Hedge-Fund Assaults and GSE Battles

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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Hedge funds.

A well-known rule of thumb is that you should get out of the market when you get stock tips from a shoe-shine boy, but what does it mean for hedge funds when they stop tipping the shoe-shine boys? Things are bad at the SkyBridge Alternatives Conference this year:

Tips at the shoe-shining station a few feet from the main ballroom were down more than 50%, to $5 or under in most instances, from as much as $20 one year earlier, a shoe shine employee said.

When there was time between the shoe-shines and the fundraising for Trump, SALT turned to introspection. Here's Leon Cooperman of Omega Advisors:

The 73-year-old Mr. Cooperman summed up the industry’s mood with comments he made Wednesday. “The hedge-fund model is under challenge. It’s under assault,” he said, adding that he was contemplating whether it was worth it to remain running hedge funds at all.

And Jim Chanos of Kynikos Associates:

“I think long-only hedge fund guys charging two and twenty should start looking to cut their expenses,” Chanos said.

Chanos said not enough alpha, or profits generated above an index, is being generated in the industry, in part because there are too many people chasing such profits.

The assault comes from all sides, including the clients. James Stewart quotes Steven Goulart, the chief investment officer at MetLife, which has been disappointed in its hedge fund returns:

“We thought a lot about what’s wrong with the hedge fund space,” said Mr. Goulart, who also serves as an executive vice president at MetLife. “One problem is that there are just too many funds, roughly 10,000 with almost $3 trillion invested. There’s too much money chasing a limited number of attractive trades.”

It is hard to find much new to say about this. Cliff Asness has a good perspective on the issue here at Bloomberg View:

Over the long haul, broad portfolios of hedge funds tend to move about 35 percent to 40 percent up or down with the stock market. That is, if the stock market suddenly gained or lost 10 percent, you might expect your hedge-fund portfolio to gain or lose about 4 percent from this market move. Of course, the goal of hedge funds is to add some return on top of this. If they can do that (after fees) then it’s not hard to show hedge funds make an investment portfolio better over the long term, no matter whether they beat the S&P 500.

Obviously, if the market goes up a lot the broad universe of hedge funds will likely lose to it. By the same token, if the market crashes it would be shocking if hedge funds crashed as much. There is an old saying: “Don’t mistake a bull market for brains.” There should be a corollary applicable to hedged investments, even if only partially hedged: “Don’t mistake a bull market for buffoonery.”

But this is only a partial defense of hedge funds: Obviously you wouldn't pay 2-and-20 fees for a fund that just provides a 0.4 beta. You could just buy 60 percent less stock instead! The key thing is whether hedge funds provide enough alpha to make up for their fees, and that is coming under question. As Asness says: "By charging so much, sometimes for fairly simple and known strategies, hedge-fund managers set expectations too high and gain no slack for the inevitable tough times all investments face."

My touchstone is: "a compensation scheme masquerading as an asset class." One reasonable worry for the hedge-fund business is that it is treated as an undifferentiated asset class by so many investors, which puts pressure on the compensation scheme. If you are a special snowflake offering hard-to-replicate performance to your clients, by all means, charge 2 and 20, but "at its peak, A.I.G. had more than 100 hedge funds," writes Stewart, representing 3 percent of its total portfolio:

“It’s no wonder A.I.G. experienced weak performance,” Mr. Lack said. “With that many funds, you get the average, and the average is mediocre. If you aren’t highly skilled in picking hedge funds, there’s no point in being there.”

If only 3 percent of your money is allocated to hedge funds, it's not really hedging you much against a downturn. And if it's allocated to 100 managers -- just 3 basis points each! -- then their aggressive idiosyncratic trade ideas are not giving you much upside. So you are left with, you know, a pile of money returning a 0.4 beta and making its managers rich. At some point you can probably find a more efficient way to do that. (Cullen Roche: "In a world where you can now mimic a hedge fund index for the cost of 0.75% it’s very hard to imagine that there’s any rationale for fees being higher than that on average.")

