IPhones, Index Funds and Sherpas

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Apple earnings.

Once you have sold everyone in the world an iPhone, what do you do? Sell them a bigger iPhone on which they can play solitaire? Sell them a smaller iPhone they can wear on their wrists? Sell them a smaller wrist-iPhone, but plated in gold so you can charge more? Yes, good ideas, those are all things you can do. But eventually you stop selling as many iPhones as you used to -- or rather, you keep selling more iPhones than you used to, but the growth is less than it used to be. It is a sad state of affairs, there in the second derivative.

This is roughly the situation that Apple finds itself in. I mean, not literally everyone in the world -- iPhones are expensive! -- but some sort of saturation seems to have been reached. "Apple Inc. said iPhone sales grew at the slowest pace since its introduction in 2007 and forecast that revenue in the current quarter will decline for the first time in 13 years, signaling an end to its recent period of hypergrowth." That, combined with "economic challenges all over the world," made it perhaps a troubling quarter for Apple. Here are the earnings release and the supplemental material. Here are Bloomberg, and Quartz, and a Wall Street Journal live blog of the earnings call.

So what do you do? Well, you do mature-company things, which I guess isn't that surprising at the biggest public company in the world. You shift the focus from user growth to recurring revenue, which explains how this is a slide in Apple's presentation:

It is not the designiest of slides. You could just say that. But the slide, with its nice round number in a big font, emphasizes the point: "What Apple was trying to do was give another way to look at services by focusing on purchases by that installed base." We've gotten everyone to buy our phones. Now we just sit back and watch them download songs and solitaire hints.

Oh also there are buybacks. Apple "returned over $9 billion to investors through share repurchases and dividends," $6.86 billion of it in buybacks. For near-meaningless context, North Korea's annual gross domestic product is about $28 billion, just about four times that quarterly buyback number. As Bloomberg's Luke Kawa put it, "Apple could've bought all the goods and services North Korea produced in Q4 with the" money it spent on buybacks.

As you may have heard, people are worried about stock buybacks, and I joked on Twitter that "surely renting North Korea for three months is more innovative than just buying back stock." And, I mean, that would be an innovative transaction! But Apple is not particularly cutting back on innovation; despite the apparent maturity of many of its products, its research and development spending continues to rise. The deeper concern about stock buybacks, it seems to me, is not about innovation, but about distribution. The problem isn't that Apple doesn't spend on innovation; the problem is that its buybacks enrich its shareholders in a way that, many people think, exacerbates inequality. Obviously no real person talks about stock buybacks in quite these terms, but I do rather like, as a symbol of the contrast between American financial capitalism and the global proletariat, the idea that Apple had the choice between just handing money to its shareholders or buying literally everything in North Korea. Of course with $27.5 billion in operating cash flow it could have done both.

Asset management.

On the one hand:

The 20 most profitable hedge funds for investors earned $15 billion last year while the rest of the industry collectively lost $99 billion, LCH said. Those top managers have made 48 percent of the $835 billion in profits that the hedge fund industry has generated since its inception.

On the other hand:

The cost of investing is tumbling toward zero for some basic portfolios of stocks and bonds as firms duel for customers. The slide has been under way for years but is accelerating as the industry’s biggest companies target increasingly cost-obsessed investors.

More than 100 mutual funds and exchange-traded funds now cost $10 or less per $10,000 invested, up from 40 in 2010, according to Morningstar Inc.

You could have an average-is-over model here, something like: Some people are good at investing, but not very many. If you can invest with the good ones, do, and pay them. If not, invest with the cheap ones. The middle ground of mediocre performance and medium-sized fees, in this era of automated investing and skepticism about the financial industry, is increasingly untenable. "If you can do it cheaper than the next guy, then yours is the one I want," says one retail investor. There are other possible models, though:

While lower expenses leave people with more money to amass for retirement and other uses, nearly free funds are equivalent to the loss leaders sold by supermarkets as come-ons, some money managers and analysts say.

They say bargain-basement funds help get investors in the door, where they can be pitched pricier portfolios that often are riskier, too.

There is probably something to that: Near-free index products make it easier to construct more complex strategies economically, just like near-free electronic trading of individual company shares made it easier for banks to offer complex option products. But I am not so sure about the loss-leader model. I am an investor in Vanguard index funds, and one of the nice things about those funds is that there is no door and I never go in it. 

RBS.

On the one hand:

Royal Bank of Scotland Group PLC on Wednesday warned it would slump to yet another full-year loss after it put aside £2.5 billion ($3.59 billion) to cover a slew of regulatory issues, including a looming settlement with U.S. authorities over the sale of mortgage-backed securities.

On the other hand:

A former senior trader at Royal Bank of Scotland Group Plc who lost his job amid the currency market rigging scandal won part of an employment lawsuit, but received no compensation because a London judge said he would have been fired anyway.

The fact that he didn't get any compensation I guess makes it a win for RBS -- obviously he is not getting his job back -- but it does sort of seem like strong worker protections for bankers fired for misconduct undermine the goal of, you know, trying to clean up banker misconduct. This guy, Ian Drysdale "is one of several traders to challenge their former companies in London’s employment tribunals in recent months," with some getting compensation. Obviously their argument is that they didn't commit misconduct -- or, in Drysdale's case, that "he was given no formal training on what constituted confidential information" and so didn't know that his participation in a chat room called the "Cartel" was wrong. But if you want a culture of compliance and a zero-tolerance approach to misconduct, you have to be willing to put up with a few arbitrary firings of bankers who get close to the line. Anyway, RBS's charges include "an extra £1.5 billion to cover litigation surrounding the sale of toxic mortgage-backed securities in the U.S." and "a further £500 million provision to cover the wrongful sale of insurance product Payment Protection Insurance," along with a writedown of its private bank's value.

