Passive Investors and Insider Traders

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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Active vs. passive.

This week S&P Dow Jones Indices released its annual SPIVA scorecard measuring how mutual fund managers performed relative to indexes. Last year, "66.11% of large-cap managers, 56.81% of mid-cap managers, and 72.2% of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively," and 

The figures are equally unfavorable when viewed over longer-term investment horizons. Over the five-year period, 84.15% of large-cap managers, 76.69% of mid-cap managers, and 90.13% of small-cap managers lagged their respective benchmarks.

Meanwhile a lot of hedge funds have had a terrible start to 2016, though it doesn't seem to matter that much:

“I think they are getting the benefit of the doubt,” Dean Backer, global head of sales and capital introduction at Goldman Sachs, said of many of the biggest hedge fund managers, owing to their historical performance. “I’m not sure people know — if they took money out of hedge funds— where they would put it,” he added.

Yes where can you invest other than in hedge funds?

On the other hand, here is James Ledbetter wondering "whether, as passive investing grows, it is having harmful effects on the economy as a whole." The harmful effects here are pretty tenuous. Ledbetter worries that "a market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not"; Cullen Roche replies that "passive indexers rely on active arbitrageurs to set prices," and that in fact, "as indexing has grown, the number of members leaving the index has increased." One thing about index funds is that they don't trade that much; even if most investors are passive, most trading will nevertheless be active, and will presumably push prices in the direction that the fundamentals demand.

Ledbetter's other concern is the antitrust worry that we've talked about before: Does common ownership of multiple companies in the same sector by the same passive mutual funds lead those companies to compete less vigorously? That is sort of a kooky theory, but a fascinating one, and one that is poised to break into the mainstream. Here is a Senate hearing from this week on "Oversight of the Enforcement of the Antitrust Laws" at which Assistant Attorney General William Baer suggests (at about 1:26:00) that common ownership of multiple companies in one sector might create antitrust violations. "I can tell you it is an issue we are looking at," says Baer. 

Elsewhere: "Equity funds draw investors for first time in 2016." And "Meet Forcerank, the FanDuel for Stocks." I thought stocks were the FanDuel for stocks?

Insider trading.

David Ganek was the co-founder of a hedge fund, Level Global Investors, that was raided by the Federal Bureau of Investigation in 2010 as part of U.S. Attorney Preet Bharara's crackdown on insider trading. Ganek was never charged with insider trading, but his co-founder Anthony Chiasson was; Chiasson was convicted, and Level Global was fined by the Securities and Exchange Commission. And then Chiasson's conviction was overturned, and Level Global got its money back: Bharara's expansive theory of insider trading liability turned out to be all wrong.

This didn't do Level Global that much good, since the FBI raid and the attendant publicity -- the U.S. Attorney's office tipped off the Wall Street Journal about the raid so it could get some pictures -- is bad for business, and the fund shut down in 2011. So Ganek sued the FBI agents and prosecutors involved, claiming that they'd violated his civil rights, and yesterday a judge let his case go forward. Ganek's basic claim is that prosecutors knew from the beginning that he wasn't knowingly insider trading: Their main cooperating witness, former Level Global analyst Sam Adondakis, admitted to trading on inside information from Dell, and told the FBI that he had informed other people at Level Global about the source of the information, but said that Ganek himself never knew the information came from corporate insiders. But when prosecutors asked for a search warrant, they submitted an affidavit falsely claiming that Adondakis said that Ganek knew about the source of the inside information.

That is bad! You are not supposed to lie to the court! I don't really know what prosecutors were thinking there. But one possibility is that, the way they thought about insider trading, it didn't matter. The Preet Bharara theory of insider trading, circa 2010, was that if you ran a hedge fund and any inside information made its way to you, then you were guilty of insider trading, regardless of what you knew about the source of that information. The mere quality of the information might itself be a tip-off that it was illicit. The post-Newman law is very different: To be guilty of insider trading, you have to know that the information comes from an insider, and even that the insider divulged it for some personal benefit. In 2010, this wasn't much of a focus for prosecutors, and so perhaps they were a bit loose with their search warrant application.

Enforcement.

