Dividends, Annuities and Hedge Funds

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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Dividend arbitrage.

It is such a simple trade:

  1. Company C in Country X pays a dividend of $100 on its stock.
  2. Country X requires withholding a 15 percent tax on any dividend paid out of the country.
  3. Investor A in Country Y owns Company C stock.
  4. If it just got the dividend, it would only get $85.
  5. But instead, the day before the dividend, it lends the Company C stock to Bank B in Country X. (Or it sells the Company C stock to Bank B and buys back a swap, or some other more-or-less economically equivalent transaction.)
  6. Bank B gets the $100 dividend, without withholding tax.
  7. Bank B pays a $100 "substitute dividend" payment to Investor A, which is not subject to withholding tax. (Or maybe it pays $95 and keeps $5 for its troubles.)
  8. (Bank B may be taxed on the dividend as income, but it gets to deduct the substitute dividend as an expense, so it pays no net tax on the trade. Or perhaps Bank B is exempt from tax on the dividend for some other reason.)
  9. After the dividend, Bank B returns the stock back to Investor A, without ever taking stock-price risk.
  10. The end. Everything is just as it was, but Investor A avoids the tax, and Bank B collects a fee.

There is nothing especially subtle about it, and yet it is elegant enough in its way. The trick is that Country X's tax code requires withholding on one transaction (a dividend) and not on an economically identical and trivially similar transaction (a "substitute dividend" on a swap or stock loan). 

Countries tend to like their dividend withholding. Gratuitous payments by local companies to foreign investors are pretty much an ideal source of tax revenue; remember, the optimal tax is one on foreigners living abroad. And the dividend-arbitrage trade is reasonably easy to shut down; you just extend the withholding requirement not just to dividends but also to substitute dividends paid by banks. The U.S. did this several years ago, but the trade is still popular in many other parts of the world, including in Germany, where dividends tend to be high and where the tax code is not quite equipped to stop the arbitrage. Here is a ProPublica/Washington Post article about dividend arbitrage in Germany that takes the usual moralizing line:

Wall Street has figured out a way to squeeze some extra income from these stocks. And German taxpayers pay for it.

As a result of the investigation, Germany's finance ministry declared the deals "illegitimate because their sole purpose is to avoid the legal taxation of dividends," and Commerzbank will shut down its dividend-arbitrage business. I won't say it was too beautiful to live. It was just a basic exploit of a basic inconsistency in Germany's tax system. If you tax a dividend to A, but not to B, then eventually they'll figure out a way to send all the dividends to B and split up the savings. Finance is about allocating capital and arbitraging away inefficiencies; the differential tax treatment of dividends to foreign and domestic investors was an inefficiency, so modern global finance arbitraged it away. Of course, to modern global finance, all taxes feel like inefficiency, and it's perfectly reasonable for Germany to put this one back.

Anyway this is not a great pitch: 

Another bank prepared an explainer for clients that says, “We’re not going to pretend to be tax experts, but it goes something like this.” The explainer then details how investors can avoid taxes by lending shares over dividend dates.

You are pitching a tax trade! Prefacing your tax advice with a folksy warning that you don't know what you're talking about is not ideal.

Elsewhere, here is a story about the LuxLeaks guy, who "was actually looking for training documents when he stumbled upon the files on his computer at PricewaterhouseCoopers." 

Variable annuities.

Variable annuities "are complex investments that are commonly marketed and sold to retirees or people saving for retirement," says the Financial Industry Regulatory Authority, and while it is customary to say that any investment other than common stock is "complex," I am willing to give Finra this one. How complex are variable annuities? So complex that when MetLife Securities was pitching customers on replacing one variable annuity with another, it "required registered representatives to inform a customer whether the proposed VA contract was more expensive than the existing VA contract," and they basically couldn't:

MSI's registered representatives answered this question incorrectly in 30% of its replacement applications by indicating that the proposed VA contract was less expensive than the customer's existing VA contract. In reality, the proposed VA contract was more expensive.

That is a pretty basic question! Like, if you ask a car salesman if the Sonata is more expensive than the Elantra, he'll be able to tell you, and he'll get it right more than 70 percent of the time. Getting it wrong 30 percent of the time suggests that MetLife's representatives had no idea what they were selling.

Obviously the other possibility is that the representatives knew that the new product was more expensive than the old one, but said it was cheaper just to get more fees. But that's not what Finra concluded when it fined MetLife Securities $20 million and ordered it to pay back $5 million to customers for "negligent material misrepresentations and omissions" in its variable annuity replacement business. "MSI misrepresented or omitted at least one material fact relating to the costs and guarantees of customers' existing VA contracts in 72 percent of the 35,500 VA replacement applications the firm approved" -- 72 percent! -- but these were apparently negligent accidents, not intentional mis-selling. Anyway here is another proof of the product's complexity:

VA Replacements constituted a substantial portion of MSI's business. During the Relevant Period, MSI sold at least $3 billion in VAs through 35,500 VA Replacements generating $152 million in gross dealer commission for the Firm.

