Research Conflicts and Hedge-Fund Troubles

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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Research.

As someone who writes my opinions on the internet, I am fascinated and horrified by sell-side equity research. If you are a research analyst, your job is to have opinions and write about them. But my opinions are my personal property, I can tell anyone I want about them, I can change them whenever I feel like it, and the government never checks up on me to see who I'm talking to about my opinions or whether, deep down, I really believe them. But if you are a research analyst, none of this is true. Your opinions -- at least, your Buy/Hold/Sell recommendations on the stocks you cover -- are material nonpublic information until they are published, on the theory, I suppose, that an analyst's opinion is itself enough to move a stock.

Right away this leads to weird results. In principle, if, say, a hedge fund manager decides a stock is good, he can buy it for his hedge fund, and then tell his closest hedge-fund buddy, who can then buy it, and then tell a few more buddies, and they can buy it, and finally he can announce publicly and try to convince everyone to buy it. It is the most natural thing in the world, to act on your own opinions before telling others about them. And in the abstract it is not crazy to imagine that an investment bank or broker who employs someone who is good at picking stocks might take that person's stock picks and (1) trade on them, (2) convey them to favored clients to trade on them, and (3) then announce them to the world. Like, that is a very logical business model! Get as much value as you can out of your valuable stock-picking ideas, first as trades, then as client service, and finally as advertising. But if you are a research analyst, that is not allowed: Your picks are material nonpublic information, and you and your bank can't use or disseminate them before they are published.

But it gets even weirder. Here is a Financial Industry Regulatory Authority case against Stephens Inc., an Arkansas broker-dealer, whose research analysts sent around "flash" e-mails to the sales force when things happened at the companies they covered. The idea is sensible enough: An analyst covers XYZ stock, XYZ announces earnings, the analyst notices and sends around the earnings to the sales force. But it ran into trouble:

Although the flash email program was intended to convey only publicly-available information, the firm did not have adequate policies and procedures to supervise the content of flash emails, and in practice flash emails sometimes conveyed more than that. Some contained information that could be understood to implicitly reveal how new public information might affect the analyst's opinion of a company, or information from which a reader might infer a potential change in the analyst's thinking about the rating, earnings estimate, or price target.

It's not just that you can't tell the sales force, or favored clients, about changes to your recommendations. You can't even say anything to them that "could be understood to implicitly reveal how new public information might affect" your opinion. But of course you are a human in the world, and all of your experiences in the world will shape your opinions. If you cover solar stocks, and you say "hey nice weather we're having" to a salesperson at the water cooler, have you revealed material nonpublic information? 

On the other hand:

Finally, in at least one instance, after market hours and contrary to firm policy, a research analyst simply cut and pasted into a flash email the draft text of a pending research report, which was then subsequently published before the market opened the next day.

There are a lot of gray areas in the rules, but this is probably not one of them.

Stephens agreed to pay a $900,000 fine, but more importantly it agreed to stop sending the flash e-mails. It's a weird result. It almost seems like Finra wants research analysts to do nothing -- no sales-force education, no client conversations, nothing -- outside of their published research, because any other contact with salespeople or clients might give away information about future published research. But research analysts who only publish research, and never interact with clients or salespeople, just aren't that useful. The Stephens analysts were helpfully sending around earnings announcements or whatever! Now they can't. Who will? Eventually, if Finra makes analysts useless, there'll be fewer analysts. And the result of this regulatory push to make sure that analysts never provide differentiated service will be that they provide no service.

Hedge funds.

Pershing Square's first-quarter investor letter is out, and it includes a sad little table of "investments that contributed or detracted at least 50 basis points to gross performance." There's one contributor, Air Products, off on the left. Over on the right, there are eight detractors, ranging from the Valeant long (negative 16.2 percent) through the Herbalife short to some currency option trades. The fund was down 25.6 percent, net of fees, for the quarter. It had a good April, though, up 10.2 percent. 

