Unconventional wisdom: Why are we turning our back on markets?
Markets may not be perfect but a cursory look at the alternative unveils some troubling flaws.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Why are we turning our back on markets?
Jerry: “He’s Bizarro Jerry!
Elaine: “Bizarro Jerry?”
Jerry: “Yeah. Like Bizarro Superman. Superman’s exact opposite, who lives in the backwards bizarro world. Up is Down. Down is up. He says ‘Hello’ when he leaves, ‘Good bye’ when he arrives.”
- Seinfeld
Why are we turning our back on public markets?
It is a question worth asking. Investors have gone nuts for private markets where opacity rules.
Political parties who championed laissez-faire are turning to top-down economic planning with elected officials serving as kingmakers for companies and whole industries.
Have we entered a bizarro world?
Was it the West Germans who tore down the wall to escape to the east?
Did China undergo rapid growth because Deng Xiaoping steered away from a market economy?
Were the shelves of the Eastern Bloc overflowing with food and consumer goods because the party Apparatchiks wisely allocated resources in a command-and-control economy?
Who is steering our economic ship – the free hand of Adam Smith or Karl Marx’s labour theory of value?
It is worth asking. I will let others opine on the political angle. I’m interested in what is happening in the investing world.
A history of markets
On the 17th of May 1792 twenty-four stockbrokers signed the Buttonwood Agreement in New York. The intention was to encourage public confidence in the markets by setting commissions and establishing rules for the trading of shares.
The name of the agreement referred to the common practice of stockbrokers gathering under a Buttonwood tree on Wall Street in lower Manhattan to trade shares.
Those first stockbrokers in New York understood the advantages of having multiple buyers and sellers gathering in a single place. That is the beauty of a market.
A market is a mechanism to allocate goods and services and to facilitate price discovery. When markets are functioning properly prices are transparent and supply and demand are aligned. This benefits everyone.
Markets are not perfect. There is always room for improvement. But most issues occur when something is preventing transparency, when the playing field isn’t level or when supply and demand is manipulated.
The Buttonwood Agreement was the first of many attempts at improving how markets function. And as investors we must admit that things have gotten better.
The golden era for fund managers
If you had to pick a time to have a 30-year career as a fund manager it is hard to argue against the 1970s, 1980s and 1990s. Regulation in response to the 1929 market crash had stabilised markets and more people were willing to invest. That did not make things transparent or fair.
Fund managers had every advantage over everyday investors. It wasn’t about fund managers being smarter. Companies would disclose things to fund managers they didn’t tell the general public. The fund managers had an informational advantage.
Fund managers were served by an army of salespeople finding new investors. The fund manager simply had to pay a commission which was passed on to the end investor.
The fund managers got to charge high fees. And the end investors didn’t complain because they were completely in the dark. They didn’t know what the fund manager was buying. They didn’t know why. They didn’t have any context to judge the performance of the fund. All they knew was what the fund manager decided to tell them.
The cracks in the foundation of this golden era were barely perceptible at first. But eventually it all came crashing down.
In 1976 John Bogle started an index fund. He argued that investors were getting ripped off. People started to listen.
Information on funds including their relative performance started trickling out. A good deal of the credit can go to Joe Mansueto who founded Morningstar in 1984.
The advent of the internet turbocharged the dissemination of information. A torrent of data showed that despite informational advantages most professional fund managers failed to beat the index. Bogle was right.
In October of 2000 the US Securities and Exchange Commission implemented Regulation Fair Disclosure requiring companies to disclose the same information to all investors at the same time. Similar regulation was implemented globally.
The impact has been remarkable. Fees have gone down. A lot. According to the SEC in 1979 the average fee for a US managed fund was 2.28% when you included sales commissions. By 2005 Morningstar data shows the average fee had dropped to 0.83%. In 2024 fees were down to 0.34%. Today you can get exposure to the ASX 200 for 0.04% through an ETF.
Increased transparency, a focus on fairness and lower fees all changed the investment landscape. Everyday investors were the winners.
The industry strikes back
Most things that are declared innovative are simply old things repackaged. That is how I feel about private assets. A few giant investors owning a company isn’t different from millions of smaller owners. The company is the company. Lending money through a bond issuance or bank isn’t different from private credit. The loan will be paid back or it won’t.
Only the packaging is different. Why the repackaging? Why the industry excitement for private assets? A cynic would argue that private markets turn the clock back. Private markets are opaque, the odds are stacked in the favour of professionals, it is hard to determine or benchmark performance and the fees are higher.
The industry wants to go back to the good old days. Who can blame them? I’m just not sure why so many investors are so quick to jump. What exactly is wrong with public markets?
The argument for private assets sounds a bit like an autocrat arguing against democracy. Just substitute markets for the will of the people. The markets are fickle. The markets are inflamed by passions. It is much better to replace markets with the benevolent expertise offered by technocrats.
The cheerleaders for private markets expect us to believe in alchemy. They tell us the act of privatising a public asset magically makes it a better investment.
They tell us that an asset is worth more held privately and is less volatile simply because the value is determined by smart people using models rather than the great unwashed that set prices in a market.
Pay no attention to the man behind the curtain we are told. But we are getting peeks – and it isn’t pretty.
