Mutual Funds and Trading Robots

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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Don't do this.

Daniel J. Rice III knows a lot about energy. In particular, he "was managing energy-focused funds and separately managed accounts at BlackRock when he founded Rice Energy, a family-owned and operated oil-and-natural gas company." Rice Energy formed a joint venture with Alpha Natural Resources, and Alpha "eventually became the largest holding (almost 10 percent) in the $1.7 billion BlackRock Energy & Resources Portfolio, the largest Rice-managed fund," a fairly obvious conflict of interest and one that you'd think Rice should maybe have talked about with compliance or something.

And he did! Yesterday's Securities and Exchange Commission case against BlackRock makes a little noise about how Rice violated some BlackRock policies, but its real anger is reserved for the (former!) BlackRock chief compliance officer who approved Rice's extracurricular activities and decided they weren't worth bringing to the attention of clients. BlackRock will pay $12 million, and the compliance officer $60,000, to settle the case. 

Here's the 2012 Wall Street Journal article that brought Rice's activities to public attention, which takes a balanced view of whether those activities were good or bad for his investors. His conflicts seem to me to be, as it were, waivable: It's not, like, impossible for a human to act in the best interests of his investing clients even if he has a private joint venture with a big stock in their portfolio. So BlackRock waived the conflicts. It's just that it waived them at the wrong level: BlackRock the company decided it was cool with Rice's conflicts, but the proper decisionmaker would have been BlackRock's separate-account clients, or its mutual fund trustees. Mutual fund trustees have something of a reputation for rubber-stamping, and I'm not sure a mutual fund client would feel any better about the trustees allowing this conflict than she would about BlackRock allowing it. There's a certain formalism to the SEC case, though I guess if you're an energy mutual fund manager running your own energy company on the side you really ought to pay attention to the formalities. Or if you're a compliance officer! Definitely some formalities there.

Adverse selection.

A few weeks ago, a bot read a tweet and made a lot of money trading Altera call options. Here is the story of the options market maker who sold the bot its options and lost a lot of money. ("I personally lost $100,000 in one second.") He feels aggrieved -- "It’s like they’re insider trading on the news"-- and it's nice to see some sympathy for a market maker these days. This is why high-frequency trading firms cancel their quotes so often: You don't want to let people trade with your stale quote because they reacted to the news faster than you did. In some ways it's surprising that slow humans are still making markets in listed equity options, though I guess it's a more nuanced (and higher-risk) form of market-making than you get in purely automated cash equities.

Elsewhere in market structure, Norway's sovereign wealth fund wishes it could trade giant blocks of stock without impacting the price, which many large asset managers consider to be a fundamental human right. "The wealth fund released a paper last week calling for less fragmentation of dark pools, a move it says will improve liquidity and help investors find buyers," and "is also backing a not-for-profit venture called the Plato Partnership Ltd., which is due to start trading next year." I love that everyone who complains about market fragmentation thinks that the solution is to set up a new trading venue. That'll show 'em! 

Mutual funds.

Eric Posner reiterates his and Glen Weyl's argument that mutual funds should not be allowed to own multiples stocks in the same industry, because mutual funds "cartelize industries," or, I mean, strictly, because there is suggestive evidence from one industry that that might happen. Joshua Gans largely agrees. I remain skeptical. "No, we did not propose banning mutual funds," says Posner, and fair enough.

Meanwhile here is a profile of Eaton Vance chief executive officer Tom Faust, who hopes that his company's NextShares idea -- which we've discussed previously, and which seems pretty neat to me -- will "save active managers from extinction." The idea is that exchange-traded funds have advantages over mutual funds in terms of administrative expenses, tax efficiency, trading costs, etc., all of which are unrelated to their being passive (and to their trading intraday at net asset value). But ETFs do tend to be passive because their structure makes active management annoying. So if NextShares can be a way to have actively managed funds with the efficiency benefits of ETFs, that will help active managers compete to keep business. Of course the bigger worry about active management is that it charges higher fees than indexing for, in expectation, similar or worse performance; greater efficiency can't entirely solve that.

