Coyote Blog

My relatively snarky post on hedge fund fees and passive management got a lot of response, including a few of challenging emails from friends and acquaintances.  So I wanted to cover a few followups here.

One of the interesting features of passive investment management is that it doesn't work if everyone does it.  I vaguely remember there is some name for this in the game theory world but I can't for the life of me remember.  Anyway, passive investment is based on the theory that the market for financial products is relatively transparent and efficient.  While one stock will certainly perform better than another, it is almost impossible (or at least really expensive) in a mostly-efficient market for a regular investor, or even an average fund manager, to parse this out.  As a  result, high fees or expenses one might incur to find these opportunities generally don't pay for themselves, and it is better to just invest in a broad basket of securities and accept the average market return.

But note that this is predicated on the assumption that someone, somewhere is actively managing.  Someone must be looking for good stocks and bad stocks and buying the former and selling the latter.  Without these folks actively managing, it would not be an efficient market.  [I am reminded at this point of the old joke about a man walking down the street with an economist.  The economist steps right over a $100 bill on the sidewalk without stopping.  The man asks the economist, "why didn't you stop and pick up that money?" and the economist answers, "in an efficient market it can't really be there."]

I remember a while back reading economic research about shopping.  What percentage of customers have to be active price-shoppers to make a market efficient?  I personally don't price shop for the small stuff.  If I need a bunch of cheap bulk stuff, I just run to Wal-Mart or Costco and buy it with confidence I am getting a pretty good price.  But why can I do that?  Because I trust these large corporations to honor their promise for low prices?  Hah!  No way.  What I trust is that there are people who clip coupons and price every dang item to the penny, and it is these folks who keep Costco and Walmart honest.  Government interventionists like to talk about the free rider problem all the time, but most all of us are free riders on these hard core shoppers.

The same is true with us passive investors.   I like to get snarky about the fees certain active investors charge, but I am still dependent on their work.  And I don't particularly doubt that there are hedge funds and private equity firms that make consistently above market returns, but I do think they are a minority.  I would equate it to max-contract players in the NBA.  No one doubts Lebron James merits a max contract -- any of the teams in the NBA would sign that deal in five seconds.  But a max deal for, say, Chandler Parsons?  Joakim Noah?  The problem with hedge funds is that the few of these folks who merit the two and twenty max contract have very likely been closed to new investors for years, in the same way it is impossible to get LeBron James to play for Memphis.  It is frustrating for me to see public and private institutions chasing yield and continuing to pay 2 and 20 to folks with an unproven algorithm and a marketing plan.  If I am going to pay 2 and 20, its more likely to be to someone in private equity or an LBO fund who is doing more than stock picking.  That's because I do think that stocks are generally well-valued on the market based on their current management, investment plans, culture, etc.  But they may contain opportunities for smart people who can come in and, for example, apply different management and culture and strategy to the people and assets.  A box that is half Kale and half candy corns might not sell for a good price because no one wants the combination, so value can be created splitting it up.

A couple of other thoughts that came up in discussions since yesterday:

• I am willing to believe that passive investing looks so good vis a vis active investing because central banks have inflated assets and compressed volatility.  If all the boats are rising with the tide of state actions that are raising the tide, then one is less likely to be fussy about which boat he is on.  What's the point of value investing when the market treats stocks as commodities?  But I can certainly see that in markets like the late 70's or pre-market-boom early 80's that stock pickers might have had more room to differentiate themselves.
• I am also willing to concede that passive investing may turn out to be a terrible trend for corporate governance.  If all your shareholders are just holding your stock as part of a basket of 500 stocks, who is going to hold you accountable?  It is very awkward for a Vanguard agitate for changes in a company, even when they might be the largest single shareholder.  Also, ironically, passive investing may be opening the door for single lone wolf activist investors to impose their will on companies, sometimes to the other shareholders' detriment.  If one person with 5% cares a lot and the other 95% are passive, that one person might be able to raise a lot of hell.

As a final note, I am a screaming hypocrite on the whole passive investing thing, since with most of my net worth I am the ultimate in active investors.  I have most of my savings in one company, the one I run.

I have mixed feelings about Groupon.  Having been an executive at Mercata 10+ years ago, I recognize that they have gotten further than we did with the group buying model by a) waiting for there to actually be social media and b) delivering electronic goods (coupons) rather than hard goods.  As a customer, I have satisfactorily participated in several groupons and as a business we have used it a couple of times as a promotional program.  As an investor, I was short Groupon for quite a while, convinced that they had no particular barrier to entry for competitors like Amazon who could grab the market if there was enough money at stake.

So, all that aside, I was fascinated by the recent settlement of a class action lawsuit.  Prior to the lawsuit, all customers could get a full refund of their Groupon through a simple contact with Groupon customer service.  After the lawsuit, customers during the class action period can only get a partial refund and then only by going to a separate class website and hassling with forms and doing a lot of waiting.  The plaintiffs will actually get less than they would have had the lawsuit not gone forward, the difference being the millions required to pay off the tort lawyers to go away.

