Three Longs & Three Shorts

Published on: 12th May, 2019

This week’s reads focus on Vanguard’s ingenious tax saving, the truth about dentistry, the kidnapping industry, India’s middle income trap risk, radical transparency in salaries among co-workers and how social valuations drive educational choices.

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1. Long read: Vanguard Patented a Way to Avoid Taxes on Mutual Funds
Authors: Zachary R. Mider, Annie Massa and Christopher Cannon
Source: Bloomberg (https://www.bloomberg.com/graphics/2019-vanguard-mutual-fund-tax-dodge/)
Vanguard, the world’s second largest fund management house, continues to astound. Not contend with becoming a giant in index funds, Vanguard has found a new innovation – avoiding capital gains taxes for its clients: “…Vanguard Group Inc. has figured out a way to shut off taxes in its mutual funds. The first to benefit was the Vanguard Total Stock Market Index Fund. Investors’ end-of-year tax forms abruptly stopped showing capital gains in 2001, even as the fund went on to generate billions of dollars of them. By 2011, Vanguard had flipped the switch in 14 stock funds. In all, these funds have booked $191 billion in gains while reporting zero to the Internal Revenue Service.”
So how is this miracle performed? “…a review of financial statements and trading data shows that Vanguard relies substantially on so-called heartbeat trades, which wash away taxes by rapidly pumping stocks in and out of a fund. These controversial transactions are common in exchange-traded funds—a record $98 billion of them took place last year, according to data compiled by Bloomberg News—but only Vanguard has used them routinely to also benefit mutual funds.
Here’s how it works: Vanguard attaches a more tax-efficient ETF to an existing mutual fund. Then the ETF siphons appreciated stocks out of the mutual fund without incurring taxes, often using heartbeat trades. Robert Gordon, who has written about the concept and is president of Twenty-First Securities Corp. in New York, calls it a tax “dialysis machine.””
The article contains a useful chart which shows how “rapidly pumping money into and out of the exchange-traded portion of the Vanguard Small-Cap Index Fund removes taxable gains for the benefit of the mutual fund’s shareholders.”
Just in case you are thinking about doing this for your fund as well, you need to know that “Vanguard even got a patent on the design, valid until 2023, so competitors can’t copy it.”
The article goes onto show that Vanguard uses heartbeat trades more than any other American fund manager. So, how meaningful is the benefit to Vanguard’s American clients from this clever tax manoeuvre: “The main benefit of avoiding taxable gains in a mutual fund is tax deferral. Funds distribute their taxable gains to investors, who pay income taxes on them in the same year. By avoiding tax events within the fund, investors get to delay taxes until they sell the fund, which could be years or decades later. It’s akin to a zero-interest loan from the IRS.”

2. Long read:  the Truth about Dentistry
Author: Ferris Jabr
Source: The Atlantic (https://www.theatlantic.com/magazine/archive/2019/05/the-trouble-with-dentistry/586039/)
Millions of people dread sitting in the dentist’s chair and most of them can’t bear the sound of the dentist’s drill grinding into their teeth. Now they can draw solace from this article which says that dentistry is “…much less scientific—and more prone to gratuitous procedures—than you may think.” The article uses American data and American examples to explain how dentists not only overcharge, they routinely make patients undergo procedures (root canals, crowns, bridges, etc) which are not required but which help the dentist boost his earnings. So why are dentists peculiarly well positioned to exploit their patients?
“In other medical contexts, such as a visit to a general practitioner or a cardiologist, we are fairly accustomed to seeking a second opinion before agreeing to surgery or an expensive regimen of pills with harsh side effects. But in the dentist’s office—perhaps because we both dread dental procedures and belittle their medical significance—the impulse is to comply without much consideration, to get the whole thing over with as quickly as possible.”
Furthermore, credible scientific reviews – the article claims – show that most dental procedures actually confer no tangible benefit on the patient: “Fluoridation of drinking water seems to help reduce tooth decay in children, but there is insufficient evidence that it does the same for adults. Some data suggest that regular flossing, in addition to brushing, mitigates gum disease, but there is only “weak, very unreliable” evidence that it combats plaque. As for common but invasive dental procedures, an increasing number of dentists question the tradition of prophylactic wisdom-teeth removal; often, the safer choice is to monitor unproblematic teeth for any worrying developments. Little medical evidence justifies the substitution of tooth-colored resins for typical metal amalgams to fill cavities. And what limited data we have don’t clearly indicate whether it’s better to repair a root-canaled tooth with a crown or a filling.”
In America patients are litigating successfully against exploitative dentists and getting some recompense. In India, given the state of our courts, that is unlikely to work. Hence the next time you are in a dentist’s chair, it is worth being objective about what he’s recommending.


