Penny Stocks and Active Management

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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What is Dick Fuld up to?

Good lord, would you believe giving the keynote address at a penny-stock conference? Would you believe that "several attendees said they didn't know who he is"? Would you believe that his speech included the words "Lehman Brothers in 2008 was not a bankrupt company"? (John Carney: "For most, the fact Lehman filed for Chapter 11 bankruptcy protection would be conclusive eFvidence it was, in fact, bankrupt.") Would you believe that it also included claims that his mother still loves him, that Lehman "had 27,000 risk managers," and that he wasn't drinking scotch or rum on stage? Other memorable lines are collected here, with the first being perhaps the best: "Liquidity is important ... I could talk for a month on this. No comment." 

Elsewhere in penny stocks, the Securities and Exchange Commission and federal prosecutors brought civil and criminal charges against two penny stock promoters, who pleaded guilty to pumping and dumping two stocks with tactics including "an eight-page glossy 'newsletter' touting RVNG stock that the promoters distributed in mid-July 2007 under a fake entity name, 'Stock Trend Report,'" which created excitement with "a warning: 'Please note: Due to high market demand for RVNG by institutional investors, some brokers may require you to phone in your order.'" That's ... not really how stocks work? 

Active management is hard.

BlackRock is pretty good at bond investing, and "sold more ETFs than any of its competitors last year," but it can't quite get active equity funds right:

Of the company’s 84 actively managed U.S. equity funds, 70 ranked in the bottom half of their categories over the past five years, according to data from research firm Morningstar. Clients have noticed: In 19 of the past 21 quarters they’ve pulled money from BlackRock’s actively managed U.S. and international equity funds.

It is not alone in this -- Pimco is also underwhelming in active equities -- and I suppose it is plausible that bond-manager and stock-manager cultures do not coexist easily. Another plausible mechanism is that active and passive equities do not coexist easily as, like, philosophies: If your firm deeply believes in passive investing and efficient exchange-traded funds, then that sort of implies a disapproval of active management, which makes it hard to recruit clients and managers to the active funds. (Though Vanguard basically manages.)

Elsewhere in investment management, Goldman Sachs president Gary Cohn "was on a short list of potential candidates to succeed Mohamed El-Erian as chief executive officer" of Pimco in 2013, before Bill Gross left. The talks never went anywhere, but that is an intriguing alternate universe to contemplate. Pimco pays a lot better: El-Erian (my Bloomberg View colleague) made almost 10 times as much as Cohn for 2013. 

Meanwhile, here is a Wall Street Journal article about how everyone trades stocks at the end of the day. (And a follow-up about plans to launch a mid-day auction for some stocks.) This is partly because index funds and quasi-indexers do their trading at the end of the day, to better match the closing price that is their benchmark. But everyone else also wants to trade when there's volume, to match the day's volume-weighted price, so they (or their volume-matching algorithms) follow the indexers to the end of the day in a self-reinforcing cycle. "Volume attracts volume," says a guy.

So okay you have an identifiable pattern: How do you arbitrage it? It seems hard? Like let's say you're a non-index, smart, informed, flexible trader. You acquire positive information about a company at noon, when no one else is trading. What can you do with it? If you just go buy a bunch of stock, you will push the price up, because there are no natural sellers to sell it to you. So you have to wait until the end of the day like everyone else; there is no incentive to be contrarian on timing. (Here's an interesting paper finding that "informed traders select times of higher liquidity when they trade.") Perhaps this is another mechanism by which the rise of indexing could be bad for active investors: It reduces the windows during which they can profitably use information.

Deutsche Bank's fine.

Gillian Tett, who apparently got the first whistleblower call about Deutsche Bank's mis-valuation of its leveraged super senior positions, is not impressed by the $55 million fine that the SEC imposed for that mis-valuation:

As punishments go, this looks disappointingly feeble given the implications of this alleged accounting misstatement. The SEC says that Deutsche overstated its derivatives holdings by at least $1.5bn. However, whistleblowers insist that the amount was several times bigger, and that if the accounts had been correct in 2008 the losses might have forced Deutsche to ask for a government bailout.