Banks and technology.

Banks are apparently looking for widgets:

Now Citigroup Inc., UBS Group AG, Wells Fargo & Co., and Banco Bilbao Vizcaya Argentaria SA are among some two-dozen financial giants hosting accelerators, hackathons and competitions to bring startups to their doors.

“The story has gone from one of competition to one of collaboration," says Julian Skan, a managing director at Accenture Plc in London. "Many fintech startups will end up being used as widgets by the banks."

"We’re the sherpas that will take entrepreneurs up the mountain," says Citigroup's chief innovation officer; the mountain appears to be Citigroup. You can see the synergies here. I once said that "Tech is an industry of moving fast and breaking things. Finance is an industry of moving fast, breaking things, being mired in years of litigation, paying 10-digit fines, and ruefully promising to move slower and break fewer things in the future." But you kind of need both! Banks are (perhaps) slow, clumsy, rule-bound, clinging to old inefficient ways of doing things that make them lots of money, but they know how things work. Financial technology startups are (perhaps) fast, nimble, innovative, seeking efficiency, but they tend not to fully appreciate the challenges of working in a highly regulated space. Letting the innovators do the innovating, and having some sherpas around to keep them away from the cliffs, might be a solution. Clayton Christensen is skeptical:

“The processes in a bank are excruciatingly interdependent," says Christensen, a professor at Harvard Business School. "When you change one thing you have to get your arms around everything else. It paralyzes you."

I suppose the alternative is pure disruption: New startups, without those independent legacy systems, come along and take business away from the banks. I don't know, though. The interdependencies aren't just about old code; they're about old financial regulation, and that is harder to disrupt.

Market structure.

Global Trading Systems, a pleasingly anonymously named computerized trading firm, "said on Tuesday that it was taking over the seats on the floor of the New York Stock Exchange that have been run by the British bank Barclays," and you should read the article mostly for Nathaniel Popper's ironic amusement at the cultural centrality of the NYSE floor, which is "now best known from the photos from the floor of the exchange that run with news reports about movements in the stock markets" and which is totally dominated by (humans employed by) high-frequency trading firms.

Even on the floor of the exchange, though, most prices are generated by algorithms that determine when to buy and sell. The humans are generally present to monitor the computers and to step in if anything goes wrong, as has happened on several occasions in recent years.

And to pose for pictures.

Elsewhere in market structure, Michael Friedman argues that changes in market structure "cast significant doubt on the wisdom of continuing to announce material news outside of market hours":

While electronic market makers and limit up/limit down both effectively moderate the impact of news, both of them switch on at 9:30 a.m. and switch off at 4 p.m. Issuers announcing negative news outside of those hours are not protected by either mechanism, and their stocks are vulnerable to violent price swings.  

The counterargument would be that price swings after hours are violent, but they don't affect too many traders, since most people don't trade after hours. Releasing more news during market hours, though, would reward whoever is fastest to react to that news. I predict a lot more complaining about high-frequency traders if that ever happens.

People are worried about unicorns.

A bit of a light day for unicorn worries, but here is "More Ugly News for Good Technology Employees." And here is: "Uber to Drunk Riders: Here, Play With a Bop It! Instead of Attacking Your Driver."

People are worried about stock buybacks.

I mean, the Apple thing. Also here is "Executive Pay, Share Buybacks, and Managerial Short-Termism"; one result on short-term versus long-term total shareholder return:

Companies with stronger short-term TSR (2008-2009) have higher subsequent long-term TSR (2010-2014) (18.1% versus 17%) and higher CapEx growth (10% versus 8.5%). These dual findings suggest that companies are not sacrificing long-term returns or long-term investment for short-term gains. Rather, these findings may suggest that companies that perform well in the short-term are also more likely to perform well in the longer-term, and also more likely to invest in the longer-term. This finding also casts doubt on the myopia criticism.

People are worried about bond market liquidity.

Not this guy though!

“New regulations have reduced volume on a normal day because you don’t have that type of market-making activity from the investment banks and other large players,” Schanke said. “But in times of big movements they wouldn’t be there anyway. 2008 is a perfect example. You didn’t have any tough regulation in 2008, but somehow the fixed-income market froze up -- which you would have expected because this type of activity is to facilitate normal trading days.”

“Obviously they are used to making money on this activity and now they can’t make money anymore,” he said. “They’re trying to find reasons for what’s going on.”

That's Oeyvind Schanke of Norway's sovereign wealth fund, who I suppose has no liquidity-mismatch risk of his own to worry about. 

Things happen.

The World’s Favorite New Tax Haven Is the United States. Italian Bank Shares Rise on Deal to Address Bad Loans. A.I.G. Opts for Streamlining, Spurning Calls for a Breakup. Yuan Bears Denounced as Delusional, Doomed by China State Media. General Electric may get rid of its light bulb business. SEC Chief: Board Diversity Is a Priority for Agency in 2016. JPMorgan in Pact With Ambac, Step to $4.5 Billion Mortgage Deal. U.S. Oil Explorers Seen Reporting $14 Billion in 2015 Losses. "It’s hard for me to understand why Morgan Stanley would leave, given the strength of Brooklyn’s brand." Vacant Office Spaces Pile Up in Houston. Former Morgan Stanley Banker to Revive Phibro Name. Janus Capital’s AUM rises 3.9% in fourth quarter. Kristi Culpepper on the Flint water crisis. How Trump Bungled the Deal of a Lifetime. How a Spectacular Hellscape Owned by the Pope Came to Sotheby’s. The rich are different from you and me: They sell their dogs with their housesBuzzFeed reporter eats cat food. The Chickening. Bible Verses Where “Fear Not” Has Been Replaced With “Um. Yikes.” 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net