Since inception, the fund is up just 0.2 percent, net of fees, cumulatively since inception, versus 55.2 percent for the S&P. But that's misleading: "Inception" here is the inception of Pershing Square Holdings, Ltd., the firm's public permanent-capital vehicle, which was launched at the end of 2012 and went public in 2014. At the time of the initial public offering, Pershing Square's 10-year annualized returns were 20.8 percent (627.7 percent cumulative), versus 7.7 percent (118.8 percent cumulative) for the S&P. Many people are skeptical about the persistence of hedge fund performance: A manager who has had a good year this year might well have a bad year next year. It's possible that a hedge-fund IPO is a particularly bad sign for persistence of future returns.

Speaking of hedge-fund skepticism and timing, the New York State Comptroller said that "the combination of high fees and disappointing returns could lead the state to ease off" its investments in hedge funds. And "China Investment Corp.’s Roslyn Zhang, a managing director at the nation’s sovereign wealth fund, criticized hedge fund managers for everything from herding into bets against the yuan to lacking skills to make money." One simple model you could have is:

  1. "Hedge funds," as a broad category, are hedged, or are hedge, in the boring and approximate sense that in bull markets they tend to underperform stock indexes, while in bear markets they tend to outperform.
  2. The longer a bull market goes on, the more investors will get sick of paying high fees to underperform the bull market.
  3. Surely their timing in switching out can't be great?

I suppose that is an argument in favor of hedge funds, though on the other hand if you have just a small portion of your portfolio allocated to hedge funds, how much is that really protecting your downside anyway?

In other Bill Ackman news, he "is parting company with the man who introduced him to his disastrous investment in Valeant Pharmaceuticals." Actually that's not quite true: Bill Doyle, who "is a former Harvard classmate of Mr Ackman and introduced him to Michael Pearson," is leaving Pershing Square, but he will keep a position at Table Management, "an entity which oversees private investments" for Ackman's family. In general it strikes me as a little weird for a hedge fund manager to also have a family office: How do you decide, consistent with your fiduciary duties to outside investors, which employees should go to which? In this case though I suspect Pershing Square's investors will be happy to part company with anyone associated with the Valeant trade.

Speaking of Valeant, it promised to cut prices on its heart drugs, and then ... maybe didn't? Elsewhere in hedge funds, merger arbitrage is having a tough year, what with all the broken mergers. ("Every day is like showing up unsure of whether to wear a helmet or a diaper." What?) Damian Lewis says that hedge fund managers are "misunderstood." SAC Capital, or whoever is paying its legal bills these days, is going to trial on a class action over Mathew Martoma's insider trading at Elan. And Brevan Howard is closing an Argentina fund that is up 18 percent since it was started last year:

“Events unfolded as we had expected. Consequently we are winding down the fund and returning capital, as we had promised, to investors.”

That's how you want all your investor letters to read.

Ellevest.

A framework that I often think about is: 

  1. The triumph of indexing, exchange-traded funds, technology, etc., will drive more investors away from high-fee active mutual funds and investment advisers and into low-cost index ETFs and robo-advisers.
  2. People will moan about how the financial industry will never be profitable again.
  3. The industry will find new ways to build products on top of the low-cost stuff, not with old-fashioned promises of stock-picking mojo but with new pitches that make use of the new technologies (ETFs, robots) to offer thematic exposures and personal customization.
  4. The industry's profits will be fine.

Sallie Krawcheck, the former chief financial officer of Citigroup, has been particularly clever in this field. Yesterday she launched "her anticipated new startup, a digital investment platform for women called Ellevest":

Women, for example, need a platform that takes into account not only her earnings, but also her salary arc — which is different from men’s. It needs to account for the fact that women live longer than men, on average, when planning for retirement. It needs to understand the salary differentials between a woman’s pay and her male counterpart’s pay and how that impacts her strategies.

And it also will take into account those decisions that women tend to make more often than men — like taking a couple of years off from a career to raise children, for instance.