I don't know, but consider that JPMorgan's fine for mis-valuing its London Whale positions was almost 17 times as big as Deutsche's fine, though the Whale error was only about 4 times the size of the Deutsche Bank one. You could argue about the relative culpability of JPMorgan versus Deutsche Bank; both sides can plausibly claim that they were valuing positions under great uncertainty, but both sides also have some bad circumstantial facts that suggest intentional deception. And lying about structured credit valuation in the midst of the financial crisis seems worse for, like, the world than lying about JPMorgan's random embarrassing loss. Perhaps JPMorgan's fine was so much bigger not because the Whale blowup was worse, but just because it was so much more public and embarrassing.

More SEC news.

Senator Charles Grassley is worried about the fact that just anyone can make a filing on the SEC's Edgar database, and wants answers from the SEC after the recent Avon unpleasantness. "It is critical that the SEC also address the systemic vulnerability exposed by this incident," says Grassley. Is it? I mean, there are a lot of Edgar filings by individual shareholders and small funds and newly-formed merger subs and so forth; it is not obvious that investors will be better off if they all have to prove that they are who they say they are before allowing them to disclose their holdings. When big public dumb things happen a lot of people fret about the damage to the integrity of the capital markets, but I can never quite figure out what that integrity consists of. People lie in Edgar filings all the time! There's not, like, a software solution to that.

Speaking of integrity, yesterday the SEC "announced fraud charges against a Long Island man accused of fleecing investors and stealing money from a brokerage firm where he worked as the director of compliance." Oops! As compliance officer, it was William Quigley's job "to open and properly route all incoming mail" at his brokerage, Trident Partners, and he allegedly "stole commission checks made out to his employer Trident and deposited them in the discount brokerage account in the name of TPIC," Trident Partners Investment Club, "a fictitious entity that had nothing to do with Trident" and was allegedly controlled by Quigley out of "a UPS Store in Wantagh, New York." This scam -- grab checks to your employer, set up a fake company with a similar name, deposit checks in its account -- is so ridiculous that no one could have suspected a compliance director of running it.

Still elsewhere in SEC actions, former Wells Fargo research analyst Gregory Bolan settled his insider-ish-trading case for disclosing information about his ratings changes to a Wells Fargo trader before making them public. (We've talked about Bolan before.) And here is the weird saga of the SEC's stalled accounting fraud case against Computer Sciences Corporation. 

Some incentives.

From a new Federal Reserve discussion paper:

In this paper, I use a decrease in dividend taxes as a natural experiment to identify their impact on firm’s price volatility. If a risk–averse executive faces price risk through his incentive contract, changes in stock volatility due to dividend taxes may increase agency costs and therefore decrease overall welfare. Stock volatility decreased after the tax cut for firms where an executive has large holdings of shares and options relative to firms where an executive has small holdings of shares and options. Therefore, with a risk-averse executive and risk-neutral shareholders, dividend taxes may exacerbate agency costs. 

Things happen.

What Will Happen to a Generation of Wall Street Traders Who Have Never Seen a Rate Hike? "It’s been a broad M&A recovery." Moody's upgraded Morgan Stanley, Goldman Sachs, Bank of America and Citigroup. "J.P. Morgan Chase & Co. is cutting more than 5,000 jobs." Wall Street Is Using the Power of Dodd-Frank Against Itself. Public markets have down rounds too. Your occasional reminder that it's a federal felony to withdraw your own money from your own bank account. Some oil wells have silly names. Married couple share husband's bonus equally. Man Named 'God' Settles With Credit Agency He Sued. Pizza-topped pizza. The game is the game. It's a duck blur. Man Shocked To Bump Into His Dog On Train Ride To Work.

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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