3. Long read: Kidnapping – A Very Efficient Business
Author: Anne Diebel
Source: The New York Review of Books (https://www.nybooks.com/articles/2019/05/09/kidnapping-efficient-business/)
This unusual and interesting article is a review of two books on kidnapping. These books are ‘We Want to Negotiate: The Secret World of Kidnapping, Hostages, and Ransom’ by Joel Simon and ‘Kidnap: Inside the Ransom Business’ by Anja Shortland. The article explains that not only is kidnapping a well organised, professionally managed business but the insurers who provide ‘Kidnap & Ransom’ insurance across the world also work as a tight knit group. Whilst the article does not talk about India, what we know about the big ticket kidnapping business in India tallies nicely with thrust of this article. Here a couple of the most interesting examples cited in this piece:
“In Argentina in the early 1970s, leftist guerrillas started snatching executives of multinational companies and demanding ransoms. This culminated in the payment of $60 million to the Montoneros, a Peronist guerrilla group, for the release of the brothers Juan and Jorge Born, executives at the grain-exporting firm Bunge & Born and the sons of its president. The ransom seems noteworthy for its heft—at about $275 million in today’s money, it stands as the largest one paid in a conventional kidnapping case. (In 2017 Qatar reportedly paid $1 billion to an al-Qaeda affiliate and Iran to win the release of a royal hunting party.) But perhaps what makes the Born case more unusual in the history of the ransom trade is the fact that Jorge himself negotiated the price while captive. He had intimate knowledge of the company’s finances and thus had a precise sense of how much money could be raised—though not, crucially, how much ought to be paid. The deal he struck was delivered to Born père, who had refused the initial demand of $100 million, as a signed memorandum.
As Argentine ransoms soared, insurers at Lloyd’s of London were beginning to rake in premiums from a peculiar product. Kidnap-and-ransom (K&R) insurance had existed since 1932—it was developed in response to the abduction and killing of Charles Lindbergh’s twenty-month-old son—but it didn’t take off until the 1960s, following a series of kidnappings of businessmen and their families in Europe and Latin America. Companies started buying coverage for those employees most likely to be targeted, and the market boomed. Had Bunge & Born purchased coverage for the brothers, it would have been reimbursed for at least a portion of the payout….
Around 90 percent of all kidnappings are successfully resolved, meaning the hostages return alive, usually through ransom—an “astonishing success rate,” remarks Anja Shortland in Kidnap: Inside the Ransom Business. And the odds are considerably better if specialists are involved: more than 97 percent of cases handled by professional negotiators are resolved successfully, almost always through ransom. (A small percentage of hostages escape and an even smaller number are rescued.) In almost all of these cases, the negotiators are provided as part of an insurance package, but if a victim is uninsured, they can be hired directly (the good ones for over $2,000 a day).”

