If the stock price becomes less informative, we expect firms to make worse decisions. We find evidence that being added to the S&P 500 index reduces a firm's investment efficiency.


We find that after a firm is added to the S&P 500, management's performance comparison group involves more firms from the S&P 500 even though inclusion does not impact firm fundamentals directly. We then explore how investment, external financing, and payout policies change when a firm is added to the index because of decisions by management. We find evidence that following inclusion investment falls, equity issuance falls, and dividends and repurchases increase. 

The stylized story would be that before joining the S&P 500, companies try to build their businesses and get better at doing stuff, and they raise money from investors to grow and improve. After joining the S&P 500, companies are more likely to coast; they stop raising money to grow and instead spend their profits on giving money back to investors. The investors don't care what they do, don't pay attention to how efficiently they allocate capital, just want some buybacks, and the companies lazily oblige. The S&P is a sort of retirement home for companies: Once you've made it to the S&P 500, you can stop trying, sit back and do stock buybacks.

We talked the other day about how Tesla Inc. is now eligible to join the S&P 500, and I suggested that maybe joining the index would make Tesla boring. Maybe it will? Maybe Elon Musk will say "enough with the rockets and tunnels and flamethrowers, it's time to focus on stock buybacks." 

Meanwhile Bennett et al. reject the antitrust concerns:

We find no evidence of an impact of inclusion on competition using measures at the firm level and at the industry level. In particular, we do not observe an increase in profit margins for included firms or for other firms in the industry already belonging to the index.

So, pretty much the opposite of Boller and Scott Morton: Joining the index is not good for you, not good for your competitors, and not good for margins.

Still I want to suggest that these papers are really making a similar argument, which is: Being owned by index funds matters for how managers run their firms. The specific ways in which it matters are debatable, but the point is that corporate managers make different decisions when they know that a huge chunk of their shares are owned by passive diversified investors. They do stuff to please the passive investors (higher prices, stock buybacks, whatever), or they don't do stuff because the passive investors aren't supervising them closely, or something. The managers are responsive to shareholder concerns, not in the generic sense that they try to make money so the stock goes up and the shareholders are happy, but in the specific sense that the changing composition of their shareholder base changes what the managers prioritize.

When people don't believe the "common ownership is bad for competition" thesis, they often don't believe that. They argue: Corporate managers care a lot about winning; they care about their own company; they are competitive people who are largely compensated in their company's stock; whatever the vague theoretical extracurricular desires of their shareholders might be, the managers themselves will maximize the value of their own company. I don't know. My view is a bit more orthodox: I tend to think that corporate managers care about what their shareholders want, and that different sorts of shareholders want different things. If you go from having non-index shareholders to index shareholders, why wouldn't they want different things, and why wouldn't you do different things?

Everything is season ticket fraud, why not

There is a lot going on here:

The Houston Astros have deployed several legal defenses against lawsuits brought by aggrieved season-ticket holders angry over the sign-stealing scandal. But one of the team's arguments is likely to surprise: that a First Amendment-inspired Texas law, designed in part to protect the media from lawsuits, also insulates the Astros. In fact, the team contends that because it issued press releases on the scandal, which then became the subject of several news stories, the First Amendment-related law nullifies the litigation against the team.

A key element of the lawsuit is the ticket holders' contention that the team's pre-scandal statements, press releases and marketing that touted the club's success and hard work induced them to buy their ducats. The plaintiffs allege that those communications are therefore fraudulent. But the team contends that such messaging is protected by the Texas Citizens Participation Act (TCPA), which the state passed to enable media and others to speak, write and associate without fear of retaliatory lawsuits. These types of legislation are also known as anti-SLAPP (Strategic Lawsuit Against Public Participation) laws. Commercial speech is exempted, but the Astros maintain what they communicated is a matter of public interest.

