April 11, 2017

Beware the Index Fund

As Toshiba seems poised for a fall, it seems like it is time to pay attention to size. A nice article in Bloomerg today highlights a systemic risk in worldwide megacorporations. For years, management, investment bankers, and investors have benefitted from encouraging an M&A boom. I like to play the game Acquire with my kids, and so they can tell you that management loves acquisition because of all the bonuses. Bankers love mergers because they generate lucrative fees. And investors will pay a premium for merged companies because they have less overhead, better access to capital, and better pricing power.

But giant companies are horrible places to work: when there are five layers of management separating the work-doers from the deciders, everybody starts triple-guessing their boss's boss's double-guessing. Having the best of intentions, employees spend their efforts making plans for the pre-meeting before the planning meeting about the big meeting, and everybody's IQ is wasted on palace intrigue.

Asia has this problem in a special way. It has been popular for Asian governments to encourage megacorporations as instruments of state policy, and this has resulted in the phenomenon of the giant zombie companies in Asia.

And this brings us to the biggest financial risk in the world today: the massive slow-moving failure of China's state-owned enterprises. These companies make up 30% of the the world's largest economy and include all the country's biggest oil, electricity, construction, telecom, automotive, and shipbuilding companies. The government is afraid to let them fail, so they are insulated from ordinary market pressures, and historically rife with corruption.

Chinese SOEs are notoriously inefficient, and the problem has been getting worse. When global trade stalled in the wake of the 2008 global financial collapse, China picked up much of the slack by artificially pumping up production and buy building up massive amounts of debt in SOEs: estimates are that 90% of China's GDP growth post-2008 comes from these SOEs. Unfortunately, smart industrial policy is dumb business: nobody's buying what SOEs are making.

It is easy to point at China and see how bad their megacorporations are. But coming back to the U.S., it seems to me that it's time to scrutinize our own assumptions about size. When you buy an index fund, you are trusting companies in proportion to their size: the S&P 500 index is mostly 50 megacorporations, including several "beauties" such as Comcast, Exxon, and Verizon that resemble SOEs in the way they make money by manipulating government regulations. What happens to our index funds when the zombies fall, political and financial fashions change, and it is no longer desirable to be large?

Beware the market-cap-weighted index fund.

Posted by David at April 11, 2017 10:05 AM
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