I write a lot about technologies, companies and industries, some about economics, but hardly ever about stocks or trading, so this column is an unusual one. But because of the hard work of a couple economist friends of mine I’m finally coming to understand a stock market phenomenon that has been hurting tech startups for over a decade — Exchange Traded Funds. Forget about bad banks, cooked books and even the recession: Exchange Traded Funds are forcing more and more good tech companies to abandon the idea of ever going public.
We saw this trend on this summer’s Startup Tour where not one of more than 30 companies we visited saw an Initial Public Offering (IPO) in its future. Every company saw itself eventually being acquired. But there’s a problem with being acquired, which is that it greatly limits the upside for entrepreneurs. Had Microsoft been acquired by IBM, for example, would Bill Gates today be the richest man in America? Heck no. Lotus Development was acquired by IBM and the fortunes of those Lotus people haven’t fared any better than those of their colleagues at Big Blue. Yes, they got $3.3 billion, but today that’s not worth much more, maybe less.
IPOs are better if they work. IPOs make entrepreneurs big rich. So why aren’t there more of them?
That’s a very good question — one that until this week was generally answered by experts rolling their eyes like they were trying to explain the great frog die-off. IPOs are too expensive, we’re told. A positive upside is no longer as certain as it was in the 1990s, they say. Acquisition is just plain easier and big companies have learned better how to grow by acquisition: look at Cisco.
Then along this week came Harold Bradley and Bob Litan of the Kauffman Foundation with a completely new and novel reason for the decline in IPOs. They say in their new study that Exchange Traded Funds have caused such volatility for newly-public tech companies — volatility that has nothing at all to do with the companies themselves — that founders are being scared away from IPOs and into being acquired for substantially less money than they might have made.
Exchange Traded Funds have been around since the early 1990s and can be thought of as index mutual funds on steroids. Both types of funds have underlying assets that reflect their target index. If the mutual fund or exchange traded fund is intended to represent the Dow 30 Industrials, then it should own all 30 stocks in equal amounts. Where the funds differ is in how they are traded and taxed. Index mutual funds are priced to represent the value of their underlying shares so the redemption price is set once per day based on the closing Net Asset Value of the stocks in the portfolio. Day traders aren’t interested in index mutual funds because there is no intra-day price volatility. There’s no shorting, either. You can’t normally borrow and short a traditional mutual fund, nor would you want to because the tax consequences could ruin the deal. But ETFs, in contrast, vary in price throughout the day based on supply and demand so day traders might be interested. If the ETF price varies significantly from the price of the underlying basket of stocks, then there is an arbitrage opportunity that some trader will notice and take advantage of — buying the ETF while selling the underlying stocks, for example — generally without the tax concerns of a traditional mutual fund because the retail ETF shares are traded through intermediary market makers that effectively decouple share gains from underlying capital gains. Got that? Me neither, but that’s the way it works. Oh, and ETF shares can be shorted, which of course increases volatility even further.
ETFs change value constantly based on supply, demand, manipulation and rumor. And here’s the weirdest part: at the end of the day index mutual fund prices are changed to match their Net Asset Value while with index Exchange Traded Funds at the end of the day the underlying securities are bought or sold to reflect the notional value of ETF shares. As a result ETFs are constantly buying and selling, leading to yet more volatility.
Now that we have some vague understanding of ETF structure, here is how they screw things up for little companies. This happens in two very different ways, first by reducing market interest in individual stocks in favor of funds that hold those stocks and second by amplifying the share volatility of small companies that are not widely traded.
In relative term,s retail investing in the USA has died. The huge trading volume increases of the last two decades have been driven almost entirely by institutional traders with their computers buying or selling billions of shares per day. Compared to these institutions, you and I and our trades have almost no impact on where the market is going. Since we have no sense of efficacy, we trade mutual funds or ETFs, which is to say we let the institutional investors do it for us.
“People have given up on picking stocks,” said Bob Litan. “Indexes are cheaper and ETFs have tax advantages. So much money is now in the index ETFs that many investors no longer care about the individual companies that underly the index.”
If an ETF is comprised of large cap stocks like Microsoft and Dell, that’s fine, but if the index is composed of smaller companies like the Russell 2000 index, those companies with very few shares outstanding are in for a wild ride. One ETF, IWM-Russell 2000, is the largest shareholder for more than 800 of the companies in that index. If the ETF goes up then the ETF has to buy more shares of the underlying securities or issue more shares of the ETF, itself. If the ETF goes down then it may have to sell shares. And none of this has anything to do with the fundamentals of those particular underlying stocks.
The shares go up and down, well, because they go up and down, which makes a CEO feel helpless — sometimes so helpless that they my choose to opt out of the system by foregoing an IPO altogether.
“The index is the tail that wags the dog, ” Litan continued when I talked with him yesterday. “It’s like riding a bull. Why IPO into that?”
And so, more often than not, tech startups these days walk away from the public markets.
Next: What’s to be done about this problem and how can it make us all rich?