"(The plaintiffs') claims expressly are based on Astros press releases," the team's outside counsel, Bryce Callahan of Yetter Coleman LLP, said at a court hearing Friday. "And, of course, press releases, by definition, are designed to communicate information about events to the public and to promote journalistic works. Press releases are given to the press. So the press will cover them and write articles about it. And in fact, that's exactly what has happened throughout the underlying issues of this case, whether that's the sign-stealing scandal, whether that's the specific press releases that we've talked about here."

So one thing that is going on here is that the Houston Astros cheated at baseball. This is bad. Every bad thing that a public company does, I often write, is also securities fraud: The company did the bad thing without disclosing it, people bought the stock in ignorance of the bad thing, when they found out the stock dropped, they were defrauded. But of course the Astros are not a public company and no one bought their stock. Nonetheless you could try to extend the theory. The Astros did a bad thing without disclosing it, and in fact while putting out press releases saying things like "we work hard and are good at baseball" or whatever, without mentioning the cheating. People bought season tickets in ignorance of the bad thing, and when they found out I suppose the value—at least the moral value if not the market value—of the season tickets dropped. (Presumably the market value also dropped due to Covid, etc., which might be a factor here.) So they sued.

If this works then … look, the point with "everything is securities fraud" is that everything is securities fraud. It's not, like, "failing to disclose serious illegal activity at the heart of your business is securities fraud," it's that every bad thing that a public company does, or that happens to it, can give an enterprising lawyer a reason to sue. It is an all-purpose tool for policing the behavior of public companies. I look forward to season ticket holders policing the behavior of baseball teams. You work your star pitcher too hard and he gets injured? You get sued for fraud. You trade your best player? Fraud. Someone needs to police baseball teams to make sure they are operating in the interests of fans, etc., the theory transfers easily enough.

But another thing that is going on here is this insane TCPA defense! The theory seems to be that if you put out a press release, no one can sue you for what's in the press release, because, as Elon Musk says, "hello, First Amendment." Obviously if this worked then nothing would be securities fraud (or season ticket fraud), because you could always say "no our public disclosures were not intended to get people to buy stock (or season tickets), they were intended to help journalists, and you can't sue us for that":

The Harris County District Court judge hearing the case, Robert Schaffer, said little during the nearly hourlong argument but did at one point strongly question the Astros. When their counsel, Callahan, tried to disabuse the argument that his position would eliminate all fraud lawsuits if a company simply issued a press release, Schaffer interrupted and said, "Hold on. That's exactly my thought as well. So any kind of case would get this exemption?"

I don't really expect public companies to try this one but if it works here maybe they will.

Sports SPAC

Elsewhere in sports:

Private-equity firm RedBird Capital Partners is teaming up with Oakland Athletics executive Billy Beane to launch the first-ever special purpose acquisition company dedicated to sports.

The SPAC, which will be known as RedBall Acquisition Corp., has set out to raise $500 million to focus on businesses in sports, and sports-related media and data analytics, according to a regulatory filing Tuesday. Possible targets could include professional sports franchises or leagues, according to the filing.

I feel like if you launch a SPAC that intends to invest in the health care space, and then you buy Drug Company A, you will not have a lot of investors who are passionate lifelong fans of Drug Company B, hate Drug Company A, and feel betrayed by your choice. I mean they might not like the valuation or whatever, that's why SPACs have withdrawal rights, but fandom won't enter into it. But if you launch a SPAC called RedBall and people are like "RedBall? They must be planning to buy Arsenal, or the Red Sox," and then you go and buy Chelsea, or the Yankees, people are gonna be so disappointed. The point of a SPAC, for investors, is that you are buying a share of a company to be named later. That's weird enough if you're buying the company to make money; if you're buying it because you love sports it seems very challenging.

Private company fraud

One aspect of "everything is securities fraud" is that public companies disclose a lot of stuff publicly. U.S. securities regulation requires companies to disclose annual and quarterly financial statements, to give comprehensive narrative disclosures about how their business is doing and how managers think about it, to describe their compensation schemes and objectives, to explain the risks of their business, to lay out the details of their capital structure, etc. If you get anything wrong, and your stock goes down, someone will sue you for securities fraud.

