Postcards - 1993 - Part Six - The Decision that Handed BlackRock, Vanguard, and State Street Way Too Much Power

The debate over passive investing has been VERY hostile for 30 years - but there's no doubt that ETFs have reached a point of unintended consequences. What comes next is what's more troubling.                                                                                                                                                                                                                                                                                                                                                                                                                 Forwarded this email? [Subscribe here]() for more [Postcards - 1993 - Part Six - The Decision that Handed BlackRock, Vanguard, and State Street Way Too Much Power]( The debate over passive investing has been VERY hostile for 30 years - but there's no doubt that ETFs have reached a point of unintended consequences. What comes next is what's more troubling. [Garrett {NAME}]( Dec 31   [READ IN APP](   Dear Fellow Investor: Two exchange-traded funds (ETFs) capture most of my attention each trading day... [Our Equity Strength Signals are largely based]( on the momentum oscillators surrounding the SPDR S&P 500 ETF (SPY) and the iShares Russell 2000 ETF (IWM) and the flow of stocks and capital in those underlying indices. The SPY has been around for 30 years…. … the SPDR S&P 500 ETF (SPY), a basket of stocks that tracks the S&P 500 Index performance, debuted in 1993. It was the first U.S.-based ETF. The prospect of ETFs - an essential form of passive investing - offers investors diversified market access and a set-it-and-forget-it approach. Even [Warren Buffett once won a bet against a hedge fund]( manager by owning a passive fund against being committed to “active management.” I’ve largely been a proponent of mutual funds and other passive investments (and, especially, private equity). However, unintended consequences of ETFs and this form of investing include [more fuel for economic inequality]( an acceleration in [executive pay compared to the average worker]( gamesmanship with ETFs via benchmarking, [valuation expansion]( and concentration of power for companies like BlackRock, Vanguard, and State Street. That is why the approval of the first ETF in 1993 is the final part of this series. Let’s explore. --------------------------------------------------------------- [Today is the last day to become a Founding Member]( - and lock in the $200 annual price forever before the regular yearly price doubles next month. [Upgrade to paid]( --------------------------------------------------------------- Advantages of ETFs So, before we trash the unintended consequences of ETFs, let’s acknowledge their benefits for the equity markets. There are at least seven things that I can conjure off the top of my head. - Diversification: ETFs offer exposure to a wide range of assets. Some are commodities, some are stocks, and some are individual sectors. There are many options, so investors don’t have to put all their eggs into one basket. - Dividends: The ETFs benefit from company dividends since they own the stocks. So, income can be generated by certain assets. - Liquidity: In most cases, ETF shares are very liquid on stock exchanges. The SPY is highly liquid. - Transparency: There is daily disclosure of holdings and real-time pricing. This is one of the reasons why I give Cathie Wood credit. She isn’t running an illiquid fund. She’s running a transparent fund with measurable performance each day. - Lower Costs: ETFs usually have lower expense ratios than mutual funds. - Tax Efficiency: Certain ETFs are structured to provide tax advantages. - Tradability: Day traders can use ETFs much like traditional stocks when trading. That all seems positive, right? Undoubtedly, the ETF market has provided many benefits to people who don’t want the burden (and underperformance) of active investing. But every good thing can have a dark underside. The debate about the role of ETFs and passive investing in the market has been fierce. In 2021, investment research giant Bernstein issued a report called: “[The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.”]( Is it worse than Marxism? Well, Bernstein suggests that index funds are extremely capital inefficient. CNBC describes the differences between a capitalistic model - under Bernstein’s analysis, followed by a Marxist (or centrally planned economy… and an economy dominated by passive investments. (RESPECTIVELY FOR COMMENTARY BELOW) [Wrote CNBC’s Alex Rosenberg in 2016]( In the first type, markets “rapidly reallocate capital into expanding and shrinking industries,” leading to “superior economic growth.” In the second, “at least someone is doing the planning of capital allocation,” even if the central planner will likely do a worse job of allocation than investors as a group. In the third, no party is making an attempt to allocate capital effectively, leaving an odd vacuum in which decisions are not made by parties lacking accountability or fiduciary responsibility. In fact, the decisions that are made do not even appear to be decisions. That’s quite a take. And the theory is interesting. For years, other funds have argued that the funds are negatively impacting the allocation of capital and that we’ve focused less on innovation and more on financialization in these markets. Other blogs have argued that passive investing like ETFs has made the markets more efficient, that centralization in these funds isn’t a big deal, and that active managers should work harder to generate returns (and that their shareholders should shoulder the risks associated with active management. And… given the performance of the average trader in America, perhaps more and more should just buy direct access to the broader - U.S.-based market (fueled largely by central bank activity) instead of gambling on penny stocks or cannabis. But there are other issues at play. When ETFs became a thing in 1993, I don’t think [regulators expected this fallout.]