Having just had to pay the fees of a tort lawyer who brought a frivolous suit against our company just to make him go away, I am sympathetic.  Had the plaintiff approached me directly, I might have given her a few bucks just to settle and avoid getting lawyers involved.  But instead the lawyer got part of his fees paid in the settlement and the plaintiff got zip.  Basically just legal blackmail, with the plaintiff as unpaid pawn.

Ages ago, I was an executive at Mercata, an Internet store whose strategy was to sell items whose price would go down as more people agreed to buy the item.  In theory, this creates an incentive for viral marketing, as anyone who buys has a financial incentive to get their friends to join in.

The company died for a variety of reasons, in part just because like many startups in that weird era of the late 90's, we just built up too many fixed costs too fast to reach breakeven in any reasonable amount of time.  We were also ahead of our time in some ways -- the model makes a ton more sense in the Facebook / social media age.

But we also failed, as did many Internet stores, because order fulfillment, product inventory, shipping, etc was and still is expensive.

Glenn Reynolds notices that a lot of folks (including Amazon in his link) are selling coupons.  This may be a blinding glimpse of the obvious to all of you, but the appeal of a retailer of selling coupons online is that they are virtually free to inventory, to fulfill, and to ship.   Think of it this way -- you want to compete online on price.  You can actually sell the physical stuff at a discount.  Or you can sell the coupon, which gives access to the customer access to the same discount but is much easier to fulfill.  It also lets you "sell" things you normally can't provide over the Internet, like a restaurant meal.

The model is not that compelling to me, because I shop online for the convenience rather than the price.  I buy some Groupon type coupons, but generally for things like restaurants rather than products.

Via Overlawyered:

The settlement discussed in this space July 17 "” in which lawyers nabbed more than $25 million in fees and expenses, while fewer than 100 consumers redeemed Ford coupons worth $37,500 "” was covered by the Associated Press last week, which stirred outrage in many quarters [Krauss/PoL, Greenfield, Cal Biz Lit]. As Cal Civil Justice notes, the settlement was purportedly on behalf of owners who suffered no rollover or other mishap. Instead, it sought damages for losses in the vehicle's resale value due to adverse publicity, a nicely circular theory, since the adverse publicity was in good measure propelled by various allies of the plaintiff's bar.

I haven't written for a while about lawsuits, in part because our company was in the process of being sued for hundreds of thousands of dollars in two cases for a) allowing a customer to get a splinter in his/her foot from walking barefoot on a wooden deck and b) allowing a guy who just had a knee operation and jumped from a height of six feet to hurt his knee.   I really didn't want to throw any more fuel on the discovery fire.

Anyway, that is all behind me, and just in time to post on a funny story via Overlawyered.  I have written a number of times about lawyers whose clients get coupons while they harvest millions in fees from a class action.  As I wrote here:

It used to be that clients would suffer some sort of injury and seek redress in the courts.  To do so, they would hire an attorney to help them.  The attorney was the hired help, compensated either hourly or via a percentage of any awards.

Today, the situation is often reversed.  It is the attorney who is identifying lawsuit targets for class actions and shareholder suits, and then seeking out clients who can maximize his chances of success.  Clients, who typically make orders of magnitude less than the attorney in class actions (think 50-cent coupons and $8 million attorney fees) are selected because they are sympathetic, or give access to a particularly plaintiff-attractive jurisdiction, or, in cases such as ADA suits in California, because they have effectively become partners with the attorney in serial torts.

So I had to laugh when I saw this story in Overlawyered yesterday:

The client class members were to receive only gift cards, not cash, in the settlement with Windsor Fashions, a clothing retailer, so Los Angeles Superior Court Judge Brett Klein thought it only fair to provide that Yorba Linda attorney Neil B. Fineman be paid his fee with "12,500 ten-dollar Windsor Fashions gift cards."

A while back, in relation to a company called Terrapass that sells carbon offset certificates (or smugness coupons, as I called them) I observed:

My guess is that TerraPass, when it sells the electricity from these
projects to customers, is selling it on the basis that it is
earth-friendly and causes no CO2 emissions.  This lack of emissions is
likely part of the "bundle" sold to electricity customers.  But note
that this would be selling the same lack of emissions twice -- once to
TerraPass certificate holders, and once to the electricity customers.
I am sure they are both told they are avoiding X tons of emissions, but
it is the same X tons, sold twice (at least).

We are starting to see this all over now.  From the WSJ, via Tom Nelson:

America's garbage dumps are reaping a windfall from the fight against
global warming. But their payday might not be doing much to reduce
greenhouse-gas emissions.

