Friday, July 23, 2010

Diversification as Monoculture

Recently I've been reading about the mechanics of American corporate governance.  In theory of course, corporate governance is entirely straightforward and democratic -- one share, one vote.  Of course, there are some special cases where founders or their heirs maintain control over a company by setting up a special class of shares that get a disproportionate representation.  While this is more common than one might imagine, it's still an exception (forgive my lack of statistics, it's Saturday) and for the most part the economic owners are in nominal control of a company.

The reality is pretty different though.  The owners are officially in control, but they naturally have to appoint a board of directors to represent them and hire a manager to run the business and make day to day decisions.  The CEO is inherently going to end up much much closer to the business than the board, who in turn is much closer to it than the shareholders.   Multilayer representative democracy is not exactly a ... ahem ... flawless system, so stuff gets lost in translation.  If you want to read about just how complicated this process of translation is, read the SEC concept release, which goes over the mechanism from top to bottom.  The consequences of making sausage with this mechanism are as obvious as they are widespread -- wildly overpaid management that has little of its own money at risk, incentivized to either placidly chew the cud and milk their control, or to go for broke at someone else's expense.

At first it seemed to me that the problem was about the dispersion of ownership.  I rant endlessly about how America is just too damn big and how they wrote the constitution to serve 4 million and not 300 million people; I thought the problem in corporate governance was similar, large corporations simply have too many shareholders to be governable.  The centralization of control opens the door to corruption.

The more I've thought about this though, the more I've decided that it's not the number of owners per se that is the overwhelming problem.  After all, even in a large company with many owners that is not controlled by its founder, say GE for example, a solid portion of the ownership lies in the hands of the largest asset management firms.  In the case of GE, the top 10 institutions own 17.4% of the stock.  They shouldn't have that much difficulty getting their way, especially when you consider that a lot of the little holders don't bother to vote at all or let their broker vote for them.  And I submit that they wouldn't (have trouble) if they had any clue what their way was.  Unfortunately, these big owners own, quite literally, everything.  The biggest owners are almost always one flavor or another of index fund or its modern equivalent , the ETF.  They just track "the market" and are professionally agnostic about the individual companies in it.  They don't have an opinion about how a company should be run, and there's no way they could have an informed one about all 500 plus that they own.  Rather than acting as a powerful concentration of ownership, they are just another middleman muddling the mechanism.

How did we get to this state then?  How did the real beneficial owners end up so far from the thing they own?  A big part of it was the encouragement people have gotten over the last 50 years that there was something out there in the wild called "the market".  This idea grew out of the work of the Chicago School and the capital assets pricing model.  They designed a toy model of a perfectly functioning market, which is an inherently equilibrium tending machine, from whence they went on to prove that in this toy model return was proportional to risk (defined as volatility).  From there, if you presume that the individual assets are uncorrelated, it's a short step to touting the wonders of diversification in providing you the highest return for a given level of risk.  You just buy your share of "the market" which is defined as "all of the assets" and you let it work it's invisibly handed magic.

This model explains the market okay if you squint just right and throw out the major data points of the century, like, say, the Great Depression, so naturally it was taken as gospel.  It also created a whole wonderful new industry for Wall Street because now they could own the same thing as everyone and charge a fee for doing so without getting blamed if things went bad.  But I'm being facetious and cynical.  The theory really isn't that stupid, even if you can hardly call it empirical science.  It does more or less explain long stretches of data in a parsimonious fashion.  And in the end, I can't say I have a better suggestion than this extreme diversification for the amateur investor.  Like so many things in economics though, it's clear that the George Soros principle of reflexivity applies here as well -- once everyone does what the theory says they should, it ceases to be valid.  In this case, everyone diversified into the same stuff, and the correlations increased dramatically, which invalidates the premise.

Now it's pretty obvious where I'm heading with this.  It seems to me that the problem was that we grew a monoculture of diversity.  Once this monoculture was established, the combination of finance and politics swept through it like a virus.  We unhooked the basic premises of capitalism, namely that owners with varying preferences care what happens to their property.  If it's only ever 1% of your property it can't really be worth worrying about, right?  In that case why would you bother with governing the investments you make?  None of them is individually important and you can't know about everything.  On top of that, they've already proven to you that you can't beat the market, and proven too that when you just buy a bit of everything, it will all magically work itself out, even if it's immediately obvious that if most people are following this advice it can't possibly work.  So there's no point in even trying to govern the corporations you own for your benefit.  Sit back, drink your coffee and enjoy your divine right to a little slice of America.

In the end, this monoculture reminds me of socialism.  Instead of centralizing economic decisions in one 'party brain' that wisely and benevolently  decides how we should allocate resources, we have centralized decisions in one theory that wisely and benevolently declines to make those decisions.  It's kinda like a lobotomized socialism.  And of course, once you take away the patient's higher brain functions, they end up running on the old autonomic reptile brain power.  Just how ancient is the Vampire Squid?


adam said...

Profound post! The micronization of ownership makes the owner-agent problem enormous. Never occurred to me that this micronization largely comes from one aspect of market philosophy.

Zantox said...

I love knowing how you go about your day (professionally). It colors your scribe here (particularly the penultimate paragraph) with the 128 count box of Crayolas :)

Clark said...

Zantox, the crayon thing really made me laugh this morning. My views are definitely colored by the fact that the ownership in my professional life is anything but micronized, to steal Adam's phrase for it.

It's just a weird way of talking my book I guess.

Zantox said...


I actually subscribe to your view quiet closely (or at least a combination of your professional direction and some of the comments in this post). I tend to bet heavily on things I believe I know well, but at the same time am broadly invested (indexed ETFs, as you say) -- mostly because I haven't a clue about the public markets (and even less faith in them -- at least at my level of investment/corporate control).

While I have encountered a number of folks in my academic and professional career that subscribe to the same philosophy, one stands out. My favorite quote from him was:

"It's okay to put all of your eggs in one basket. Just make sure you WATCH THE F'ING BASKET".

(I kindly note that he is/was a principal in a private equity firm).