Alpha, Activism and Ether

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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Alpha and beta. 

A basic premise of the efficient markets hypothesis is that you shouldn't be able to beat the market in simple dumb ways. (Stronger forms say you shouldn't be able to beat it in difficult smart ways either, but leave that aside.) So buying stocks with relatively low prices, or low volatility, or good recent past performance, or that start with the letter R, or that have green logos, or buying on Monday and selling on Thursday, shouldn't get you returns that are better than a broad market index. But sometimes that stuff works anyway, and so there are "smart beta" funds that try to beat the market in simple dumb ways (sometimes with math, but still): They don't do much active trading or subjective stock-picking, but they do overweight stocks with relatively low prices, or low volatility, or good recent past performance, or whatever, because stocks with those factors have generally outperformed the overall market.

Why does this work? There are about three possibilities. (Here I am loosely following Cliff Asness.)

  1. Perhaps the outperformance of, say, stocks starting with the letter R is compensating investors for some extra risk: Those stocks have some risk in addition to regular market risk, and so investors demand higher returns for holding them.
  2. Perhaps there is some persistent human behavorial bias that affects prices: People are always gloomy on Mondays and happy on Thursdays, so stocks are cheap on Monday and expensive on Thursday.
  3. Or maybe it doesn't work at all, it is all an illusion in the data, and as soon as you mention the outperformance of stocks with green logos it will stop.

Anyway, at the Financial Times, John Authers is skeptical of smart beta, arguing both for theory 1 (the outperformance compensates for risk) and theory 3 (it is data-mining and illusion). There are various flavors of theory 3: Perhaps a factor's outperformance is purely imaginary, or perhaps it was real enough, but as soon as you identify it a bunch of hedge funds pile in and arbitrage it away. They might even go further:

That leads to another problem, identified by Rob Arnott in a paper for Research Affiliates, a pioneer of smart beta. A strong backtest at any point in time, he reasons, may be because the factor tested has become expensive.

Very perversely therefore, a strong backtest almost becomes a reason not to buy into a strategy. And if a strategy looks good now simply because it is expensive, that may be an active reason to fear that it will now perform badly.

Robin Wigglesworth is also skeptical, though he is also skeptical about the skepticism. 


One model you could have for activist investing is that activism itself tries to exploit an anomaly: Some companies are badly managed, and you can identify them and improve their management and capture above-market returns. But like other anomalies, this one tends to disappear when it is identified: The worst managements get fixed, other managements keep their jobs by co-opting activist ideas, and you end up with a ton of bored activists competing to demand that well-run firms buy back a bit more stock. The above-market returns dissipate. What do you do? One plausible approach would be to export U.S.-style activism to places that have not been fully scoured by other activists, and that have perhaps a bit more room for governance improvements. This is risky -- Elliott Associates had a rough time fighting a shareholder-unfriendly merger in South Korea -- but I guess it has more upside than just asking for more buybacks. So here is a story about Dan Loeb's activism in Seven & i Holdings in Japan, which Loeb worries might appoint its chief executive officer's son as his successor:

“The criteria used to determine the next CEO should be competence and the ability to run this company successfully, not family ties or preserving the Suzuki family dynasty,” Loeb said in a phone interview on Sunday.

I don't know much about the situation, but, sure, appointing CEOs based on competence does seem like low-hanging governance fruit.

Elsewhere in activism, "Avon Products Inc. is nearing the settlement of a skirmish with activist investors that would enable the embattled beauty-products retailer to sidestep a proxy fight." Here is Michelle Celarier on the cooling romance between Bill Ackman and Michael Pearson. ("While Ackman went out of his way publicly to make Pearson look good, Pearson rarely returned the favor.") And here is Jeffrey Gordon on activism and the "monitoring board":

The thinly informed independent director has no answer to the activist’s counterplan and thus is not a credible adjudicator for the institutional investor. That is, given the present board model, the institutional investor cannot say, “we know management is biased, but the directors, who have deep knowledge of the firm and the industry, have looked closely at the activist’s counterplan and have rejected it, and therefore so should we.”

Reform should move not in the direction of closing down the activists who are bringing the news about this design flaw.  Rather we should develop a new role for the board: credibly evaluating and then verifying that management’s strategy is best for the company (or making changes if it is not).

He argues for private-equity-style "thickly informed" boards instead of the modern system of independent but loosely engaged boards.

People are worried about stock buybacks.

Yahoo's core business, as we like to say around here, is worth less than zero dollars. That is the result of investing in projects (like, say, buying Tumblr) that Yahoo's management chose to undertake, presumably -- or so corporate-finance theory predicts -- because they had a higher expected value than the other projects that Yahoo didn't choose. (Imagine those projects!) So, for shareholders, a dollar that they give to Yahoo's management to invest ends up worth, not just less than a dollar, but less than zero dollars. If you give Yahoo a dollar, it will burn it, and then beat you up and take another quarter.

But there is a bright spot: Yahoo has given some of its dollars back to shareholders. "The company bought back shares worth $6.6 billion from 2008 to 2014, according to Robert L. Colby," explains Gretchen Morgenson. Every one of those 6.6 billion dollars that it gave to shareholders was worth a dollar to them, which is more (by a bit more than a dollar) than the value of the dollars that Yahoo kept.