You could just about imagine a near future in which running a hedge fund is no longer a way to accumulate dynastic wealth. For the managers like Cooperman who have already accumulated dynastic wealth -- when the industry was smaller, managers were more aggressive, opportunities were easier to exploit, stock-market comparisons looked better, and fees were paid without complaint -- the solution may be to conclude that it's not "worth it to remain running hedge funds at all." (Here as in so many things, George Soros and (sort of) Steve Cohen are pioneers.) The easiest way to make a lot of money in as a hedge fund manager these days is to already have a lot of money in your own hedge fund, and you can run that strategy from a family office. I worry about the next generation of hedge fund managers, though, who haven't yet had a chance to bank billions of dollars in fees. How will they fund their family offices?

Fannie and Freddie.

Look, I understand that there are a lot of real controversies around the bailout and nationalization of Fannie Mae and Freddie Mac, and I actually have some sympathy with the shareholders' arguments that the government changed the deal on them in an unfair way. But every time I read this argument my brain falls out of my head and I have to crawl around under my desk looking for it:

Gibson Dunn lobbyist and attorney Michael Bopp in a statement on behalf of Perry Capital wrote, “Treasury’s illegal actions so far have stripped $130 billion of loss-absorbing capital from the GSEs, ensuring that even the slightest downturn would now require a taxpayer bailout. Perry Capital has raised the alarm by litigating and lobbying for a capital cushion to protect taxpayers and public investors. Congressman Mulvaney’s bill would fix this unsustainable capital hole.”

Okay look. Here's how it works. Fannie and Freddie had $130 billion. The government took it from them. Now, if they lose $100 billion, or $50 billion, or $10 billion -- "even the slightest downturn" -- the government will have to give them back $100 billion, or $50 billion, or $10 billion, to keep them afloat. That's a bad scary bailout! If the government has to give Fannie and Freddie $100 billion, then it will only have $30 billion left of the $130 billion it took from them.

The proposed solution is for the government to just give them back the whole $130 billion right now.

There are some arguments from fairness and corporate governance for that approach, but there are no arguments for it from taxpayer protection, or arithmetic. Definitely giving Fannie and Freddie $130 billion now costs more than maybe giving them $100 billion later. Of course maybe Fannie and Freddie will lose, like, $200 billion, and then the taxpayers will have to give them the whole $200 billion and be in the red. But even if the government gave them back $130 billion today, a $200 billion loss later would eat through the capital and require a further bailout, leaving the government just as much in the red. (I oversimplify somewhat -- some proposals are for the government to stop sweeping profits and allow Fannie and Freddie to build capital going forward -- but it remains the same arithmetic. Every dollar that Fannie and Freddie give to the government now is a dollar that the government has now, and might have to give back in the future.)

That's not actually what this article is about; it's just an aside that makes me mad. The article is about the lobbying efforts on behalf of Fannie Mae and Freddie Mac shareholders to get Congress to come around to their point of view. They've had some success, and Representative Marsha Blackburn has introduced a bill to suspend the government's sweep of Fannie's and Freddie's profits that has been supported by the investor group and its founder Timothy Pagliara:

The day before Ms. Blackburn introduced the bill, Mr. Pagliara donated $5,000 combined to Ms. Blackburn’s primary and general campaigns, his first donation to her since 2009.

Mr. Pagliara said the timing of his donation was a coincidence. He said that he had earlier suggested such a bill to Ms. Blackburn and had a longstanding relationship with her but didn’t have influence beyond the suggestion.

Yesterday we talked about the mining-company agent in Guinea who urged company executives not to "forget the budget for the people who are working for us here," so that he could "be more confortable [sic] with the technicians of the ministry of mines." There is a universal human need to be more comfortable with the people you're pitching. 

Meanwhile here is a story about how the Clinton Global Initiative "set up a financial commitment that benefited a for-profit company part-owned by people with ties to the Clintons," which I mention mainly for this sentence about Clinton friend Mark Weiner:

Mr. Weiner has a company, Financial Innovations Inc., that makes campaign souvenir items such as coffee mugs and pens.