Private companies don't do this. Often they disclose similar information, though less of it and less formally, but they usually disclose it only to their investors, or to people who are in discussions with them to invest. It's not just on a website; everyone can't look at it, only the—theoretically—sophisticated private investors who are considering an investment and doing their due diligence. 

So you'd expect that private company fraud would be caught less often. If you lie in a Securities and Exchange Commission filing, lots of people can read it and might spot the lie, and short sellers and whistle-blowers will have incentives to do so. If you lie in a letter to a handful of potential investors looking to get rich, the readers will be fewer and might want to believe. 

So you'd also expect that private company frauds would be a lot more egregious. If you're going to do an accounting fraud at a public company, you need to deceive auditors and make the fraud so impenetrably complex that sophisticated short sellers can't figure it out. If you're going to do an accounting fraud at a private company, you can just type whatever numbers you want into a spreadsheet, print it out, and send it to people. There is nothing hard or complicated about the fraud; the hard part is choosing the right people to send the spreadsheet to.

I feel like the SEC usually focuses on public-company fraud, because (1) it's easier to see and (2) it affects public investors, widows and orphans, etc. The SEC usually doesn't focus so much on private-company fraud, because (1) you have to look harder for it and (2) it mostly affects accredited investors, venture capital firms, etc., who can presumably take care of themselves.

But recently there has been a mini-wave of private fraud enforcement actions and they seem super egregious. We talked last week about YouPlus Inc., which was a story of a guy allegedly typing fake numbers into a spreadsheet and fake customer names into a list. And here is Trustify Inc.:

The Securities and Exchange Commission [Friday] charged Trustify Inc., an online marketplace purportedly designed to connect customers to a network of private investigators, and its founder and CEO Daniel Boice with fraudulently offering and selling over $18.5 million of securities to more than 90 corporate and individual investors.

The SEC's complaint, filed in federal court in the Eastern District of Virginia, alleges that between 2015 and 2018, Trustify and Boice falsely held Trustify out as a successful startup with lucrative corporate clients, thousands of investigators in its network, and growing revenues.  According to the complaint, however, Trustify's number of investigators and revenue were far lower than represented and the company was unable to pay its employees and vendors and effectively ceased operations.  Boice allegedly misappropriated at least $8 million of investor funds to pay for personal expenses for himself and his then-wife, also a Trustify executive, including private jet charters, vacations, a luxury car, jewelry, and mortgage payments.  Boice also allegedly diverted hundreds of thousands of dollars to his purported consulting company GoLean DC LLC.

Again, allegedly, fake revenues, fake customers, etc.; also fake co-investors:

Boice told the Venture Capital Fund that an established investment bank had agreed to be the lead investor for the Series B round. This was not true.

The Venture Capital Fund, which previously had invested just over $4.7 million in the Series A round, agreed with Boice to wire funds for the Series B round if the following conditions were met: (1) it received confirmation that the investment bank had wired funds to Trustify; (2) the round was substantially funded prior to its investment; (3) its investment would be escrowed in a specific bank account; and (4) its investment would be returned if the Series B round did not meet its minimum investment target of $15 million.

In June 2018, Boice caused the Venture Capital Fund to receive an email that purported to be from the investment bank's managing partner ostensibly confirming the investment bank's $7.5 million investment and welcoming the Venture Capital Fund to the Series B round. The email was fake.

Like, I dunno, if you said in an SEC filing "Big Bank X is investing a lot of money in our company," and they weren't, they'd probably hear about it, and deny it, and you'd be caught in like a minute. But you can say that in a private investment memo to a venture capital fund with millions of dollars to invest and they'll just send you money and the SEC won't notice for like two years. 

I suppose "we're a network of private detectives" is a good business to be in if you're allegedly doing securities fraud. "Why bother investigating," your investors might say, "they control all the investigators anyway."