4. Short read: Could the single engine driving India crash? Yes, if you go by one of Modi’s top guys
Author: ET Online
Source: Economic Times (https://economictimes.indiatimes.com/news/economy/policy/could-the-single-engine-driving-india-crash-yes-if-you-go-by-one-of-modis-top-guys/articleshow/69247983.cms)
It was about time someone brought the ‘middle income trap’ risk back to the front and centre of the discourse on the Indian economy. There are few better than Rathin Roy to have done it, not just because he is one of India’s finest macroeconomists. That he is a member of the Prime Minister’s Economic Advisory Council (PMEAC) makes this an admission of sorts by the establishment, adding some gravitas to the discourse. (He is also the Director of National Institute of Public Finance & Policy, a think tank which influences India’s fiscal policy making). This comes at a time when pretty much every data point – macro or micro, over the past two quarters is pointing towards a slowdown in the only engine that has been firing the Indian economy over the past decade – consumption. Roy reckons there are structural reasons behind this which if not rectified soon can pose a serious risk that India will remain a lower  middle income country or get caught in the so called ‘middle income trap’ like Brazil or South Africa and will never become another China or South Korea. He says “In the history of the world, countries have avoided the middle income trap, but no country — once caught in it — has ever been able to get out,”
“…The World Bank’s lower middle income range for countries is defined as per capita gross national income (GNI) of between $996 and $3,895. As per 2017 figures, the income of an average Indian was in the vicinity of $1,795, which placed the country well below the halfway mark, data from Bloomberg shows.
During the same period, the comparable figure for China stood at $8,690, which put it well above the halfway mark in the upper middle income range — defined as GNI per capita between $3,896 and $12,055.
Roy said that the 10 crore Indian consumers who have so far been powering India’s growth story are now beginning to plateau out. He called it an early warning: since 1991 the economy has been driven not by exports but by what these 10 crore consumers wanted to buy.
The risk, Roy said, now runs deeper; the possibility that India will remain stuck at the middle income range has now started appearing more and more real, which indicates India will never be another China or South Korea but could begin replicating basket cases like South Africa or Brazil where large swathes of poor population are powering not growth, but crime.
…And it’s not just Rathin Roy. Even the Ministry of Finance, in its Monthly Economic Report of March 2019, had shed ample light on the current scenario. “India’s economy appears to have slowed down slightly in 2018-19. The proximate factors responsible for this slowdown include declining growth of private consumption, tepid increase in fixed investment, and muted exports,” it had warned.
…And what does Roy think of the claim about India being the world’s fastest-growing economy? India certainly is currently the world’s fastest-growing, but this is not the fastest growth in India’s history, he says, adding an interesting aspect to the debate — he thinks India is fastest only because China is not currently the fastest.
A growth rate of 6.1-6.6 per cent is not bad, but consumption slowdown is going to put that under threat, Roy warned: “A time will come when that will stop.”

5. Short read: Dear school leavers, don’t believe all the stories that will be told to you about the world you face
Author: Pratap Bhanu Mehta
Source: Indian Express (https://indianexpress.com/article/opinion/columns/dear-school-leavers-5720017/ )
In his latest blog, my colleague Saurabh Mukherjea writes about “The Tussle Between What we “Should do” & What we “Must do”” blaming in part to societal expectations for “what we should do”. In this Indian Express OpEd, Pratap Bhanu Mehta extends the debate to Indian students’ educational choices and how they are driven or rather constrained by the same social valuations. At a time when millions of students are making their choices for higher educations, this piece from the vice chancellor of Ashoka University, an institution that is bringing some change in the way Indians think about higher education is indeed worth pondering over.
“The larger social structures constrict educational possibilities and the way in which we imagine the relationship between education and life. As another generation of school leavers enters college or the job market, we will console them with familiar platitudes. Do not place undue emphasis on marks. Choose an educational pathway that you like, rather than conform to social pressure, and so on.
These are fine sentiments and make a good deal of sense. But even as we say these things, we know there is something hollow about them in our social context. The familiar tensions between the practical demands of navigating a pathway in a modern economy, and education for its own sake, will play out within each one of us.
…broader structures of inequality and unfreedom actually constrain educational choice. The freedom we urge upon our students runs into a world of necessity and constraint; and the promise that education will be the pathway to equality exposes them to a new kind of inequality…
…the inequality challenge is not just about access. It is about modes of valuation that are inherent in the way we think of the relationship between education and society. The philosopher, Thomas Nagel, once wrote: “When racial and sexual (and you might add, caste) injustice have been reduced, we shall still be left with the great injustice of the smart and the dumb, who are so differently rewarded for comparable effort.” It must be pointed out that “smart” and “dumb” are categories that are themselves the products of forms of social valuation. But to deny the fact that in our cultures there is a deep tension between the cult of individual achievement and the equal valuation of persons, would be to deny reality. You might argue that to acknowledge some particular achievement (good marks) is not necessarily to devalue persons who do not display that achievement. But the truth is that it is hard to sustain that distinction in practice. In aristocratic societies, trappings of wealth and social valuation go hand in hand. In our societies, manifest ability and social valuation go hand in hand; recognising accomplishment shades over into valuing persons differently.
But this mode of valuation is compounded by two other features of modern society. The first is meritocracy, the idea that your achievement is due to individual effort. Again, this is an understandable association. But its corollary is that failure is also an individual failing. In an aristocratic society you might be subordinate, but the psychic story is that this is just the nature of things. In our societies, the individual is devalued or blamed for the lack of achievement, there is a different kind of stress associated with falling behind. Valuing individual achievement is a great spur to ambition, but it is also a psychological disaster: In modern constructions of failure, you have no one to blame but yourself.
The second myth of modern society is this: You might not be able to do some things well, but there are other things you might do well. This is good advice. But the plausibility of this advice depends again upon modes of social valuation. In societies where the income and status gaps between different professions are inordinately high, the line between choosing your own thing and being condemned to social oblivion can be pretty thin. In societies where the social cost of not making it to the top five or 10 per cent are so high, it is also more difficult to make the argument in good faith to “do your own thing.” The life penalties associated with those choices can be much higher.”

