Weekly Edition #72

In this edition:

Softbank is a Japanese conglomerate that has many different businesses. It’s founder, Masayoshi Son (Masa) was the richest man in the world during the 2000 tech bubble. He then went on to lose billions in the tech crash. Softbank increased by 4,600%+ in the tech bubble only to crash down 99% from its high in 2000 to its low point in 2002. Masa went on to rebuild his fortune and is currently worth around $21 billion. In 2017 Masa launched the Softbank Vision Fund, which was the first $100 billion venture capital fund. The investment thesis was investing in companies and giving them so much money that they would outspend, kill their competition, and then dominate their market. Since its launch we always thought this was a bad idea. Raising huge amounts of money in an industry where companies are small, leads to one outcome, overvaluation. If you need to invest $100 billion into startups, eventually you will start investing more and more money into fewer companies, therefore driving up their valuations and driving down returns. This is the antithesis of capital discipline. If you have unlimited money ($100 billion isn’t unlimited but pretty close to it), then you spend like crazy.
This hasn’t panned out so well for the fund or its investors (what a surprise!). There have been many ridiculous stories in which the fund invested hundreds of millions into companies only to then exit with huge losses. Softbank invested $375 million in a robotic pizza making company only to lay off 80% of its workforce and switch its business model 2 years later. Softbank also invested $300 million in a dog walking company only to sell it back to the company a couple of years later for a loss. Its highest profile blunder was WeWork which they invested $16.9 billion only to go public last year at a $7.3 billion valuation. All this after nearly going bankrupt and having to pay Adam Neumann (the founder) hundreds of millions of dollars to leave the company.
It’s no surprise then that with so much money to invest and doing relatively little due diligence in many companies, the Vision Fund has lagged behind the S&P 500 and the Nasdaq. The fund was up roughly 40% through the end of 2021, compared to 72% for the S&P 500 and roughly 100% for the Nasdaq. Returns depend in large part on valuations. And the more money you have to invest the easier it is to overpay.

We’ve written before that ETFs are much more tax (and cost) efficient than mutual funds. This is because of the way each structure works. When you invest in an ETF you are buying ETF shares in the open market. There is no money going directly to the ETF company, you are buying the shares from another investor or from a market maker (who creates and redeems ETF shares from the ETF issuer). When you invest in a mutual fund you send cash to the mutual fund company, and they go out and buy the shares. When you want to get money out of the mutual fund, the mutual fund company has to sell shares to raise cash to distribute to you. This process of selling shares can create a tax liability for every fund investor. Therefore, it is possible that you invest in a mutual fund, you lose money over the period, and have to pay taxes at the end of the year. This is because the tax liability doesn’t only depend on your actions but also on the actions of the other investors. This is just one of the reasons why ETFs are superior to mutual funds.
Vanguard was charged a fine for unnecessarily burdening investors with a tax liability. They had some mutual funds and created an incentive for some large institutional clients to move their investments to other funds. This selling by the large clients left many of the fund’s investors with large tax bills. It doesn’t make any sense to have to pay taxes on actions you have no control over. You have no control over if investors will decide to buy or sell. Therefore, you shouldn’t have to pay taxes based on someone else’s actions. With ETFs you only pay when you sell, and that’s controlled only by you.

We’ve written several times before about Charles Schwab’s robo-advisor. A robo-advisor is essentially a website which gives you asset allocation advice. You deposit your funds, take a risk tolerance questionnaire, and they recommend an allocation. The site also rebalances your portfolio and takes into account taxes, and a lot of things that actual advisors also do. When Schwab launched their robo-advisor they marketed it as being zero fee, they didn’t charge anything for the service. They did say they used Schwab ETFs and that’s where they would earn their money.
However, all the allocations included unusually large cash balances, ranging from 6 – 23% depending on the investor’s risk tolerance. They claimed that it was because cash was a strategic investment and part of a sound portfolio. However, the true reason was that they didn’t pay much interest (or any interest) on this cash balance, but they could lend it out through their bank and earn much higher yields. Therefore, the true cost of these portfolios was around 0.12 – 0.46% (assuming Schwab earned 2% on the cash). As rates move up, this cost increases. We think the trend to lower fee is great. Today we can invest in a globally diversified portfolio for very low cost. The drawback of this fee pressure is that it incentivizes companies to hide their fees. Schwab’s headline fee was 0%, but in reality, it was as high as 0.46%. Therefore, it’s not that investors are paying less, they just think that they are.

A key metric for pension funds is their funding ratio. The funding ratio measures the percent of liabilities that are covered with the assets currently in the pension fund. To measure this, they discount their future liabilities by a discount rate (usually derived from a long-term bond yield) and assume a certain rate of return for their current assets. The difference between the discounted liabilities and the assets is the funding ratio. Therefore, the funding ratio highly depends on the discount rate and their return assumptions. The discount rate is largely driven by long-term bond yields, so there is not much discretion there. However, the return assumptions depend on the asset allocation (which they control), and the return assumptions for each asset class which they can influence (to be clear they can influence the assumption, not the actual return itself).

This is the reason why many pension funds have increased their allocations to private equity and private debt. The expected returns for these assets are higher than their public counterparts (erroneously we think), so increasing their allocation makes their funding ratio look better. This is also why they’ve been increasing allocations into riskier investments. The riskier the investment, the higher the expected return, and the higher the expected return the higher the funding ratio. No pension fund manager or politician wants to have to ask their taxpayers for higher taxes or lower future payouts in order to improve funding ratios. The easiest way out is to invest in riskier stuff and hope it works out.

Going off the last article, the drawback with investing in risky and illiquid investments is that you cannot get your money out when you need to. Well, you can but you will need to pay a price. Private equity funds tend to have a 10 – year life. So, if you need your money beforehand, you will not be able to redeem your investment. A secondary market has developed in which investors will buy and sell stakes in private equity funds. The buyers in this market have all the leverage. If someone wants to sell, then they are in need of cash and will be willing to accept a low price in order to obtain the liquidity.
Calpers started getting more and more into private equity a few years ago in order to boost their expected returns. This was driven in large part by their chief investment officer (which is now no longer there). Now they sold $6 billion of their private equity positions at a discount. Calpers sold in order to have cash to take advantage of other opportunities. They had to sell them at roughly 10% discount to their values in September. Liquidity management is extremely important. You never want to be in a position to be a forced seller of an asset.

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