Mostly I think about how fun and satisfying these cases must be for the SEC. They're used to reading complex footnotes to public financial documents to try to find subtle misrepresentations of a company's financial condition, and then they get all these cases of people just writing fake numbers in crayon and faxing them over to venture capitalists. "This is so easy," the SEC investigators must think, once they have their hands on those documents. "We should do this more often!"

New Goldman Sachs scandal

Don't you kind of want this to lead to a multi-billion-dollar fine?

New York health authorities will investigate a Hamptons charity concert opened by Goldman Sachs chief David Solomon and headlined by the Chainsmokers after footage showed crowds of partiers, according to Governor Andrew Cuomo.

Cuomo said he was appalled by "egregious social distancing violations" seen in videos of the Saturday night event in Southampton. "We have no tolerance for the illegal & reckless endangerment of public health," Cuomo said, noting the Department of Health will lead the inquiry.

The event was held on a field Saturday night and billed as the "Safe & Sound drive-in concert" with attendees expected to enjoy the music by their cars and in designated spots. About 2,000 people turned up for the performance with an opening set by Goldman's chief executive officer, who moonlights as DJ D-Sol, and the Chainsmokers as the main act.

Videos shared by revelers appeared to show groups gathering near the stage. Some concert-goers without masks congregated outside cars to party with friends.

Like, "ordinarily this would be a $50 fine for violating social distancing rules, but because Goldman Sachs was involved it has to be 10 digits." You know how it is. (Disclosure, I used to work at Goldman.) Also:

Solomon was on stage for an hour, just him and a turntable on an elevated platform, mask around neck, surrounded by animations of cherries and his deejay name, D-Sol, in flashing bubble letters. He put his hand up in the air, playing electronic dance beat takes on popular songs -- not unlike the Chainsmokers, with more Fleetwood Mac than Coldplay. Giant plumes of smoke went up in front of the stage as the sky turned pink and orange.

Well everyone needs a hobby. Jimmy Cayne was famously playing bridge when Bear Stearns collapsed, and it would be a nice callback if Goldman ran into liquidity trouble and people were like "where's David Solomon" and the answer was "opening for the Chainsmokers at a yacht party off Ibiza." And they'd call him frantically, and send an analyst on a chopper to the yacht to try to get his attention, but he'd have his headphones on and it'd be so loud and the analyst would be shouting "WE ARE GETTING A LOT OF COLLATERAL CALLS" but he'd just be rocking out and wouldn't hear her until it was too late.

That's not this, but this one is good too. I hope Goldman's lawyers have set up a war room to handle this, I hope a battalion of Sullivan & Cromwell lawyers are heading out to Southampton to argue the nuances of social distancing regulations. There has been this inspirational subplot of Solomon's rise in which the old graybeards told him that he would never really make it as an investment banker unless he gave up his DJ'ing dreams, and he persisted despite their warnings—"You know what, it's who I am, and nobody would tell me not to play golf," Solomon actually said—and overcame the long odds against him to become both the CEO of Goldman Sachs and a guy who can DJ a party in the Hamptons. I just want that plot to go somewhere, you know? Nothing against Solomon, or Goldman, just as a matter of dramatic satisfaction it'd be funny if the moral that we all take from this, in a year or two, is "boy, turns out you really can't be both an electronic dance music DJ and a bank CEO, what a bad idea that was."

Things happen

Malaysia Ex-PM Najib Razak Sentenced to 12 Years in Jail in 1MDB Unit Case. Boaz Weinstein Piles Up 90% Gain in Hamptons, Bets on More Chaos. Goldman revamps employee reviews, opening door to greater job cuts. Under Armour Receives Wells Notices From SEC. Fund Administrator for Fortress, Pimco and Others Suffers Data Breach Through Vendor. Vanguard Challenges Bond Behemoths With Active Funds. "Now working alone, he has been hunting more frequently, gathering up Sundrop's kills to drop off in front of Gracie Mansion, the New York City mayor's residence, in what he describes as his own form of protest against police brutality." "She apparently feels a bit guilty and slightly embarrassed about letting down the image of her cousins bouncing across the Alpine snows with barrels of brandy around their necks." 

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