( Power and Control Let’s start with the most important part of a public company. The voters. When public companies hold shareholder meetings, the people and companies with the largest stakes decide. [In December 2022]( the Harvard Law School Forum on Corporate Governance noted that the three largest companies in passive investing - BlackRock, Vanguard, and State Street had a “median stake in 21.9% in S&P 500 companies (in late 2021). By 2020, they were the largest shareholder in 88% of S&P 500 companies, according to the American Economic Liberties Project ([Via CNN]( [The same Harvard analysis]( showed they had nearly 25% of all votes for these companies’ annual meetings. The authors noted: “In addition, we also engage with objections regarding the likely future growth of the Big Three, and we show that the power of the Big Three is likely not only to persist but also to grow significantly.” The stakes have been growing… and will likely grow again in 2023 thanks to the deep dips in the market and the necessity to allocate capital (unless they’re all set to buy up all the single-family homes possible). To put into perspective how quickly Vanguard grew in the [era of Quantitative Easing - thanks to Ben Bernanke]( - in the first five years that Bernanke announced inflation targeting as an official Fed policy, the number of stocks that Vanguard owned at least 5% of the S&P 500 company increased from around 115 in 2012 to roughly 490 by 2017, according to various estimates. By 2020, [Caleb Griffin at Belmont University said that Vanguard]( owned 8.8% of all outstanding S&P 500 shares. By the [end of 2021]( it was 10%. Then there’s BlackRock, which owned at least a 5% stake in more than 97% of S&P 500 companies in 2020. When the U.S. faced a crash in 2020, the Federal Reserve - unable to buy corporate bonds - created a workaround that says BlackRock manages a junk-bond fund and handles the buying. This company [not only has $9.1 trillion under management]( the Federal Reserve’s balance sheet), but it has also had the honor of hiring the former head of the Swiss National Bank, Philipp Hildebrand, and Stanley Fischer, the former Vice Chair of the Federal Reserve. That’s “power” that not even Goldman Sachs has. With this level of power - comes their views of corporate responsibility. Effecting Change and Forcing Behaviors Remember, BlackRock’s CEO Larry Fink said the quiet part out loud just a few years ago. “Behaviors are gonna have to change and this is one thing were asking companies. You have to force behaviors, and at BlackRock, we are forcing behaviors," [he said](. An excellent example happened at Exxon Mobil (XOM) a few years ago. An activist investor named Engine No. 1 had a small stake in the energy giant and wanted Exxon to reduce its climate footprint. They won the proxy battle - and even appointed three independent board members. Before that vote, few people knew of the impact-centric activist firm. How’d they pull that off? Exxon’s largest institutional investors were BlackRock, Vanguard, and State Street. All three voted against Exxon’s board, giving Engine No. 1 more power and aligning with the activist’s goals. [Fink later said]( “No issue ranks higher than climate change on our clients’ lists of priorities. They ask us about it nearly every day.” With that voting power comes the capacity to “force behaviors” on companies related to the Environmental, Social, and Governance (ESG) movement. ESG is a form of “stakeholder capitalism” that prioritizes stakeholders outside traditional shareholders. This includes communities, a focus on climate change, and can and will balance diversity, equity, and inclusion (DEI) policies over maximizing profits. Oddly, certain authors argue that BlackRock and other large funds don’t engage in these practices … or that it’s “[still up for debate.]( But BlackRock has an entire page on its corporate website dedicated to “[stakeholder capitalism]( In addition, they launched a [Stakeholder Capitalism Centre in 2022](. When I attended Johns Hopkins’ government program, part of my graduate thesis centered on shifting away from shareholder capitalism (which dominated markets since the 1960s) toward stakeholder capitalism at Top Tier Business schools; in fact, Johns Hopkins even created a business school with that model in mind. Professors advocated for this behavior on climate change regularly, calling it a critical part of the “double bottom line.” Such policy has morphed into other social and geopolitical matters that may or may not impact profitability and/or long-term sustainability. I have mixed feelings about the concept, as it has already contributed to even greater corporate welfare at taxpayers' expense. Of course, that’s good news for guys like Larry Fink, who look at the ESG movement with dollar signs in his eyes. We can see how they have the capacity to effect change through boardrooms in a way that public policy at the state and Federal levels cannot. And that’s dangerous that we must operate on the whims of Larry Fink. Yes, the shareholders of the ETFs might be the ones that are investing across the market, but the power lies in the votes, which the institutions control. It’s an odd form of corporatism - or even dirigisme - that can and will have consequences. These institutions are not elected officials - much like the European Union’s centralized government, which is full of people who don’t have any direct accountability to the people. ETFs don’t either. [A few pilot programs are now]( designed to allow fund investors to help decide how to vote on specific proxy battles. But is there any sense of irony that the largest institutional shareholder in [BlackRock is… Vanguard?]