But Morgenson argues that stock buybacks are bad because Yahoo should have invested that money in its business:

Given these figures, Mr. Colby reckoned that Yahoo, if it had invested that same amount of money in its operations, would have had to generate only a 3.2 percent after-tax return to produce overall net profit growth of 16 percent annually over those years.

But the world exists! Would shareholders be better off with the money, or with Yahoo's negative-valued business? 

More generally, the thesis here is that "buybacks provide only a one-time benefit, while smart investments in a company’s operations can generate years of gains." This assumes, however, that the company's managers are better allocators of capital than the company's investors -- that managers invest productively, while investors just eat every dollar handed back to them. You can have your doubts about Yahoo's investors as allocators of capital -- they bought Yahoo stock! -- but, versus Yahoo's management, I know who I'd pick.

Blockchains and Ethers.

Here's Nathaniel Popper on Ethereum, a ... thing ... that combines blockchains, smart contracts and even the Internet of Things into one irresistibly buzzy package. (Michael Novogratz, who previously got Fortress Investing Group to buy bitcoins at their peak, has bought a "significant" amount of Ether, the virtual currency of Ethereum, which is how you know it's got buzz.) Popper:

The system is complicated enough that even people who know it well have trouble describing it in plain English. But one application in development would let farmers put their produce up for sale directly to consumers and take payment directly from consumers. There are already dozens of functioning applications built on Ethereum, enabling new ways to manage and pay for electricity, sports bets and even Ponzi schemes.

I don't think Ethereum actually moves the produce from the farmers to the consumers, but perhaps the payment system is cheaper than PayPal? But, yes, fine, blockchains and smart contracts are smart ideas, and I guess someone has to create the standard for them.

In any case, the Ethereum app store is a delight. Here's a "triple-entry accounting system." Here's one Ethereum Ponzi scheme, which is dressed up adorably as a game ("Protect the Castle!"). Here's a chain-letter scheme ("King of the Ether Throne"). Here's a pyramid scheme. Here's another pyramid scheme. Isn't financial innovation great?


Outside of the blockchain, finance is pretty cyclical, so if you pay attention you will frequently see articles to the effect of "XXX, which helped cause the global financial crisis, is coming back!" Here's one about how "banks are again touting home-equity lines of credit, which allow homeowners to draw down the equity in their home as they need the cash, as well as cash-out refinances, which involve taking cash out of a home while refinancing and ending up with a larger mortgage balance." We are not yet at 2005 levels, but we are at about 2002 levels, so get ready for a crisis in around 2020? Or not? Aggressive lending against rising home prices may have been the most visible, and in some sense most "fundamental," aspect of the last crisis, but on the other hand banks loosen lending standards all the time and it rarely leads to a global financial crisis. I am more sympathetic to the view (see Gary Gorton, Morgan Ricks, etc.) that instability in short-term funding mechanisms was a more immediate trigger than aggressive home lending, and that you can have bubbly cash-out refinancings without a crisis. But I guess we'll find out.

Are bankers evil?

If you like this sort of thing, here's the sort of thing you'll like:

To me, banks are experts at exploiting asymmetries of information. Furthermore, they often amplify this asymmetry themselves by complexifying the products they offer or by disclosing only fractions of the information they have.

Of course, investment banks’ clients are the principal target of this type of strategy. While banks typically claim as their main value that their clients’ interests always come first, the reality is usually quite different. Therefore, banks will routinely increase the complexity of a transaction to make it difficult for the client to understand where the bank makes money or to make it difficult to compare to transactions proposed by other banks.

People are worried about unicorns.

"Later this year, or in 2017, will be a really good time to start a company," says Aileen Lee, the venture capitalist who is perhaps most famous for, you know. I suppose it is intuitive enough that, when money is scarce, the companies that do get funding will tend to be the good ones. When anyone can get funding, presumably the quality of the average startup goes down. Elsewhere, here are some views on why the initial public offering market has dried up. Here is "The Speed of a Unicorn." And here is a Securities and Exchange Commission case concerning alleged fraud by a fund "that marketed shares in promising pre-IPO tech companies in the Bay Area." Watch out for fake unicorns!

People are worried about bond market liquidity.

You know, I once promised to throw a party for the one-year anniversary of "people are worried about bond market liquidity," and I think I missed it. As far as I can tell, I first wrote about it on March 19 of last year, and first used the exact phrase on March 24. It has been quite a year -- a year full of ups and downs, much like waves on a sea of bond-market liquidity, or like the cliffs and valleys of the liquidity landscape, which is a multidimensional beast. Anyway, happy belated Bond Market Liquidity Worrying Day. Here's some worrying about hedge funds who invest in Treasuries.

Things happen.

US companies warn tax avoidance crackdown will hit earnings. Oil Firms Slow Exploration to Weather Low-Price Era. Want to Bet on Oil Companies? It’s All About the ZIP Code. Energy Companies Pay Up to Raise Cash. Miners buy back own bonds to soothe debt fears. Japan’s NTT to Buy Dell Systems for $3.055 Billion. IRAs Have a Regulatory Headache Coming. Mutual-fund derivatives rules are controversial. US high-street banks face $5bn hit from Fed’s more dovish stance. "It seems that man is losing out against the machine." Microsoft meets with private equity over Yahoo deal. Searching for Sundar Pichai. Google dorking. Food fraud. Underwear-stealing cat. Mailed cat.

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

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