We sometimes talk around here about one of the crucial lessons of the last few years of financial scandals, which is: Don't put it in writing. But taking that over-literally can also get you in trouble. Here is a strange little Securities and Exchange Commission enforcement action against the Westlands Water District for doing some accounting manipulations to meet the debt service coverage ratio in its municipal bonds without raising rates on customers. Those manipulations seem to have been basically legitimate -- they involved taking money earned in previous periods and never recognized as revenue for some reason and reclassifying it as current revenue -- and Westlands's independent auditor signed off on them. The internal memos seem to have been sober and sensible and not at all embarrassing. And then this happened:

At the public Board meeting at which the transactions were discussed, Birmingham and Ciapponi recommended that the Board approve the transactions. They told the Board that Westlands needed additional revenue to achieve a 1.25 debt ratio and the Board could either increase rates and charges or approve the transactions. When one Board member, who was also a Westlands customer, began to question whether rates and charges in an area in which he owned land would be raised as a result of having to meet the covenant, Birmingham joked that they were engaging in “a little Enron accounting.” 

Oh no! Don't do that! Don't joke about "Enron accounting" in writing, sure, but don't joke about it in a public board meeting either! The SEC tends to hear about that sort of thing.

Elsewhere in "don't put it in writing," Hulk Hogan is suing Gawker for publishing a sex tape of him, and Gawker's internal chat logs are part of the evidence in the case. I don't exactly know how they are playing as evidence, but as someone who has read a lot of chat logs in connection with Libor and foreign-exchange and whatever manipulation, I have to say that I found the Gawker chats impressive for their spelling, coherence and overall pretty high standard of comedy. "I would characterize it as workplace humor," said Gawker editor John Cook, on the stand. If you are going to go to trial over your dumb online chats, they might as well be funny.

Bonuses.

"Deutsche Bank AG, which runs Europe’s biggest investment bank, cut its bonus pool by 11 percent after rising legal expenses hurt earnings last year and said volatility in financial markets means the first quarter may be challenging." And Dan Davies argues that the European bank additional tier 1 capital contingent convertible market could be improved by making coco coupons senior to bonuses:

Most AT1 has contractual provisions making it senior to equity dividends -- you can't pay a dividend on common stock while missing it on preference shares. But there's been no tradition of mentioning compensation, so de facto, AT1 coupons are pari passu or even junior to staff bonuses. This isn't the spirit of the regulation.

He suggests a new norm "that before a bank missed any AT1 coupon, it had to reduce the cash component of variable compensation to zero (it could still pay bonuses -- it would just have to pay them all in dilutive stock or, indeed, in CoCo bonds)."

Elsewhere, "Anshu Jain, who stepped down as Deutsche Bank AG co-chief executive officer at the end of June, received 2.2 million euros ($2.5 million) of severance pay and can keep a chauffeured car at the company’s expense until he leads another firm."

Typos.

Well this is embarrassing:

The hackers breached Bangladesh Bank's systems and stole its credentials for payment transfers, two senior officials at the bank said. They then bombarded the Federal Reserve Bank of New York with nearly three dozen requests to move money from the Bangladesh Bank's account there to entities in the Philippines and Sri Lanka, the officials said.

Four requests to transfer a total of about $81 million to the Philippines went through, but a fifth, for $20 million, to a Sri Lankan non-profit organisation was held up because the hackers misspelled the name of the NGO, Shalika Foundation.

Hackers misspelled "foundation" in the NGO's name as "fandation", prompting a routing bank, Deutsche Bank, to seek clarification from the Bangladesh central bank, which stopped the transaction, one of the officials said.

Doesn't it seem like Federal Reserve payment-transfer credentials should be harder to steal than that? Not that I know how hard these hackers had to work, but still. My theory of the "CEO scam" is that more people should pick up the phone before just transferring millions of dollars based on electronic instructions. That worked great here, after the typo. But even properly spelled routing instructions can be fake.

People are worried about non-GAAP accounting.

Should I make this a recurring section? What it shares with bond market liquidity is that the people worrying about it are mostly worrying that people aren't worrying enough about it. But people worry about it constantly! Obviously U.S. public companies disclose their financial results under generally accepted accounting principles, which, remember, are themselves only an imperfect man-made approximation of those companies' underlying economic reality. But the worry is that companies also disclose non-GAAP numbers that make them look better, and that they somehow bamboozle investors and analysts into paying attention only to the non-GAAP numbers and ignoring the "real" ones. But investors and analysts are constantly complaining about it, so who is being bamboozled? Anyway, here is Yahoo's Sam Ro:

Currently, profits as measured by standardized accounting principles are much lower than the profits executives are spouting to their investors. And it has billionaire investors and Wall Street strategists wrestling with the possibility that the much of the profit growth we’ve seen is actually just an illusion.

