Too Much Beta for the Alpha Dogs
Or don’t go after BlackRock, Vanguard, and State Street, but instead compensate corporate executives based on their stock’s outperformance relative to benchmark
Move over meme stocks and crypto: it’s time for criticism of index funds again. Farhad Manjoo wrote a big piece recently in the NY Times on the specter of Blackrock, Vanguard, and State Street’s large stake in all public corporations. Several senators have introduced a bill that would require large passive funds to vote based on investors’ preferences, and Matt Levine is drawing us back to where it all began to ponder whether index funds should be illegal (he’s joking, though others might not be).
There are two broad concerns raised by the rise of index funds. The distorted voting concern worries that large passive shareholders may vote their shares in ways that distort corporate behavior, such as by pushing the idiosyncratic beliefs of Blackrock, Vanguard, and State Street employees (“time for some ESG!”). The anti-competitive concern looks at the large share Blackrock, Vanguard, State Street, et al. have in all the companies in an industry and wonders whether that is restraining corporate competition because common owners of companies across an industry benefit from less competition and higher prices.
I don’t find the anti-competitive concern that persuasive, but others do. Before they push changes to how passive investing works that may have substantial downsides, I want to follow the premise of their concern to suggest a different, more persuasive and beneficial change: push more companies to shift management’s equity-based compensation to be based on stock outperformance relative to peers.
If the anti-competitive concern is true…
Of the two concerns from the rise of passive investors and Blackrock, Vanguard, and State Street’s transformation into investing behemoths, the anti-competitive concern is the more fundamental one, suggesting that the very core of broad-based passive investing contains economic rot. I’m going to focus on it.1 On its face, the anti-competitive concern does not seem that plausible, and the motive and means here are much less than meets the eye. Though it’s often written as if Blackrock, Vanguard, State Street & co. benefit from rising asset prices, that’s not substantially true: it’s the ultimate investors in their ETFs who really benefit if all airline stocks go up for example, with Blackrock only gaining a tiny amount from fees on slightly greater assets. And if Blackrock did want to push companies to compete less to boost stock prices across a sector, it’s unclear how Blackrock would claim credit for that work.
That said, there are studies showing some relationships between greater index and quasi-index stockholding share in a company and less competition (though the initial high profile example of the incredibly poorly returning airline stock sectors suggests the research lens here may be missing some things). More recently and closer to the gas pump, after public investors lost hundreds of billions over the last decade’s fracking boom, they have really pushed oil and gas companies to grow and compete less. But that restraint does not seem to have come from index funds, just from investors generally.
But what if we take the passive investor anti-competitive concern as true? If it is, it’s through some story of how the incentives of passive investors – for the market generally to do well, but with little concern for over or underperformance of any individual stock – flow through to company boards and management.
That essential story, though, is one we can largely tell about how executives are already compensated. Stock-based compensation disproportionally rewards executives based on whether the stock market as a whole goes up or punishes them when the market goes down.2 We could significantly sharpen corporate incentives by compensating executives for their outperformance versus their peers. That’s a much more direct route to address the anti-competitive downsides of increased cross-company shareholding, and it does so without first endangering the infrastructure or promotion of broad-based passive investing, likely the single best development for the investing public of the past 50 plus years.
To increase corporate competition, tie more executive compensation to stock alpha
Broadly speaking, corporate executives’ financial upside is driven by compensation plans that are largely triggered by stock performance and pay out in awards of stock or options to buy stock.
There are various criticism of this model – do we pay executives too much?, should triggers be based on non-stock performance metrics?, should the stock triggers be longer-term? – but let’s ignore those here. Instead, executive compensation is incomplete even on its own financial premises because it compensates executives so much based on broad stock market performance, not their distinctive performance relative to their peers and the market generally.
This distinction between broad market performance and individual performance relative to that often goes by the terms beta and alpha, and it’s at the heart of the passive investing revolution. Most investments – and investment manager performance – are driven by what the market (or sector) broadly does, not by individual stock-picking. We shouldn’t compensate investment managers a lot for broad market performance, as it’s not in their control and we can access it very cheaply (thank you, Blackrock, Vanguard, State Street & co.). We should reward active investment skill, the alpha of performance above and beyond the benchmark.
What’s true for investment managers should be true of executives. If the market or a sector goes up 100%, and a company in that sector goes up 75%, the executive gets a windfall, even as their performance was worse than their peers. Instead, we should pay for alpha.
In practice, executive compensation does have some additional ways it rewards for alpha. Executives with companies that significantly outperform the market and peers may get larger compensation awards in the future and may be more likely to stick around at the top, giving them more chances for large payouts.
But more explicitly tying executive stock-based compensation triggers and payouts to outperformance relative to peers would engender a more competitive, aggressive posture between companies. Certainly, it would have much more dramatic effects on corporate behavior that the contortions critics of passive investing would lead us down to reconfigure passive shareholding.
Alpha-based stock compensation is more durable during market downturns, a recently remembered virtue of compensation schemes
As you may have noticed over the past six to twelve months, stock markets don’t just go up and to the right. Sometimes, stocks go way down. This blows up most companies’ stock-based compensation schemes. The triggers for future rewards are now far out of reach, and the payouts – especially if in options – lose lots of value too. Depending on what happened previously, some executives’ compensation schemes may be fine, others’ value may have evaporated.
What happens next varies a lot by companies. Sometimes they’ll adjust compensation schemes by re-setting triggers and payouts, other times they won’t. There’s a lot of stress, confusion, and arbitrariness here.
Instead, compensation tied more to alpha would be a more robust, predictable schema. It isn’t affected by broad market conditions, instead staying isolated on the individual performance of the company versus its peers. In a simple example, even if your company is down 20%, if your major peers are down 40%, you’ve done a good job. Whether you’re rewarded for that shouldn’t depend as much on some ex post rejiggering of the compensation scheme.
Alpha-based executive compensation has some wrinkles. Defining corporate alpha has some subtleties: who are each company’s peers or benchmark? Should we be tightly focused on the sector a company is in or look too at the sectors the company may expand to? Should we adjust for different equity to debt ratios? How international should comparisons be? There’s now no easy place to look this up, no common reference points. But investment finance has lots of tools to approach these questions.
Getting companies and corporate boards to shift to alpha-based compensation is an uphill battle. Perhaps the large voting powers of passive shareholders like Blackrock, Vanguard, and State Street could help…
And there’s one last benefit of shifting corporate stock-based compensation to be more alpha-based. I think we’d benefit the more we think of and judge performance relative to benchmark. We are in a world that still blurs this a lot. How we talk about and evaluate schools, politicians, healthcare, individual lives: the “data-driven” focus still often means looking at the end outcomes, not relative to benchmarks or where things started. An alpha-based approach helps reward and celebrate the too unheralded work of making bad situations a bit better. It helps counterbalance the often-massive incentives to spend lots of time selecting for already good trains to jump on board. The alpha-based approach can reveal and remind us how large a share of outcomes are outside our control. And detecting true alpha is tough – that should give us more humility in understanding how things shake out, perhaps more fortitude in those moments when things didn’t turn out great.
Shifting how stock-based compensation works obviously doesn’t directly lead to that change in orientation. But how we measure is what we show what matters, and few metrics are as observed or high stakes as how we measure financial outcomes and judge executive performance.
The distorted voting concern seems likely to be true, though it’s unclear how big a deal this is. John Coates’ paper The Future of Corporate Governance Part I: The Problem of Twelve turbo-charged this debate and lays out various responses to the concertation of shareholder voice.
As discussed below, the “punishment” side of the coin doesn’t always pay out when the stock market does poorly.