That's like a 5 percent commission. You can't get 5 percent on common stocks these days. For 5 percent, your product had better be complex.

Hedge funds.

Today is the Ira Sohn conference, which is your chance to hear some of the smartest men (all men!) in the investment management business discuss the market, impress you with their brilliance, and then pick some trades that will have about a coin flip's chance of working out. Seriously, here are Josh Brown's recaps (part 1, part 2) of last year's Sohn conference presentations, which were thoughtful and insightful and wide-ranging, and here is Julie Verhage's recap of how last year's Sohn picks worked out, which was basically terrible. At the Milken Institute conference on Monday (happy conference week!), Steve Cohen worried about the lack of talent in the hedge-fund space. But the deeper structural worry is not that there isn't enough talent, but that applying talent to single-stock investing is not necessarily all that correlated with results. Maybe every hedge-fund manager is smart and hard-working and handsome, but stock prices are a random walk anyway.

Oh by the way, that Milken video -- of a panel moderated by Ilana Weinstein and featuring Cohen, Cliff Asness and Neil Chriss -- is long but worth watching both for some good insights on how to think about hedge funds but also, and especially, for Cohen's hilarious innocent hands-in-the-air disclaimers that he just runs a family office and has never even heard of hedge funds.

Elsewhere, Cohen's family office "is starting a venture capital unit," called Point72 Ventures, "to fund and help develop financial technology for asset managers." And: "Berkshire business model is simple and effective, yet rarely copied." And here is Ben Carlson on the scourge of investment consultants

As a group, hedge fund performance has been abysmal over the past decade or so. Consultants and those picking the consultants don’t receive nearly enough blame for this. The hedge funds are, in most cases, just giving these large institutional investors what they ask for (usually a strategy to fight the last war). Consulting firms pitch their “access” to top performing funds, but that’s usually the funds that outperformed in the past, not to be duplicated in the future.

ROIC.

Look, any financial metric can be misleading in some circumstances -- "I could write a paper on perverse ways you could destroy your company by raising your ROIC," says Aswath Damodaran, tantalizingly, about return on invested capital, which the Wall Street Journal calls "all the rage" among financial metrics -- but the fundamental question is, should companies be thinking quantitatively about whether the projects they invest in are likely to return more than their cost of capital, or should they not be thinking about that? There are definitely cases where the answer is no! Starting Facebook in a dorm room: probably not a decision driven by expected-return spreadsheets. But for most regular public companies that mostly invest in actual business projects that are supposed to make money in the reasonably foreseeable future, it is weird not be judged in some quantitative way on how much money those projects make and how much you spent on them. That is just basic stuff. And yet:

The focus on ROIC helps explain why activists push decisions sometimes labeled short term.

Activists said they aren’t inherently opposed to investment projects, but that companies have to justify spending. If a plant or a new line of business falls short on expected returns, companies should find a different project or give the cash back to shareholders, they said.

One way to think about the short-termism debate is that many public-company investors really do want their companies to invest mostly in projects that are likely to return more than their cost of capital in the foreseeable future. This is a very reasonable demand for almost all projects at almost all companies. There are exceptions: Some companies are engaged in real moonshots that have only a low probability of working out, many years from now, but if they do work out they will be transformational. (These projects could have a high ROIC too, but that might be harder to prove.) Probably a lot of those companies shouldn't be public companies. But, again, there are exceptions; Google and Amazon seem to have earned the market's trust that they can both run core businesses economically and invest in long-term opaque projects. (And there are sometimes controversial moves the other way; e.g., the pharmaceutical business is mostly about collecting portfolios of moonshots, while Valeant's innovation was to get rid of the moonshots and focus on foreseeable return on capital.) 

The question is often: Is this management team one of the exceptions? If a company wants to invest in something whose economic benefits it can't quite justify numerically, and shareholders object, does that mean that the shareholders are short-term idiots? Or does it mean that the managers are undisciplined empire-builders? I don't think there is a general answer to that question, though I tend to sympathize with the ROIC people: Most public companies probably should be trying to earn their cost of capital most of the time.

Bloodchain.

