The Gaming of Games
Roger L. Martin

I have to admit that the thing I like most about Peter Drucker is how often he said things that were dismissed at the time as improbable, extreme or even wacko and 25 years later were considered so obvious that they are assumed to have always been the case. In 1954, he told managers that they should sit down with their direct reports every year and establish objectives by which they will be managed.  Sounded farfetched in 1954 but now you would be considered incompetent if you didn’t manage by objectives. In 1966, he told the business world that its important players would soon be ‘knowledge workers’ not the physical workers that it was used to managing and that managing knowledge workers would be completely different.  That sounded farfetched in 1966 (and even more so in 1959 when he coined the term), but now it is barely an interesting concept because it is so obviously true.  In 1976, he predicted that workers were on the verge of finally owning the means of production, but rather than through a Marxist revolution, it would occur through the stock ownership via their pension funds.  Seemed like an over-the-top prediction in 1976, but 25 years later, it was obviously true.

Given the importance with which Peter viewed pension funds – essentially as the savior of modern capitalism – it is interesting to ask what he would think about the central role they now play in stock lending worldwide.  Stock lending is somewhat of a murky business.  Any institution that owns a share of stock can lend it out and earn a fee for the providing that service. The value of stocks lent at any given time is open to great debates. The International Securities Lending Association estimated the value of outstanding stock loans as $1 trillion in 2007. Finadium Institutional Investment Manager Survey estimated the size to be $4.7 trillion in 2007 and $2.5 trillion in 2008, and found over 90% of institutions surveyed engaged in stock lending.  So it is a gigantic business and almost all pension fund managers lend stocks, and due to their large size, are almost certainly the largest lenders of stocks.

This begs the question: Who is on the other side?  Who are the borrowers?  The answer is short-selling hedge funds and other proprietary traders.  They need to borrow stock in order to be able to short it.  So they borrow stock, short sell it, hope that it goes down in price, buy it back at the lower price, make a big profit, and return the stock back to the lender.

Let’s consider the systems dynamics of this relationship.  Pension funds are the most long-oriented investors in the entire capital markets.  They have 30, 40, 50 year obligations.  Their only interest is in having stocks increase in value over time to the highest level possible in order to meet their obligations to their pensioners.  In stark contrast, hedge funds have interest in maximum volatility because they make their biggest money on the 20% carried interest that they earn and that carried interest appreciates most with big movements in the securities which they hold. They couldn’t care less whether stocks go up or down. The only thing they care about is that stocks don’t move slowly and steadily; that would be bad for them.  Pension funds put in their hands the capacity to put a $1 trillion+ perpetual short on the world’s stock markets and on top of that, the capacity to jerk markets wildly up and down with how they execute their short positions.

And this is in the interests of pensioners how? It is disgraceful.  Yes, the pension funds can earn fees from stock lending that will measurably increase their annual returns.  But at the same time, it immeasurably reduces their long-term returns.  But since the latter is an opportunity cost not an easily measurable cost like the former, it isn’t counted.

But stock lending by pension funds combined with short selling by hedge funds is a key part of gaming the game of democratic capitalism.  The hedge funds simply trade and toll value.  They don’t care if they are damaging the capital markets on which they depend.  They contribute to volatility in legal and illegal ways.  By far the biggest enabler of this gaming is the pension funds who lend them the stock to engage in short-selling and on top of that, provide them lots of their funding through limited partner investments from their alternative investment portfolios.

Neither is in the interests of pensioners or democratic capitalism.  If we want to protect the good game of democratic capitalism against the gamers who would destroy it, we need to honor Peter Drucker’s memory by preventing pension funds from hurting their pensioners by enabling hedge funds.

AUTHOR:

Roger L. Martin has served as dean of the Rotman School of Management, University of Toronto since 1998.  His research work is in Integrative Thinking, Business Design, Corporate Social Responsibility and Country Competitiveness. He has written 14 Harvard Business Review articles and published seven books. In February 2013, his eighth book, Playing to Win: How Strategy Really Works, co-authored with former P&G CEO AG Lafley, will be released (HBR Press, 2013). In 2011, Roger placed 6th on the Thinkers50 list, a biannual ranking of the most influential global business thinkers. In 2010, he was named one of the 27 most influential designers in the world by BusinessWeek. In 2007 he was named a BusinessWeek ‘B-School All-Star’ for being one of the 10 most influential business professors in the world. BusinessWeek also named him one of seven ‘Innovation Gurus’ in 2005.  Roger received his  MBA from Harvard Business School.