6. Short read: Why radical transparency about salaries can pay off
Author: Emma Jacobs
Source: Financial Times (https://on.ft.com/2VgC6kn )
The iconoclastic hedge fund manager, Ray Dalio of Bridgewater Associates emphasised about ‘radical transparency’ in the work place, well documented in his book ‘Principles’. This piece in the FT focuses on transparency in perhaps the most opaque aspect of worklife – salaries. “Pay has long been considered a taboo subject in many parts of the world. As Kim Scott, previously at Google and Apple, and author of Radical Candor, puts it: “We behave about money the way the Victorians behaved about sex.”
At Marcellus, we are hoping to establish a culture of radical transparency having started with full disclosure in salaries. As the piece goes onto argue that it is relatively simpler in early stage companies such as ours, yet it might be the way forward for even large established organisations if done with the right intent and understanding of the pitfalls. In particular, the author argues that such transparency in pay can help bridge the gender and racial pay gaps that exist across organisations globally.
“Organisations work “very hard” to make pay opaque, she says. “They know they can’t always justify differences. It’s in [their] interest as an employer not to be open about these things.” Such secrecy puts workers at a huge disadvantage in negotiating salary, says Alison Green, the US management consultant behind the site Ask A Manager, who has compiled an anonymous database on pay. “It also makes it far harder to uncover pay disparities by gender or race.”
….Technology and legislation are shifting attitudes to pay secrecy. At its most extreme, some companies have embraced radical transparency — making their staff’s salaries accessible to each other. Could this be the future?
Social media has made the private public, and websites such as Glassdoor and Salary Expert help workers find information about pay. At the same time, legislation has brought pay under public scrutiny. In the US and UK, listed companies are required to publish the pay ratio between chief executives and workers’ averages. Gender pay gap reporting has been introduced in the UK and France. A new law in Germany allows women to ask for the median salary of a group of at least six men doing similar work, and vice versa.
In 2017, the BBC revealed that two-thirds of its highest paid stars were men. The following year, Carrie Gracie resigned from her post as China editor, writing in an open letter that the broadcaster was “breaking equality law and resisting pressure for a fair and transparent pay structure”.
One BBC employee says that the pay controversy has encouraged some men to share their salary levels with female staff, so they can discover if they are being underpaid. “It can be immensely helpful. The genie is out of the bottle. We believe that transparency is right in court proceedings, in MPs’ expenses. We need to be more prepared to be open with each other about what we earn.”
…Research by the Fawcett Society last year found that 53 per cent of female workers and 47 of male workers would be uncomfortable disclosing their pay to a peer. However, when they believed there was discrimination, 62 per cent of women and 57 per cent of men would share the data.”

Note: the above material is neither investment research, nor financial advice.Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.
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