“Nobody is having that conversation,” says Krawcheck, of this career break. “But obviously, as a woman, that can keep you from achieving your goals.”

Now my own view of investing advice is that people overrate the importance of an adviser who understands an investor's unique needs, because what all investors need is as much money as possible without losing any. (The financial solution to the loss of income from taking time off to raise children is to have more money, but that is the financial solution to every problem.) One perhaps notable point is that Ellevest charges 50 basis points per year, versus 25 basis points at Wealthfront and 15 to 35 basis points at Betterment. If you have thematic differentiation for your robo-adviser, you can charge twice as much.

Scandal, etc.

I have previously expressed my fondness for the bribery business, because it looks so much like the regular business of sales. You try to get local knowledge, you rely on introductions, you pay people for performance, you butter up your contacts at the client -- who can say where buying a client a steak dinner shades into buying him a Rolex? Global Witness and the Wall Street Journal have published investigations into the dealings of Sable Mining Africa Ltd. and its founders, Andrew Groves and former England cricketer Philippe-Henri Edmonds. The allegations are ... well, the Journal says that Sable "made payments to government officials in West Africa in 2010 before winning lucrative mineral concessions"; Global Witness says that Edmonds and Groves have a "stock market empire built with bribery and scams."

But what fascinates me is, you know, look at the foreign-exchange manipulation cases. That stuff was barely even illegal, but there is an endless supply of e-mails and chats where traders tried to sound like the worst mob kingpins imaginable. Meanwhile the e-mails in the Sable investigation are so bland and friendly. Here's one from Aboubacar Sampil, an agent in Guinea who was close to the son of the country's president, Alpha Conde:

“[D]o not forget the budget for the people who are working for us here,” read an email sent from Mr. Sampil’s account on Aug. 18, 2010, to Mr. van Niekerk, then a Sable executive. The email asked Mr. van Niekerk to transfer cash to a bank account owned by Mr. Conde’s son “so I can be more confortable [sic] with the technicians of the ministry of mines.”

Obviously if you want to you can picture him winking as he typed it, but I submit to you that it is impossible to tell, just from the face of this e-mail, whether it relates to licit or illicit activities. "A Sable representative confirmed the payment and said it was for services Mr. Conde’s son provided to Sable before the election campaign."

Elsewhere, U.K. Prime Minister David Cameron was caught on a hot mic telling the Queen that Nigeria was "fantastically corrupt," so Nigerian President Muhammadu Buhari -- who "has a reputation for personal probity" -- demanded that Cameron help find all the stolen assets that corrupt Nigerians are hiding in the U.K.:

"I am not going to demand any apology from anybody. What I am demanding is the return of assets," Buhari said at an event, to applause from Nigerians in the audience.

"What would I do with an apology? I need something tangible," he said, rubbing his fingers together in a gesture commonly used to refer to money. The audience laughed.

Ahhh that is such a good response. Elsewhere: "At least $50 million allegedly diverted from a state investment fund in Malaysia was spent on luxury properties in New York and Los Angeles by the stepson of the Malaysian prime minister."

Oh and here in the U.S. there are criminal and civil cases against "Jason Galanis, whose checkered past dates from an accounting fraud case during his days as a major Penthouse shareholder to stock fraud charges last year," his father John, whose own Wikipedia page is impressively checkered, and various associates of theirs. The charges are pretty standard stuff: They're accused of (1) convincing a Native American tribe to issue some bonds and invest the proceeds with them, (2) selling those bonds to investors in accounts that they controlled without the investors' permission, and (3) then using the bond proceeds for their own purposes rather than investing them on behalf of the tribe. My favorite part may be that the "alleged schemers used investor money for criminal defense fund and for luxury purchases at Barneys, Prada and Gucci." Gucci, whatever, I have come to expect that, but when you are defrauding investors to pay the lawyers representing you in your previous stock-fraud case, something has gone wrong in your life.

People are worried about unicorns.