You'd think it would make, like, at least synthetic collateralized debt obligations? Or blockchains? But, no, Financial Innovations Inc. makes coffee mugs and pens. 

Merger litigation.

Is it possible that we are reaching the end of the golden age of merger litigation? For a long time, whenever a deal was announced, plaintiffs' lawyers immediately announced a lawsuit, and the company quickly settled by revising the disclosure slightly and paying a six-figure fee to the plaintiffs' lawyers. It was a "tax on M&A," and Delaware courts got sick of it, and now it is more or less dead: "The heyday of 'file a case, make $500,000' is clearly over," said, amazingly, a plaintiffs' lawyer, earlier this year.

But of course there are still merger lawsuits. You can't just collect a tax any more; now you have to make a real case that the board did something wrong. But even there, things may be getting tougher. Here's Ronald Barusch:

In a short but unambiguous order handed down last week, the Delaware Supreme Court effectively told trial courts to throw out future cases challenging mergers as long as they’re properly approved by shareholders.

If investors are fully informed and have the power to turn down a takeover deal, it doesn’t matter how many or how big are any mistakes directors make in the process — as long as a majority of shares owned by disinterested stockholders are voted “yes.”

The standard, said the court, is "waste," meaning that directors will only be liable for damages in a properly approved deal if they were more or less intentionally wasting company assets. "The court basically indicated it wasn’t likely to be pertinent since 'the vestigial waste exception has long had little real-world relevance because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.'" Here's the decision. I suppose you can still argue that the disclosure was misleading. But there does seem to have been a sense that merger litigation has gone a bit too far, and that boards and their advisers need to be able to make decisions with some protection from second-guessing.

Fintech.

I worry that I was a little too cynical about Sallie Krawcheck's startup Ellevest yesterday. My view of financial advice is that everyone wants goodreturns, it is hard for advisers to provide that, and so the advisers fall back on promises to really understand their investors' unique needs. But everyone's needs are the same -- more money -- so those promises are mostly just marketing. But I found this description of Ellevest mildly persuasive:

The focus on life goals rather than numbers is also research-based.

"Our original ethnography really displayed to us a few different things, and the first one was when it came to investing, she just didn't see herself inside of what traditional investing looks like because there's not a benchmark," VP of product design Melissa Cullens told Business Insider.

I suppose it is sensible to have some life goals -- buy a house, whatever -- and save enough money that you are likely to be able to afford them, and perhaps advising people on how to achieve those goals, rather than just how to turn their money into more money, is a valuable service. Personally I will stick to throwing as much money as I can into index funds and hoping for the best, but that is of course never investing advice. Elsewhere in fintech: "Community Bank Group Suspends LendingClub Purchases."

Management techniques.

The regulatory investigations into Libor manipulation have long been a source of amusing e-mails, but now they have moved on to outright physical comedy:

Jonathan Mathew, one of five former Barclays Plc employees accused of manipulating Libor, told a London jury that he was routinely humiliated by his boss when he made mistakes working on the money markets desk.

Mathew, who is partially deaf, said on his first day of testimony that he was hit on the back of the head with a 12-inch baseball bat, shouted at and forced to stand on a chair in the trading room to answer a quiz on world capitals by his boss, Peter Johnson.

The quiz "wasn't particularly hard," and a regulation baseball bat is longer than 12 inches, but still, you know, rude. But as a method of building loyalty and esprit de corps, hazing has something to be said for it. Sometimes I miss investment banking a little. 

Elsewhere in London courts: "Ex-Deutsche Bank Broker Gets Record Sentence for Insider Trading." It's four and a half years, which is the U.K. insider trading record; it does not come close to challenging the U.S. record.

People are worried about unicorns.

As with Ant Financial, I am not quite sure that Chinese ride-hailing company Didi, or Didi Chuxing, formerly Didi Kuaidi, is a unicorn: It is a private technology company with a valuation of "about $26 billion," which more than qualifies, but it is not so much venture-backed company as it is a joint venture of big public companies, "created last year when separate apps backed by Tencent and Alibaba merged." But this is all hair-splitting, or horn-splitting; Didi is a major competitor to Uber, the Ubercorn, and so it occupies some important territory in the Enchanted Forest.