A drumbeat of concerning news about valuations
ASIC recently did a spot check of auditors verifying the valuations of private assets held by super funds. Auditors are important because the owner of the assets also values them. There is an inherent conflict of interest. The auditor is one of the checks and balances.
I will quote from the AFR article describing the findings:
“ASIC also concluded, after reviewing one audit by each of the five largest accounting firms (Deloitte, EY, KPMG, PwC and BDO), that only one firm had obtained sufficient evidence to conclude the asset valuations in that fund’s financial statements were reliable.”
This is troubling. But there should be other checks and balances within the super funds to mitigate the inherent conflict of interest. There are also reasons for concern here.
At the end of 2024 it was reported that APRA found issues with the frequency of valuations, conflicts of interest in the valuation process and governance. They found issues with more than half the super funds which managed 80% of the unlisted private assets.
It isn’t just the super funds. Private credit powerhouse Metrics (currently not covered by Morningstar) had some of its funds downgraded by Lonsec who cited governance issues including a lack of separation between the debt and equity investment committee.
Why is this concerning? Because when a loan goes bad Metrics effectively repossesses the assets and becomes the owner. And this is happening more. According to the AFR the Lonsec report “revealed that 34 per cent of Metrics Income Opportunities Trust’s investments were equity or equity-like, up from 14 per cent from last year.”
If the value of the equity is the same as the value of the loan investors won’t face loses. This is why the integrity of the valuation process is important and why Lonsec looked at the governance process so closely. In response to the downgrades Metrics has announced they are making changes to their governance structure.
Are there any indications the valuations are off?
Citing governance issues and pointing out conflicts of interest is one thing. Showing real world examples where valuations miss the mark is another. There are some indications that the values of private assets don’t reflect reality.
Bloomberg reported this week that a $457 million commercial property investment by QSuper in 2020 (which subsequently merged with Australian Retirement Trust (ART)) was just written down to zero. When the tenant moved out ART choose to default on the loan which indicates their view on the value of the building. In cases like this the timing of when the value of the building dropped is critical. Investors are transacting daily based on valuation. If it isn’t correct somebody is getting cheated.
Super funds were criticised by APRA for not appropriately writing down investments in Canva during the tech freefall in 2022. APRA insinuated that super funds simply ignored what was happening in the market and the fact that other Canva investors were writing down their investments.
Universities in the US have piled into private assets to such a degree that according to the Association of College and University Business Officers they have an average of 2/3rds of their portfolios in private and non-traditional assets.
Now they need cash and the fire sale is on. Yale is reportedly selling $6 billion of assets with media reports speculating they will recoup between $5 and $5.4 billion. This is Yale. They practically invented investing in private assets under legendary endowment manager Dave Swensen. They are selling some of the best assets in the world....at a meaningful discount.
According to the AFR this is not unusual. Discounts in the secondary market where motivated sellers are trying to offload assets can be between 10 and 60 percent of their value.
It is hard to believe these assets are being valued correctly if they can’t be sold at the price they are held on the books. Isn’t what you can sell something for – right now – the value? Not what you wish you could sell it for. Not what you hope you could sell it for in two years.
How would we react if a portfolio manager holding publicly traded shares decided to value them at what she thought they were worth instead of the market price?
Final thoughts
“Democracy is the worst form of government, except for all the others.” This quote was popularised by Winston Churchill. I feel the same way about markets.
Markets aren’t perfect. They require constant vigilance to make sure they are functioning properly. They tend to temporarily go off the rails when fear and greed infect investors.
The transparency of markets and constant price discovery can be challenging for investors. It is hard to resist the signalling mechanism of prices. But there are benefits.
Transparent pricing ensures fairness when transactions are executed. It provides liquidity for investors. It means that everyone knows exactly what everything is worth at any given time. The list goes on.
Private markets is a misnomer. There is no market involved. If there was, the laundry list of issues I’ve outlined with governance and valuation wouldn’t exist.
We’ve solved 99% of these problems in public markets. Partly through the mechanism of markets and partly through decades of financial innovation and regulatory improvements.
It is frustrating that we seem to have gone back in time with private markets. But they aren’t going anywhere. As investors we need to demand more out of private market participants – the fund managers, the regulators, the gatekeepers and the service providers.
There needs to be more transparency into how assets are valued. More focus on the liquidity mismatch between infrequently valued assets and investors transacting daily. The fees should be lower. In short, we need to demand the same protections that have been fought for and won in public markets.
Private markets are now coming after retail investors. Maybe you are getting sales pitches. Maybe you have invested. Think about some of these issues when you are doing your due diligence. Think about how even the most compelling sales pitch stacks up against the benefits of public markets.
Email me at [email protected] with your thoughts.
Shani and I have a favour to ask
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What i’ve been eating
I spent the weekend in Auckland watching the Wallabies lose. Every time I go to New Zealand there is one thing on my mind – venison. I don’t know why there isn’t more venision on menus in Australia. I would happily chair the Royal Commission looking into this matter of great public importance.
This was my first trip to Auckland so I can’t make a definitive statement on the relative merits of different restaurants - but I do know that Amano is terrific. While every dish was great the standout was the venison. Pictured is the venison carpaccio with salsa verde, parmesan and aioli. I am not embarrassed at all to admit that I ordered a second helping for the table.