People are worried about unicorns.

WeWork, the hip shared office space unicorn, raised $430 million at a $16 billion valuation to finance a push into Asia, bucking the trend of down-rounds and gloom among unicorns. Though people are still worried, and "WeWork’s valuation is so high relative to peers that it has many in the real estate sector scratching their heads":

“It is just not possible to grow that aggressively … and maintain those sorts of margins,” said David Alberto, a veteran operator of serviced-office centers, a similar business model that has caught on in the U.K. “I honestly think it’s a bubble.”

I don't go around calling bubbles here, but I have to say I don't really understand WeWork? Like, Vornado, which owns something north of 37 million square feet of office space in Manhattan and Washington, D.C., plus lots of other stuff, has a market capitalization of about $16.7 billion, or roughly one WeWork. "As of early this year, WeWork had more than 5 million square feet open," which it rents from other landlords. The sharing economy seems like an incredible opportunity to add new intermediation, and new fees for middlemen.

In other unicorns that I don't understand, the Honest Company, Jessica Alba's honest unicorn, apparently makes a big thing about how you are supposed to avoid using products that contain sodium lauryl sulfate, "but two independent lab tests commissioned by The Wall Street Journal determined Honest’s liquid laundry detergent contains SLS." Avoiding SLS in laundry detergent is pretty much Honest's raison d'être -- Alba "started Santa Monica, Calif.-based Honest in 2011 after she said she had an allergic reaction to a popular brand of laundry detergent" -- so this is embarrassing. Honest disagrees with the Journal.

And in probably-not-quite-unicorns that I definitely don't understand, here is "Facebook Buys Masquerade to Challenge Snapchat's Rainbow Vomit." Rainbow vomit, and other sorts of rainbow gore, have become a bit of a theme in the unicorn-worry space, though I gather that the rainbow vomit at issue here is a good thing? Or something? I don't know. 

While we're on the subject of rainbows, the other day I mentioned Ant Financial, an Alibaba affiliate that is raising private capital at a $50 billion valuation as preparation for an initial public offering. I questioned whether Ant could be a unicorn, given its Alibaba affiliation and the raw biological fact that you can't be both an ant and a unicorn. But reader Braden Williams e-mailed to disagree, arguing that "ant unicorns totally exist" and attaching this illustration:

So now you have that. 

People are worried about bond market liquidity.

I was sick yesterday and spent much of the day on my couch, staring dead-eyed at the newspaper, and staring back at me from the front page of the New York Times business section was "Mutual Funds Oppose S.E.C.’s Plan for a Bigger Cash Cushion":

The essence of the industry’s complaint is that the idea of segregating securities in a portfolio on the basis of how many days it would take to sell them is a fool’s errand. Liquidity, or finding a buyer for what you want to sell, is one of Wall Street’s foggiest and most subjective notions. To guess how many days it would take to sell a leveraged loan or a corporate bond from Brazil is next to impossible, experts argue.

Things happen.

Professor to Wall Street: You're Doing Swaps Accounting Wrong. European Corporate Bonds Are Clear Winners After ECB Move. Mystery 'Dude' Rattles Turkish Stock Traders With Massive Bets. Not much has changed at the rating agencies. Eurozone Financial Transaction Tax Plan Stalls, Says Minister. Goldman Sachs Hire Came as Bank Pitched 1MDB. Yahoo Labors to Carry On With Core Business While Exploring Sale. Yahoo's Mayer Hopes to Stay in Job Even If Company Changes Hands. Bridgewater Hires Ex-Apple Executive Jon Rubinstein as Co-CEO. Anna Gelpern on "The Rubble of Argentina’s Debt Settlement." Banks Reach for 'Renewable' Financing to Satisfy Long-Term Funding Rules. The invisible hand of the government: "Moral suasionduring the European sovereign debt crisis. John Gutfreund, 86, Dies; Ran Wall Street Investment Firm at Its Apex. Google's DeepMind beats Lee Se-dol again to go 2-0 up in historic Go series. Naming and necessity and Hulk Hogan. 'Here's What Happened When I Sold 100,000 Fanny Packs to Donald Trump.' "50 Cent says the stacks of cash aren't real and he isn't hiding any assets." Man Used Cellphone Jammer on Train To Get Some Peace and Quiet: Attorney. Most Interesting Millennial in the World. Tortoise walker wanted. Giant rabbit.

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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