( Performance Matters? I’d love to sit here and tell you that State Street and Vanguard care about the performance of their ETFs. But it's not the most logical system if capital isn’t allocated efficiently under this system - and Bernstein was even halfway right. We would just have to look at the performance of various ETFs in the alternative energy space chock full of unprofitable companies with high short interest. The reality is that these companies collect fees for managing the portfolios, and they’re not exactly worried if they perform. Plus, these funds will lend their shares of garbage stocks to short-sellers at very high fees. But don’t worry. They’ll likely have an inverse fund - or even triple leveraged ETF - with exposure to the same sector or industry. It’s also hard to conjure a scenario where many of these theme ETFs, ranging from cannabis to sports gambling, from solar stocks to ESG, have been healthy for retail investors. The argument goes that there should be a market for anything - and ETFs are an efficient way to provide that access. It doesn’t change that so many of these ETFs are poison due to the pump-and-dump style schemes we’ve seen across fads in the last decade. And I don’t think most people understand how leveraged ETFs work - and why they can be extremely dangerous in any environment. There’s a specific way to trade these ETFs - which we discuss in the [Republic Risk Letter](. Herding and Benchmarking Over the last few years, the explosion of ETFs has created a large pool of investors buying up the Top 7 - those Magnificent stocks - because they need to replicate their benchmark. As I noted in a recent article, one of the more ridiculous ETF transitions of the last few years was the [Knights of Columbus Catholic ETF.]( This fund quickly transitioned to the [S&P 500 Catholic ETF and bought nearly the same weights as the top stocks in the S&P 500 ETF.]( Because they aren’t trying to outperform for their investors. They’re trying to meet or match their benchmark. That’s how you get to keep a fund active and keep your job. They’re only focused on fees, even if the stocks in the portfolio have little to do with the fund’s actual theme. This buying also has an impact on valuations. In August 2017, [a Bloomberg Gadfly columnist, Steven Gandel,]( noted that the growth of ETFs and passive investing from the Dot-Com Bubble to 2017 had fueled an uptick in valuations at the lowest levels of the market. [He noted in 2017]( At the height of the dot-com bubble, for instance, when the most expensive stocks in the market, mostly tech shares, were trading at 50 times earnings, the cheapest stocks by quintile were trading at less than 8 times earnings. The market’s cheapest 20 percent of stocks are now trading at nearly 11 times earnings and becoming more expensive. Back in August 2017, the PE ratio of the S&P 500 was 23.6. Today, it’s 26.3x. We’re back in a new bubble that hasn’t quite deflated. Standby. The Inequality Side We’ve discussed the negative consequences of inflation targeting and changes in compensation tax laws in 1993. However, ETFs were aided by this inflation targeting and quantitative easing while at the same time juicing executive pay. [Steven Gandel also noted]( that a study showed a direct relationship between rising passive ownership and rising executive pay. He cites a 2016 European Corporate Governance Institute study that analyzed pay at the top S&P 1500 companies and another 500 firms. It turns out that executives who worked at companies with high levels of common ownership made about 25% more than those with less exposure. In addition, CEO pay increases by up to a factor of 10 when we see a substantial uptick in passive ownership, the report says. There you have it: ETFs are just more juice for the Top 1%. Systemic Risk Passive investing isn’t a significant problem on its own - yet - for the financial markets. However, these ETFs do have unintended consequences. We can look at the sheer size of BlackRock, State Street, and other companies in the space over the last 30 years and see a growing concentration of risk. Our Equity Strength Signal went negative on February 23, 2020 - weeks before the worst of the COVID selloff hit. I have a hard time believing that the 33% decline that followed didn’t have something to do with the massive passive forces of this market. When performance doesn’t matter (only fees) - the real place where the passive funds can get into trouble is forced selling. And that happened across various sectors when ETFs and other funds had to dump shares due to their investor stipulations. We’ll continue to talk about these themes in the year ahead. But I explicitly note that the markets have changed over the last 11 years. Central banks' combination of passive investing and massive capital injections have been dominant forces in this market - compared to earnings and broader economic trends. It’s a different world - and we’ve figured out how to play it smartly and reduce our risk. It’s The Last Day to Become a Founding Member Today is the last day for anyone to become a [Founding Member of the Florida Republic]( and you can lock in the $200 annual price forever before the regular yearly price doubles next month. The Republic Letter arrives every trading day in the morning, and your Postcards are complimentary as always. Remember, we are launching our reversion momentum portfolio tomorrow, and in doing the screens today, I was a little shocked by what popped up there. We had to qualify everything - but a shocker on the initial screens was General Motors (GM). This is a terrible company that I refuse to own, but I can see it as a valuable trading asset in the year ahead, depending on our [Equity Strength Signals](. I hope you all have a wonderful New Year, and we’re looking forward to attacking these markets starting on Tuesday. Stay positive in 2024, Garrett {NAME} Secretary of State The Florida Republic Invite your friends and earn rewards If you enjoy Postcards from the Florida Republic, share it with your friends and earn rewards when they subscribe. [Invite Friends](   [Like]( [Comment]( [Restack](   © 2023 Garrett {NAME} 548 Market Street PMB 72296, San Francisco, CA 94104 [Unsubscribe]() [Get the app]( writing]()