Perhaps the Enchanted Forest is not quite the idyllic place I had imagined; here is a McKinsey article titled "Grow fast or die slow: Why unicorns are staying private." It's not just unicorns, though; private equity is also having trouble taking companies public, and KKR has written down First Data almost as though it was a unicorn.

Elsewhere, here is a thing about how some venture capitalists look for the "blue flame," which means people young and dumb enough to work all the time on their laundry-delivery startup or whatever, as opposed to old people like me who get tired even reading about "blue flame." Hyperloop One seems to work. And here is a story about how "VCs Hunt for the Next Unicorn on Snapchat." I worry a little that they will end up with a unicorn that looks like a cartoon dog with a giant lolling tongue. (Did I do it? Was that a successful Snapchat joke? I am so afraid of Snapchat.)

People are worried about bond market liquidity.

They are, but on the other hand:

Auctions of long-term debt by the U.S., Spain and Portugal all drew strong demand Wednesday, with the Treasury sale seeing unprecedented appetite from one class of investors. Japan sold 30-year notes Thursday at a record-low 0.319 percent. Buyers are also clamoring for company bonds, in a week that may be the busiest this year for corporate borrowing in the U.S. and Europe.

Me yesterday.

I wrote about LendingClub. It is still a bit hard to know how big a deal it is. I said that "forging loan application data to make a securitizer think that you met its standards for borrower disclosure, while not actually meeting those standards, is just the reddest of red flags," and alarmingly reminiscent of previous securitization scandals. So that's bad! But they caught it themselves, bought back the loans, and voluntarily got rid of their chief executive officer over this. It's a good response! As I said on Tuesday, "if 2008-era bankers did what LendingClub did, we'd give them a medal."

Besides the misdating of loan applications, the other LendingClub controversy is its ties to Cirrix Capital LP, a fund that invests in its loans. From the Wall Street Journal:

Many online lenders use captive funds to keep demand strong for their loans. By selling loans to and investing in Cirrix, LendingClub opens the door to potential conflicts of interest and accusations that it is favoring one client over others.

“Was there a reason for anyone to even doubt that the loans were being divided up fairly?” said Brian Weinstein, chief investment officer of Blue Elephant Capital Management, which invests in online loans. “You don’t want investors to ever even ask that question.”

It is such a post-2008 mentality, that even the suggestion of a possible conflict of interest -- with no actual evidence of conflict -- is taboo. 

Elsewhere, John Gapper points out that marketplace lending is "vulnerable to the credit cycle, rather than floating in a brave new technology world." Here is a story about "private lenders helping reshape the American home-mortgage market." And elsewhere in financial technology, more or less: "Google to ban payday loan advertisements."

Things happen.

Wages Up, Profits Down: Winners and Losers of Higher Labor Costs. Banks Are Out, Investors Are In for Buyout Firms Seeking Funding. The Most Powerful People In The Financial World. Wall Street's Dealmaking Goes From Boom to Bust in a Few Months. Nightmare on Wall Street: Busted Deals. Jamie Dimon gets into war of words with banker he called a 'jerk' on CNBC. Hedge Fund Managers Ditch Decorum in Shouting Match Over China. China insurance regulator sends inspectors to Anbang. Crédit Agricole Profit Hurt by Stake Sale. Nissan to Buy 34% of Mitsubishi Motors for $2.18 Billion. T. Boone Pickens thinks that Muslims should not be allowed to come into the U.S. The socialist calculation problem and the Internet. Young Americans Drink More, Eat Worse, and Stay Skinnier Than Everyone Else. Blockchain for art. MegaBots raises $2.4 million to create league of human-piloted, giant fighting robotsGardens of Eden. Why share a desk with your dog? Bartolo Colon Home Run tattoo. Selfie toaster. Taylor Swift collects Taylor Swift award. Pope McCorkle III Is Your 2016 Name of the Year. "But, Hermione, I thought we weren’t allowed to create shell corporations on Hogwarts’ grounds."

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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