Hedge-Fund Robots and Disgusted CEOs

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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Hedge funds.

I feel like there were maybe a couple of decades when "alpha" and "beta" were useful terms for talking about investing performance, but now we are reaching the end of that golden age:

“We are now realising that a lot of what we thought was alpha is actually an alternative form of beta,” says Yazann Romahi, the head of JPMorgan Asset Management’s quantitative investment arm. “This will transform the hedge fund industry.”

That's from this article by Robin Wigglesworth about how quantitative-finance groups are increasingly trying to replicate and compete with hedge-fund strategies. "The basic return of a market is known as 'beta' in financial jargon," writes Wigglesworth, but obviously that can't quite be the sense in which Romahi is using the word. The modern sense is that "beta" is anything a computer can get you, while "alpha" is anything it can't. (More formally "beta" is the set of coefficients of whatever regression you happen to like to describe the connection between risk factors and returns, while "alpha" is the residue; as you find more factors to shove into your regression, more of the world becomes explainable by those factors, and the residue gets smaller and smaller.) You can have high-risk strategies and low-risk strategies and high-performing strategies and dumpy low-performing strategies and they can all be "beta." For a hedge-fund manager to set herself a goal of generating "alpha" now seems positively quaint. (Similarly, criticizing hedge-fund managers for not achieving "alpha," as measured against some risk-factor model designed to replicate hedge-fund strategies and minimize residues, seems a bit unfair.)

Anyway one hedge-fund strategy that seems to have been solved is mergers-and-acquisitions arbitrage:

For instance, Yin Luo, the chief quant at Deutsche Bank, says the single biggest determinant of whether a deal completed is its age. In other words, the longer it drags on the less likely it is to go through. But he has identified a multitude of factors that affect the M&A strategy’s success rate, using the same statistical techniques that doctors use to determine how long a cancer patient has to live.

As is often the case with quants, they are confident that their mathematical approach produces better results than human intuition. The traditional M&A arbitrageurs are “good but often not very accurate. Our model has actually proven more accurate than the arbitrage funds”, Mr Luo says.

The counterargument is of course that these models are based on historical regressions, and if the relationships change in the future, the hedge-fund-replicating strategies will break down. "They all fail miserably when the market regime shifts," says a fund-of-funds investor and quantitative finance professor. This counterargument would have more force if there was a lot of evidence that, as historical relationships change, non-quantitative human hedge fund managers are particularly good at changing their strategies. But it seems like lots of people also manage to fail miserably when the market regime shifts. 

Body language.

One thing that we sometimes talk about around here -- yesterday, for instance -- is the notion that investors who meet with a company's executives can gain insight into the company's future performance by interpreting the executives' "body language." I always sort of half-think that "body language" is a euphemism for, like, the executives just tell the investors what the next quarter's margins will be or whatever. But, no, apparently "body language" is a real thing and even computers can notice it:

James Cicon thinks they can. A finance professor at University of Central Missouri, Cicon built software that analyzed video of the faces of Fortune 500 executives for signs of emotions like fear, anger, disgust, and surprise. The emotions, he found, correlated with profit margins, returns on assets, stock price moves, and other measures of performance at the associated companies.

It turns out that bad emotions are good for the company:

Although fear, anger, and disgust are negative emotions, Dr. Cicon found they correlated positively with financial performance. CEOs whose faces during a media interview showed disgust–as evidenced by lowered eyebrows and eyes, and a closed, pursed mouth–were associated with a 9.3% boost in overall profits in the following quarter. CEOs who expressed fear–raised eyebrows, widened eyes and mouth, and lips pulled in at the corners–saw their companies’ stock rise .4% in the following week.

Dr. Cicon pointed to psychological research to explain why investors interpreted negative emotions as a sign of positive movement in share price. “Fear is widely recognized as a powerful motivator. Thus it is not surprising to find that a CEO who appears fearful under interrogation is perceived by the market as a CEO who will work harder to increase firm value,” said the paper, which was co-authored by Steve Ferris of the University of Central Missouri and Ali Akansu and Yanjia Sun of New Jersey Institute of Technology.

I have trouble believing that explanation? But if you do believe it, it is a wonderful data point about late capitalism, which apparently extracts more value for shareholders in proportion to how much it immiserates, not just workers, but also CEOs. Also it is a good advertisement for aggressive shareholder activism: The more fear a Bill Ackman or a Carl Icahn inspires in CEOs, the better those CEOs will apparently perform. Though actually it is even a better argument for disgusting shareholder activism? There is a market niche for a Sloppy Eater Activism Fund, where you have lunch with the CEO, spray food everywhere, and he is so disgusted with you that he goes and achieves great prodigies of profitability. I'd like to see a quant fund try to replicate that! That is pure alpha.

Too big to etc.

Is Neel Kashkari laying the groundwork to run for elected office? I mean, he ran for elected office before; it didn't go that well. I don't know how much precedent there is for a regional Fed president to be elected to the Senate or whatever, but we live in unprecedented times. In any case his speech Tuesday about breaking up the too-big-to-fail banks, followed by a media tour where he talked to Bloomberg Television and the Financial Times and the Washington Post and Reuters and CNBC, is maybe a bit more populist than I would have expected from the president of the Minneapolis Fed? From the Financial Times:

In an interview with the Financial Times, Neel Kashkari, who took over as head of the Minneapolis Federal Reserve at the start of the year, warned that the Fed needed to work harder to rebuild public trust and communicate with American citizens. Economic anger, he said, was “all around the country and it is non-partisan”.