Anyway now "Apple Inc. is investing $1 billion in Didi, giving the Chinese ride-hailing startup a powerful ally and dealing a blow to Uber Technologies Inc. as it tries to build its business in the country." Uber is unfazed, or whatever this is:

Travis Kalanick, Uber’s chief executive officer, responded to the news by noting a new personal connection to Didi.

“girlfiend owns @apple shares which makes her a didi investor,” he said in a post on his verified Twitter account.

Here is Bloomberg Gadfly's Tim Culpan on what this means for Apple's China strategy. On Twitter, Michael Santoli suggests that Apple might be "just following Yahoo's playbook: Invest $1B in a China startup as core biz peaks?" He adds a smiley-face emoji, suggesting that he is kidding, but honestly that's what I'd be doing if I ran Apple. Last month I described my simple dumb model of Apple, in which it is wonderfully excellent at computer hardware design but might have trouble finding the next big thing. If you get really good at computer-design perfectionism, that does not necessarily build the skills you need to find entirely unrelated new lines of business. Fortunately, though, if you are as good at hardware design as Apple is, you will have hundreds of billions of dollars lying around that you can invest in companies that might find the next big thing for you. Large-scale venture capital seems like a perfectly reasonable solution to the innovator's dilemma. 

People are worried about bond market liquidity.

And they have won a great victory. Or at least a little victory:

The European Securities and Markets Authority proposed this month to phase in standards on bond liquidity and trade size that will determine whether securities fall under the new rules for disclosing pre- and post-trade bid and offer prices. The European Commission, the EU’s executive arm, had instructed ESMA to soften a previous draft of MiFID II technical standards to avoid impeding markets.

By gradually tightening the rules over a four-year period, “significantly fewer instruments than initially proposed would be subject to the real-time transparency regime at the start of MiFID II,” according to ESMA. Banks and asset managers said phasing in the requirements makes sense.

“Sourcing liquidity in the corporate bond market can be challenging,” said Stephen Fisher, a managing director at BlackRock Inc. in London. “It’s very much a creep and go approach on ESMA’s part, and that’s the right way to do it.”

"Creep and go" is probably a good approach to bond market liquidity generally. 

Elsewhere, John LeFevre ("GSElevator") crept and went through a parking garage in Hong Kong that serves Goldman Sachs and looked at the fancy cars. And one less fancy car: "With an old model Porsche 911 Turbo," writes LeFevre, "this guy is definitely worried about bond market liquidity." The worry is real.

Things happen.

Antitrust in the Age of Amazon. New Attack Reported by Swift Global Bank Network. M&A Still Has a Heartbeat. A Brexit FAQ. "Goldman Sachs Group Inc (GS.N) is hosting its first ever leveraged finance conference next week as the Wall Street bank tries to strengthen its position in debt underwriting and looks for new avenues of growth." California Lawmaker: Vanguard Should Pay No State Taxes. John Boehner has one word of advice for Wall Street: 'plastics.' Citigroup Said to Disband Raytcheva’s Proprietary-Trading Team. In Puerto Rican Debt Standoff, Proof of the Rising Clout of Minority Holdouts. ‘I’ll Never Retire’: Americans Break Record for Working Past 65. Country Club Members Are Bearing the Brunt of the Golf Recession. Hawaii sounds nice. SEC Charges Shell Factory Operators With Fraud. "Impossible to launder money" at Vatican bank, says chairman. "The community banking lobbyist whom Jamie Dimon called a 'jerk' likened the JPMorgan CEO to the villainous banker in 'It's a Wonderful Life.'" Allison Schrager against the universal basic income. A Justin Bieber song about Excel. Are you seeing 'Money Monster' this weekend? Illegal primes. Broth bros. "All generals in the Russian armed forces pass physical-fitness tests." The Pentagon is building a ‘self-aware’ killer robot army fueled by social media

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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