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There seems to be an increasing amount of criticism directed at Exchange Traded Funds. How do you respond to this?
Not to be glib, but the answer really depends on the criticism being leveled. For example, we believe that there is a lot of merit to criticism of ETFs that are based on underlying derivative contracts, rather than physical baskets of stocks, bonds or whatever else is contained in the index tracked by the fund. The use of derivatives introduces higher levels of complexity (e.g., counterparty risk, and flow trading to manage exposures) that is usually far from transparent. This is a movie we've all seen before, most recently in the sub-prime mortgage bond fiasco. Unfortunately, we know by now how this movie usually ends. The good news is that this type of structure is far more prevalent in Europe than it is in North America. The bad news is that European financial regulators are preoccupied with other issues these days, so these ETF issues may remain unaddressed for far too long. Another criticism of ETFs that we have a lot of time for is that too often they are nothing more than active strategies dressed up in index clothing. As we have long stressed, the only portfolio that every investor can passively and simultaneously hold is the market cap weighted portfolio. By definition, any departure from this portfolio is an active strategy of one type or another, whether that is a tilt within a given asset class, or a different mix of asset classes.
To be sure, there are practical issues when it comes to implementing this view - for example, as we've written many times, market cap weighting applies much more easily to equities than it does to some other asset classes, like bonds and commodities. However, the point is clear. Today, we see too many ETF sponsors creating new products that are based on incredibly narrow indexes (or worse, leveraged indexes), and fear that at least some investors may be fooled into believing that they are somehow avoiding the risks of active investing by investing in an allegedly "passive" strategy, when this couldn't be farther from the truth. However, this argument is also closely related to another one whose merits we find more dubious. This is the assertion that the growing market share of ETFs is somehow inhibiting capital formation in the United States, because investors are reducing their interest in individual stocks. To begin with, going public is not automatically the best route for a small company to take, as anyone familiar with Canadian corporate finance can attest. In the absence of deep venture capital and private equity markets as are found in the U.S., too often small Canadian companies are forced to go public too early, then proceed to fall short of investors' expectations in a quarter, and find themselves unable to raise more funds to support their growth. Frankly, if growing interest in ETFs prevents more U.S. companies from going public until they are large and stable enough to quality for inclusion in an index, this is not a negative, in our view. Beyond this however, given the manifest and extremely well documented failure of most people (and funds) to achieve sustained success as active investors in individual stocks, we don't see "going back to the good old days" as a "solution" that is in their best interest.
In the past, you have been pretty negative on the outlook for municipal bonds in the United States. Given all the criticism of Meredith Whitney for her overly pessimistic forecasts for municipal defaults, have you changed your views on this issue?
We're not so sure her forecasts are overly pessimistic in terms of the size of the underlying problem - though we admit her default rate estimate was too aggressive, at least in the short-term. A review of the extensive analysis of the size of public pension fund shortfalls in a series of papers published by Robert Novy-Marx and Joshua Rauh should put to rest any doubts about the size of the pension funding shortfall facing many state and local governments. And make no mistake, the consequences are beginning to appear - and they are ugly. We have argued that the smallest state in the nation - Rhode Island - may well be the proverbial "canary in the coal mine" for the United States. Consider what has happened there over the past year. First, the small city of Central Falls declared bankruptcy and cut the size of pension payments to retirees when its pension fund ran out of cash. 'Later, the state's General Assembly passed a law that gave bondholders first claim on the state's tax revenues, out of fear that the state of its pension underfunding (the worst in the nation) could close its access to bond markets. This came at about the same time that the SEC announced an investigation into the adequacy of the state's disclosures to investors in its bonds. Most recently, Gina Raimondo, the Democrat (and former venture capitalist) who is the state's General Treasurer, has introduced a wide ranging pension reform plan that involved cutbacks to benefits to current retirees - accompanied by a brutally direct, and admirably clear education campaign that focused on the inescapable math at the root of the problem (see, for example, "The Little State with the Big Mess" in the 23Oct2011 New York Times).
Rhode Island is a perfect, perhaps the perfect, example of what Walter Russell Mead has termed the "Blue State Model", which includes lavish benefits for public sector unions, lavish social programs, and a political and regulatory climate that is generally unfavorable to business. Mead argues, and we agree, that this model is, ultimately, unsustainable. We suspect that Raimondo also agrees, when she refers to Rhode Island as "Athens on the Narragansett". There is, however, one big difference - Greeks generally find it much harder to move to Germany where the economy is booming than Rhode Islanders who set out for Texas (indeed, RI is a national leader in population loss, and especially loss of middle class family households). In some ways, the easier mobility in the United States (even after taking two career concerns, health insurance and underwater mortgages into account) makes the challenges facing Rhode Island and other blue states potentially even more difficult to resolve than those facing Greece - which, after all, can default on its debt, withdraw from the Euro, and hope to devalue its way to an economic recovery. Under these circumstances, it comes as no surprise that the public sector unions in Rhode Island are seeking to overturn the law giving bondholders preferential access to the state's tax revenues, on the theory that "every party should share the pain." In our view, Whitney was too early on her default rate call, but her analysis was right on target - keep your eye on the Ocean State to see where we may be headed next.