"It really leads to great anger if you violate the core beliefs of a society," added Kashkari, which would be a good campaign slogan. David Reilly argues that bank shareholders should be the ones to break up the big banks. Jordan Weissmann thinks that "Kashkari is going to be fascinating to watch":

We now have a former politician with establishment credentials who has ascended to a somewhat influential position within the Federal Reserve basically running a campaign to chop banks down to size—or at least make them dull, safe, and certainly less profitable.

Elsewhere in Federal Reserve news, the Fed released the minutes of the January Open Market Committee meeting yesterday; they were well received. "Federal Reserve officials appear increasingly reluctant to raise short-term interest rates at their March policy meeting, and possibly beyond," was Jon Hilsenrath's takeaway. And elsewhere in U.S. political news, here is "How Sanders, Trump Threaten Market Confidence."

Market structure.

The latest entry in the saga of IEX's effort to become a public stock exchange is this very strange letter from IEX responding to criticism from the New York Stock Exchange, Nasdaq and BATS:

IEX has not set out to misrepresent anything through intent, negligence or recklessness. We stand by our words and actions since our founding. To the extent there are misinterpretations of our message, we appreciate the opportunity to clarify them with this letter and will always seek to engage in healthy dialogue on aspects of market structure that impact investors and the trading community. 

The tone is mostly like that, a weirdly passive-aggressive non-apology apology. The other exchanges have spent a lot of time complaining that IEX is saying mean and misleading things about them, and those complaints seem to have affected IEX more than I would have expected. Though less than the exchanges would have hoped, since this letter doesn't really take back anything IEX has said. 

Elsewhere, "Prosper Marketplace Inc. has started charging borrowers more for loans on its platform, as the company deals with a greater risk of defaults while striving to keep its loans attractive to investors with higher-yielding alternatives." And there is a cashless electronified Monopoly.

People are worried about unicorns.

We've talked before about how difficult it is for unicorns to leave the Enchanted Forest and enter the harsh cruel world of the public markets, but I'm not sure anyone has ever expressed that particular unicorn worry more eloquently than did J.P. Morgan Asset Management yesterday in its Eye on the Market note. The note included a chart labeled "Many unicorns finding it hard to survive in the wilderness," illustrated with a drawing of a unicorn vomiting a rainbow that could serve as a mascot for this section of Money Stuff:

At least I may rename the section "Unicorns are vomiting rainbows." Elsewhere, here is a McKinsey article on "Valuing high-tech companies": "It might feel positively retro to apply discounted-cash-flow valuation to hot start-ups and the like. But it's still the most reliable method." And here is an essay criticizing the current system of startup founding and funding and calling for a new system that would "focus not only on how much money is raised, and on investor returns, but also on how we generate value for users, elevate communities, and build a more equitable and inclusive system." It begins, irresistibly: "Startups, like the male anatomy, are designed for liquidity events."

People are worried about bond market liquidity.

Today's installment of the New York Fed series on bond market liquidity is about perhaps the most important of the bond-market-liquidity worries, "Are Asset Managers Vulnerable to Fire Sales?":

Goldstein, Jiang, and Ng (2015) provide strong evidence that these run-like dynamics stemming from holding illiquid assets are indeed at play. They show that mutual funds holding corporate bonds are more vulnerable to sudden investor withdrawals than are equity-only funds after episodes of underperformance: Because corporate bonds tend to be more illiquid than stocks, the first mover advantage is amplified. Conversely, the authors also show that investors in funds that hold Treasury securities (which are highly liquid bonds) have little redemption sensitivity to performance even though they have the same payout structure as corporate bond funds.

The Liberty Street Economics blog writers run a "macroprudential stress test" measuring the expected spillover losses caused by "a permanent, unexpected parallel shift of the yield curve of 100 basis points," and find that bond mutual funds are now more vulnerable to run risk than they were a decade ago. 

Me yesterday.

I wrote about sell-side equity research.

Things happen.

U.K. Finance Sector Has Most at Stake in EU Membership Talks. The People's Bank of China Moves to Daily Open-Market Operations. Central banks: Negative thinking. Iran Balks at Committing to Capping Its Oil ProductionPolitical Backlash Grows in Washington to Chinese Takeovers. "Seven years after launching, Foundation Capital Partners LLC has closed down, with the Greenwich, Conn.-based company having never closed a deal." Spanish Unit of China’s ICBC Raided in Money Laundering Case. "Over a quarter of the 120 employers surveyed by the human relations consulting firm Willis Towers Watson said they give performance-based bonuses to employees who 'fail to meet expectations.'" Booms and banking crises. Sentencing Trends in Major White-Collar Cases. "To determine which employees might soon get pregnant, Castlight recently launched a new product that scans insurance claims to find women who have stopped filling birth-control prescriptions." Working is making millennials fat. "Autorisé aux chiens. Interdit aux banquiers." Teen Arrested For Practicing Medicine Without License. Weird Pringles. Mosquito factory. Man candles and brogurt. Ski cat.

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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:
Zara Kessler at zkessler@bloomberg.net