Here is Izabella Kaminska on a new plan "developed by students at University of Edinburgh Business School" that would use the blockchain "to create a new, more efficient model of blood transfers between hospitals." Yesterday we talked about the weird mysticism of using the blockchain to transform dollars into "pure digital assets": Dollars are already digital assets; the blockchain may be an efficient way to move them, but the talk of transforming them is mostly obfuscating mumbo-jumbo. Blood has the opposite problem. The problem with blood is not with efficiently transferring legal entitlements to it, or with reconciling different parties' ledgers to reflect how much blood they own. Owning blood is useless. You have to have it in your body. Blockchain can perhaps speed up the process of transferring blood between hospitals -- perhaps it is more efficient than just, like, e-mailing other hospitals or whatever -- but there's only so much it can do for the settlement process. The settlement of a blood transfer requires moving blood, actual physical blood, and you can't do that on the blockchain.

People are worried about unicorns.

There's nothing a unicorn likes more than to kick back and relax with a nice game of ping-pong, but now even that simple pleasure is losing its appeal:

“Last year, the first quarter was hot” for tables, says Mr. Ng, who thinks sales track the tech economy. Now “there’s a general slowdown.”

In the first quarter of 2016, his table sales to companies fell 50% from the prior quarter. In that period, U.S. startup funding dropped 25%, says Dow Jones VentureSource, which tracks venture financing.

Mr. Ng is Simon Ng, owner of Billiard Wholesale in San Jose, "who drives a Porsche Boxster to work." Twitter, the ex-unicorn whose stock hit its lowest closing stock price ever yesterday, is the face of the ping-pong crunch, though it is putting a hilariously brave face on the matter:

Asked why Twitter stopped buying tables, spokesman Jim Prosser says: “I guess we bought really sturdy ones.” Twitter spokeswoman Natalie Miyake says: “Honestly, we’re more of a Pop-A-Shot company now,” referring to an indoor basketball game. 

Sure, sure, it's Pop-A-Shot, not a bubble bursting. I continue to be a little ambivalent about reader drawings in this space, but I could probably use an illustration of two unicorns playing ping-pong.

Elsewhere! A while back we talked about the dream of replacing the market with a central computer that allocates resources and sets prices. I joked: "This is called the socialist calculation problem, and it is pleasing that late-stage unicorn capitalism has solved it." I was talking about mutual funds' approximate valuations of private tech companies, and was mostly kidding. But here is a story about how Uber is working on replacing surge pricing (which uses prices to allocate resources, although it uses an algorithm to set prices) with an algorithm that will just figure out how many drivers should be driving and where. I am not entirely sure about the mechanism for that -- isn't the point of Uber that its drivers are independent contractors motivated by piecework pay rather than by their bosses' orders? -- but, whatever, as Arindrajit Dube points out, it's one unicorn step toward socialist calculation. And it seems fitting that the libertarians at Uber would be leading the way.

People are worried about bond market liquidity.

Here's a speech by Benoît Cœuré of the European Central Bank about, among other things, the effects on liquidity of the ECB's Public Sector Purchase Programme of buying European government bonds:

The impact of the PSPP on market liquidity remains an empirical question. And looking at the available data, we do not see evidence of significant disruptions in market functioning.

First, price discovery appears to be smooth and issuers are able to place new securities to the market in large volumes. Trading volumes have not fallen systematically as a result of PSPP. Based on TradeWeb data, trading volumes in core markets such as Germany are roughly 5% lower than two years ago. However, trading volumes in Italian, Spanish and Portuguese bonds on that platform are around 20% higher. That said one should not draw hasty conclusions from what remains a fragile set of indicators. Too little is known of the liquidity offered by dealers to end-investors. And therefore, the ECB will monitor market liquidity carefully as our asset purchase programme is further rolled out.

Things happen.

U.K. Banks Brace for ‘Brexit’ Ahead of EU Poll. Saudi Regulator Makes New Moves to Lure Foreign Investors. Billions Are Being Invested in a Robot That Americans Don't Want. Robots Will Strike Asset Management Firms First. Prosper Marketplace to Cut Jobs and Shuffle Executives. Société Générale Profit Rises Despite Weakness in Investment Banking. Freddie Mac Won't Pay Treasury Dividend After $354 Million Loss. Credit Suisse to Sell Distressed-Debt Portfolio for $1.27 Billion. AXA to Sell Its U.K. Life and Insurance Business. The proposed Net Stable Funding Rule is out. Mountain of Tin Draws Investors to World's Biggest Untapped Site. The New Qualification for China’s Tech Elite: Goldman Sachs. Multi-billion euro carbon-trading fraud trial opens in Paris. BHP, Vale Face $44 Billion Lawsuit Over Brazil Dam Disaster. If Larry Summers is right about secular stagnation, he’s also right about Harvard’s endowment. China Presses Economists to Brighten Their Outlooks"Nobody slices a fish or boils a bagel like us." Donald Trump is too gullible to be president. Dog eats butterfly.

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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