Thursday, March 24, 2016

Slow money

Would it make sense for firms to try to slow down their equity structure?

Equity markets are made of two classes of participants. The minority consists of long-term investors who, like Ulysses, have 'tied themselves to the mast' and would rather fix things when a company runs into problems than sell out. The majority is made of up rootless speculators and nihilistic indexers who cut and run the moment the necessity arises.

Because their holding period is forever, the long-term investor class does all the hard work of monitoring a company and agitating for change. Keeping management honest is the only recourse they have to protecting their wealth. Speculators and indexers are free loaders, enjoying the same upside as investors without having to contribute to any of the costs of stewardship.

How might long-term investors be compensated for the extra expenses they incur in tending the garden?

One method would be for a firm's management to institute a slow/fast share structure. The equity world is currently dominated by the fast stuff, shares that can be bought and sold in a few milliseconds. A slow share is a regular share that, after having been acquired, must be "deposited" for, say, two years. During the lock down period the shareholder enjoys the same cash dividends as a fast share but they cannot sell. Only when the term is up can the slow share be converted back into a fast share and be got rid of. The illiquidity of slow shares is counterbalanced by a carrot; management makes a promise that anyone who converts into slow shares gets to enjoy the benefit of an extra share down the road i.e. a stock dividend. So a shareholder with 100 fast shares who pledges to lock them in for two years will end up with 101 fast shares once the lock-up period is over.

The investor class, which until now has received no compensation for their hard work, will quickly choose to slow down all their shares and enjoy the biennial stock dividend. Feckless speculators and indexers, unwilling to stay tied down for two years, will keep their fast shares and forgo the dividend. After all, the S&P's constituents could change at any moment, so an ETF/index fund needs to be able to cut and run. And a speculator's trend of choice could reverse at any moment.

By the way, ETFs and index funds aren't the only asset type that I include in the fast money category. Also qualifying are the huge population of funds that claim to be "active" but are actually "closet" indexers, as well as all those funds that say they are engaging in 'investing' but are really just speculators. Given the possibility of sudden redemption requests, they need the flexibility that liquid fast shares provide.

As the slow/fast share structure goes mainstream, the benchmark to which market participants are compared, the S&P 500 Index, will evolve into two flavours, the Fast S&P 500 and the Slow S&P 500, the former including the fast shares of the 500 index members while the latter includes only the slow. The Slow S&P will, by definition, show better returns than the Fast S&P, since slow shares enjoy stock dividends at the expense of fast shares. Nihilistic indexers and rootless speculators will choose to benchmark themselves to the lagging Fast S&P. Active investors with a genuine long-term bias, most of whom will choose to own slow shares, will compare themselves to the better-performing Slow S&P.

Mass adoption of fast/slow share structure could change the complexion of the very combative active vs passive investing debate. Passive investors have typically outperformed active investors after fees, largely because they have been able to freeload off of the stewardship of long-term investors. With a new structure in place, buyers of passive indexed products would—by definition—begin to underperform the average long-term active investor. This is because the dual share structure obliges the passive class to compensate long-term investors for their efforts.

I suspect that the adoption of a fast/slow share structure would increase the size of the investor class. After all, with a long-term investing mentality now being rewarded, those on the margin between the investing class and the mass of speculators/indexers will elect to slow down their shares. Once they have lost the ability to cut & run, the only way to protect their wealth will be through constant surveillance of management and a more activist stance. This is a good thing since long-term shareholders are better stewards of capital than short-term ones. In general, share prices should rise.

On the other hand, as more shares are locked down, market liquidity will suffer. Will the increase in stock prices due to improved stewardship outweigh the drop in prices due to a much narrower liquidity premium? If I had to guess, I'd say yes. Which means that even feckless indexers and speculators should support the subsidization of long-term investors.

Addendum: This isn't a new idea. Read all about loyalty-driven securities here.
Disclaimer: I consider myself to be 50% speculator, 25% indexer, 25% investor. But I'm trying my best to boost the last category.


  1. Couldn't somebody buy a long share then effectively "sell" by issuing a derivative?

    1. They could 'sell' their slow shares that way, but if they do so counterparty is now stuck holding the slow risk and, as such, will now have to exercise stewardship. Since the counterparty's best alternative is to buy a fast share, slow it down, and accept a stock dividend after two years, the fee they will require to accept slow risk will be at least the size of the stock dividend.

    2. Derivatives subvert the slow/fast distinction (though with counterparty risk). Moreover the lesser liquidity can widen the scope for Op/Fut expiry games.

      ST/LT capital gains tax is supposed to make the distinction but that can be handled by derivatives too.

    3. "Derivatives subvert the slow/fast distinction (though with counterparty risk)."

      Give some more details.

  2. Help: Where is the slow risk? I am a custodian. I buy a slow share, write a synthetic fast share on its back and put the slow share in a box. The client pays me for creating the synthetic fast share (I guess?), I collect dividends, and after two years I take the slow share out the box to liquidate the transaction. My client and his clients have meanwhile bought and sold the synthetic fast share among themselves, vindicating or not their belief that they can do so profitably, but I can't see a problem there for me the custodian. Am I having a dumb day?

    1. Can the original synthetic fast share be putted back to the custodian at any time by the client? Or must it stay in circulation for two years before it is cancelled?

  3. How is this different from the USA's preferential tax treatment for long term capital gains? Tax preferences are muddier (since the actual value depends on the rest of the portfolio), and US laws generally consider 1 year (rather than 2) to be long term, but ...