Is Warren Buffett too big to fail?

Hahaha good point, Bank of England, good point:

The Bank of England has written to the US Treasury asking why Berkshire’s reinsurance operation — among the world’s most powerful — was left off a provisional list of “too big to fail” institutions drawn up by the Financial Stability Board.

It seems like there's a plausible theory where even giant insurance operations don't get you "systemically important" status, which is reserved for insurers like AIG that run lots of non-insurance-y financial risks. But that theory runs into trouble when the U.S. has designated more or less traditional primary insurers (MetLife, Prudential) as too big to fail, and when Berkshire has a certain amount of derivatives activity itself. But it's, you know, folksier than AIG. 

Elsewhere in insurance, Alexander Chatfield Burns's insurance empire continues to melt; its assets seem to have included "a supposed $40 million stamp collection that couldn’t be authenticated." Fortunately it was small enough to fail, and to fail entertainingly.

Bank earnings.

Credit Suisse beat earnings expectations but the stock dropped. One worrying fact is that Credit Suisse's common equity Tier 1 capital ratio actually fell -- from 10.1 to 10 percent -- "partly because much of its capital buffer is denominated in now relatively weaker currencies" and partly because it was "buying up its shares to deliver to employees as compensation." Another worrying fact is that investment banking profits were up, but no one quite knows how much investment banking Credit Suisse will be doing in the future, so it's hard to know how much to care about those earnings. "The risk is that the debate around the incoming CEO shifts from the potential for strategic change to the risk of capital raising," is one analyst's unimpressed reaction.

Sovereign debt.

There's no particularly great news out of Greece. The central government is seizing local government funds, the yield curve inverted "on Dec. 8, 2014, and hasn't looked back since," the European Central Bank "staff have put together a proposal to increase the haircuts on Greek bank collateral that is offered in exchange for Emergency Liquidity Assistance (ELA) from the Bank of Greece," and there's talk of parallel currenciesDan Davies thinks Greece will muddle through, but "nothing will be done until the last minute," so "Greece is going to be leaking risk-on attitude into the rest of the market for a couple of weeks." 

Meanwhile in Ukraine, Ukreximbank's bond restructuring seems to be going well, but Russia is threatening to take Ukraine to arbitration over its sovereign bonds, and it is hard to imagine that going well. Maybe Steven Seagal could be one of the arbitrators.

Convertible bonds are great.

The Wall Street Journal criticizes convertible bonds, saying that given their low or even negative yields they "look like more of an outright bet on equities than in the past."As a former designer-builder-marketer of convertible bonds (disclosure!), I want to defend my old product against this charge, which seems plainly wrong. Regular bonds have low or even negative yields these days; all interest-rate product is at risk if rates go up. But convertibles are at considerably less risk, because they have less interest-rate sensitivity and because they have an equity option. As the Journal says, "Convertible investors hope that if and when interest rates do rise, it will be for the right reasons: that growth is stronger and more sustainable, which should be good news for equity markets." Whereas if things go poorly, a five-year senior unsecured bond at a zero-ish interest rate is a better investment than stock, and not a massively worse investment than an eight-year senior unsecured bond at five percent. And if things go crazy, a convertible is at least in theory a bet on volatility, and should make money in volatile markets, though there is some history of that not working out. 

Things happen.

Never tweet. Facts About Factors. Public pensions and payday lenders. GE might sell its commercial lending business to Wells Fargo. BP is preparing takeover defenses. Should there be separate civil and criminal insider trading laws? (Probably, yes.) Is Wall Street Really Robbing New York City's Pension Funds? (No; previously.) The chairman of ForceField Energy was arrested for stock manipulation as he "was preparing to board a plane in Ft. Lauderdale bound for Costa Rica." There are now more hedge funds than ever. TPG is leading a consortium to buy Cirque du Soleil and expand into China. Paul Volcker has some more ideas for regulation. TEDx Harvard. "It may look like a true squid at first glance, but the vampire squid is actually the last surviving member of a separate order, called vampyromorphida. "

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This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net