For more than a decade, the landfill
here has made extra profit simply by collecting methane given off by
rotting trash, and selling it as fuel. Last year, the landfill learned
that doing this also qualified it to earn hundreds of thousands of
dollars via a new program that pays companies to cut their
greenhouse-gas emissions.

Eliminating methane lets dumps sell
"carbon credits" to environmentally conscious people and companies. The
long-term goal of trading credits -- basically, vouchers representing
reductions in carbon dioxide and other greenhouse gases -- is to reduce
global pollution by encouraging others to cut emissions when the buyers
of the credits can't or won't cut their own.

"It seemed a little suspicious that we could get money for doing nothing,"
says Charles Norkis, executive director of the Cape May County
Municipal Utilities Authority, which has raised $427,475 selling
credits since February, or 3% of the authority's projected solid-waste
revenue for the year.

The sale of credits by these landfills
undermines a premise of the global fight against climate change. The
credit system was designed to encourage pollution cuts that wouldn't
have happened without a financial incentive. But the credits aren't helping the environment if they're merely providing extra profit for cleanups already made. And dumps already have an incentive to capture methane because selling it can be profitable.

More on this same carbon offset issue in the European / UN system here.

Why a carbon tax, if we really feel we must limit CO2, is better than cap-and-trade / offset system here.

For RSS readers who probably don't get the updates to posts, I have added a number of updates to my post on smugness coupons, also known as offset certificates.

A few weeks ago I wrote about the changing relationship between attorney and client:

It used to be that clients would suffer some sort of injury and seek
redress in the courts.  To do so, they would hire an attorney to help
them.  The attorney was the hired help, compensated either hourly or
via a percentage of any awards.

Today, the situation is often reversed.  It is the attorney who is
identifying lawsuit targets for class actions and shareholder suits,
and then seeking out clients who can maximize his chances of success.
Clients, who typically make orders of magnitude less than the attorney
in class actions (think 50-cent coupons and $8 million attorney fees)
are selected because they are sympathetic, or give access to a
particularly plaintiff-attractive jurisdiction, or, in cases such as
ADA suits in California, because they have effectively become partners
with the attorney in serial torts.

At that time, the issue was Bill Lerach suing his clients for dropping him as attorney (Because, after all, it was really his lawsuit and not theirs).  This time, the issue is in a class action against Microsoft (emphasis added, via Overlawyered)

Judge Scott Rosenberg ruled Friday that Microsoft attorneys could
not ask the named plaintiffs about their relationship with attorney
Roxanne Conlin. The company's lawyers wanted to question the
plaintiffs, arguing that Conlin had referred to them during jury
selection as "just regular people who bought software" and who
volunteered to step forward to sue Microsoft.

The lawsuit was brought by Joe Comes, a Des Moines businessman who
owns a chain of pizza restaurants, and Patricia Anne Larsen, a retiree
from northwest Iowa, and two business _ Riley Paint Inc. of Burlington
and Skeffington's Formal Wear of Iowa Inc. of Des Moines.

Microsoft attorney David Tulchin said Larsen has been a friend of
Conlin's since 1982, when Larsen held fundraisers for Conlin's failed
run for governor. In 1999, Conlin represented Larsen in an employment
discrimination case against Larsen's former employer, Eaton Corp.

Tulchin said Comes has been Conlin's son's best friend since high school.

Microsoft attorneys claimed Conlin recruited these friends to act as
plaintiffs in the case so she could sue the company and that her
comments during jury selection opened the door for Microsoft to
challenge the plaintiffs' motivation in filing the lawsuit.

Who would even imagine such a thing?  In this class action, as in many, the class members will probably get coupons while Conlin makes millions.  Or, as Microsoft observes:

Tulchin claimed that Conlin and her co-counsel, Richard
Hagstrom of Minneapolis, have the most to gain in the lawsuit

Attorneys like Conlin know they are vulnerable on this

Conlin said Microsoft wants the jury to believe that class-action
lawsuits are attorney-driven cases brought for money when in reality
they are a way for individuals with small claims to come together to
take on large, powerful companies.

"Businesses like Microsoft have poisoned the public view of these
forms for seeking redress by spending billions of dollars to spread
propaganda. Now they seek to collect on their investment by improperly
suggesting to the jury that the plaintiffs are not real plaintiffs,"
she said.

You think?

From Overlawyered:  Another lawsuit where customers get the coupon, and lawyers get the cash.  I would love to see the use rate on the coupons out of these suits. I have gotten a few for like $1.24 off something that I threw away.  I mean, in several cases, the company was offering better coupons in the Sunday circular.

Though I thought it was kind of silly at first, I am coming around to supporting legislation that attorneys should get paid in the same currency as customers.

Also from Overlawyered is this good news about courts finally taking legal action against people who file fraudulent suits and claims:

A Fayette minister and a teacher are going to prison for their role in submitting phony Fen-Phen drug settlement claims in Jefferson County

Good, though we might have to have a massive amnesty in Mississippi or half the state could end up in jail.