Wednesday, September 9, 2009

WSJ: Vanguard's John Bogle, Warren Buffet Speak Out Against Short Term Nature of Markets

Wow, this is some fascinating stuff, especially to a person who has written in these pages we have to ask ourselves what are the markets for at this point. Instead of their original purpose (raising capital, speculating on the fundamental fortunes of a business) they seem to have become nothing more than a way to find random sub-second arbitrage opportunities, by a select group of computers at one firm versus another.

These are some mighty heavyweights in the investment world so it might actually have some weight - John Bogle of Vanguard Funds, Warren Buffet of Berkshire Hathaway, Louis Gerstner (formerly of IBM) among others. Certaintly the outpouring of resistance will come fast and furious from those who benefit from the status quo ... you can be sure tales of doom will rain down since we'll lose "liquidity". The horror.

I have a very simple solution - simply tax at a 40% rate any transaction that is shorter than the time a human eye can blink. That would not solve everything but I think it would eliminate 75% of the current issues. Daytraders (of the human kind) would still be welcome. HAL9000 would of course suffer. The question to ask is do sensible restrictions on things that have gone completely haywire (30-70% of trading done by computer; much of it in time frames no human could ever react to), that would hurt a tiny niche of players (who now dominate the markets) - but for the (potential) betterment for the masses, be something that the majority want? And yes some liquidity would go away but I am ok paying a bit extra so that the market actually has something to do with fundamentals again. A small price to pay in my mind.

I doubt this will get anywhere once it gets through the winding course that is Washington D.C. since financial oligarchs dominate the country's political mind share, but at least someone with a much louder voice than I is asking the very necessary questions... "adult conversation" is here. Going to Washington and trying to have a discussion about anything "long term" to people whose only focus is 1 election cycle, is an irony onto itself.

Obviously, the questions are a lot bigger than HAL9000 trading - that has become a stock market dysfunction (sorry to the HAL9000 based readers). The whole system should be rethought, from compensation packages that reward top execs "win or lose" and encourage almost all focus on near term quarterly results (beat the numbers at all cost) without almost any care to the long term health of companies, to the completely broken board of director system, to accounting rules that exclude option awards each quarter as "a cost" (wink wink) ... but at least this is the beginning of the beginning of a conversation.
  • Investors, corporate boards and managers' focus on short-term gain has become so detrimental to the economy that unless they voluntarily change their behavior, regulators should step in, according to an Aspen Institute statement to be released Wednesday that is signed by Berkshire Hathaway Chief Executive Officer Warren Buffett, Vanguard Group founder John Bogle and former International Business Machines CEO Louis Gerstner, among others.
  • "We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy," said the statement, signed by 28 high-profile managers, investors, academics and others.
  • Over the past several decades, investors have become increasingly focused on the short term, trading more and more frequently. In 1990, for example, the average holding period of a stock trading on the New York Stock Exchange was 26 months; now it's less than nine months.
  • At the same time, companies have become more focused on the short term as well, with managers concentrating on hitting near-term targets, such as analysts' quarterly earnings estimates, and as a result often forgoing measures that promote long-term growth, such as research and development -- or even routine maintenance.
My gosh let me sit down, seeing these words in print and backed by such people... maybe these folks have been reading Fund My Mutual Fund?
  • Often, discussions about so-called short-termism have devolved into finger-pointing exercises. Managers will charge investors with being overly focused on short-term results, for example, while investors will say managers' short-term focused compensation schemes and cozy relationships with boards of directors are at fault.
  • But the Aspen Institute statement argues the problem is actually systemic ...
Yes yes! It's the system, the whole architecture. Make some room for the AARP crowd outside of the Matrix, we're gaining converts.
  • ....and regulators need to change incentives to encourage long-term investing.
Bogle, and Buffet - now you too can be called socialists for caring about something other than "short term profitability at any cost to a society". To which I ask, how did we ever allow libraries in this country? They don't provide profit and hence are a stain on the country - but I digress.
  • "It's not just managements or boards or regulators or investors," said National Association of Corporate Directors Chair Barbara Hackman Franklin, a former Commerce Secretary under George H.W. Bush who signed the statement. "We're all in the soup together we really need to stop and say, 'Wait a minute, do we really want to keep doing this?'"
  • "There's a bias in the system and as long as our system is biased toward short-term trading, we have to expect that's what we're going to get," she said.
  • Sharply lower trading costs and the advent of information technology has made it far easier for investors to trade more frequently in recent decades. With the introduction of 401(k) plans, investors have become increasingly passive, leaving trading decisions to fund managers who are often compensated based on their short-term performance.
  • Finally, derivative products enable activist investors to buy a company's shares while simultaneously making bets its shares will fall, allowing them to take large voting stakes while having no real economic stake in the company.
  • Because investors ultimately have the power to hire and fire managers and set compensation, their focus on the short term has pushed companies to act in the short term as well.
  • "Any CEO feels the pressure of meeting Wall Street expectations."
Here are the proposed solutions - are they perfect? Most likely not but it's a conversation starter.
  • To encourage investors to take the long view, the statement suggests that the government could change the tax-code to reward long-term holders over short-term holders -- by, for example, setting capital gains tax rates that get gradually lower the longer an investor hangs on to a companies shares.
  • Additionally, fund managers should act in the long-term interests of the investors whose money they manage (what an outrageous concept!)-- something that, the statement argues, fiduciary duty stipulates they do.
  • Finally, activist investors who take large stakes in a company should be required to disclose when they have entered into derivative contracts to hedge away risk.
Feel free to comment, even if you are a "socialist"... like Warren.

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