Insider Traders and Active Managers

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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Salman.

The Supreme Court oral arguments in the Salman insider trading case are tomorrow, and is it not absolutely bizarre that the Supreme Court is being asked to make up insider trading law? I mean consider this:

Salman argues that courts should interpret criminal laws strictly, particularly when Congress hasn’t mentioned the particular crime.

That's not how it works anywhere else. Normally the way you interpret criminal laws -- strictly or otherwise -- is that you start by reading the law that Congress passed, and see if it applies to what you did. If "Congress hasn't mentioned the particular crime," it's not a crime. That's how crimes work. But Congress just plain forgot to pass a law against insider trading, ever, but everyone really wants it to be a crime, so courts and regulators and prosecutors have just casually assumed that the law against using "any manipulative or deceptive device" in a securities trade covers insider trading too. And people have gone to prison for many years for this crime despite there not being an actual written law against it. It's pretty weird.

Anyway the Supreme Court has a range of options in front of it in the Salman case, though throwing out insider trading law entirely until Congress writes a law against it probably isn't high on the list. The main options seem to be:

  1. Allow insider trading liability only when the insider giving the tip receives a tangible personal benefit, meaning that Salman-like cases -- an insider tipping a relative about upcoming corporate news -- would not be criminal insider trading. This seems wrong.
  2. Get rid of the personal benefit requirement, meaning that Newman-like cases -- a corporate investment-relations employee giving an investor guidance on his model -- would be criminal insider trading. This also seems wrong.
  3. Affirm and clarify what everyone sort of thinks the law is now, which is that either a personal benefit or a family relationship or just, you know, you know it when you see it, is enough for criminal liability. This seems more or less fine, though vague.
  4. Articulate some new clear conceptually sensible standard for what is and isn't illegal insider trading. That would be ... good? But also, like ... very far after the fact? This is the Supreme Court's "first insider-trading case since 1997"; in the interim, people have spent many years in prison based on a law that not only isn't written down anywhere, but also that no one fully understands. Even if the Supreme Court comes up with some conceptually clean and sensible insider trading rules, it seems a bit odd to apply them retroactively.

Janus to Henderson.

There are two parallel but distinct insights driving the long-term trend toward passive investing, which are:

  1. It is pretty hard to beat the market, and
  2. It's particularly hard if you're paying really high fees.

Insight 1 argues for passive investing, and Insight 2 argues for cheap investing, and while there is a lot of practical overlap they are different things. If you buy an S&P 500 index fund with a 2 percent expense ratio -- they exist! -- you'll tend to underperform the market by about 2 percent. If you buy an actively managed mutual fund with a 0.1 percent expense ratio, then your odds of outperforming, or at least performing in line with, the market go way up. But it is much harder to run a cheap active fund than it is to run a cheap index fund, or even an expensive index fund. "Smart beta" helps -- you get a computer to make your decisions, and save money on chairs (and on active trading costs) -- but if you want to run actual active funds, with human managers coming to work every day and making investment decisions, at some point just getting bigger looks appealing. Not because being bigger helps you beat the market -- if anything, you'd expect it to work the other way -- but because you can save on administrative expenses and get more distribution and generally drive your costs down so you can compete with passive management on price. 

Anyway that seems to be the generally accepted explanation of why Henderson is acquiring Janus Capital:

“This is one of many transnational deals we’re likely to witness with the relentless rise of passive management. Active managers need serious cost efficiencies to ride out this turbulent phase. Business as usual is no longer an option,” says Amin Rajan, chief executive of Create Research, the fund management consultancy.

("This deal does not represent a defensive move," says Henderson's Andrew Formica, before adding "we might have lost ground with big clients if we were not able to show we are a global player.") And there might be more: "The trend of M&A in this industry is going to increase as firms look to stay relevant in an increasingly challenging market to operate vs passive products and increased regulatory scrutiny." Of course as asset managers consolidate, people who are worried about the antitrust implications of diversified investors will get more worried. How will we feel when every public company is owned by the same 10 investors, half index funds and half active funds?

Speaking of which, we have talked a bit before about an earlier version of this paper (free version here), "Standing on the Shoulders of Giants: The Effect of Passive Investors on Activism," by Ian Appel, Todd Gormley and Donald Keim, but it is worth revisiting their conclusion that "increasingly large ownership stakes of passive institutional investors mitigate free-rider problems associated with certain forms of intervention and ultimately increase the likelihood of success by activists." If passive investors make activists more successful, then the fact that the passive investors don't themselves push managers to be more competitive may not matter that much. That's what the activists are for.

Blockchain blockchain blockchain.

Look, I spend a certain amount of time making fun of banks for their plans to set up private permissioned trust-based blockchains. If you have a dozen trusted banks and you want to keep track of what securities they own, you could just get a notebook, and give it to one of the banks, and make it write down who owns what, and then pass the notebook to another bank at the end of each month. Or you could create the Depository Trust Company. The problem of how to get a finite number of trusted market participants to agree on what they have traded with each other is not especially novel or difficult.

On the other hand, the bitcoin blockchain, and other open permissionless trustless public blockchains, have pretty interesting properties. They allow for competition from parties who are not big incumbent banks, creating the possibility of real innovation -- in payments or money transfers or derivatives smart contracts or whatever -- rather than small incremental change suited to the banks' legacy business models. The only problem is that the public blockchains are a mess, full of sketchy anonymous weirdos, and constantly being hacked. Banks, with their endless worries about compliance, tend to want to stay far away.

So this is potentially fun:

Instead of creating a completely new private blockchain, J.P. Morgan engineers say they have found a way to limit access to transactions shared via a network to people who need to know the details, like parties to the trade or a regulator.

The project—called Quorum—is being built off the publicly accessible Ethereum network code. J.P. Morgan, run by Chief Executive James Dimon, plans to share its new code for its system with outside developers, something the bank has recently started doing as a way to entice top engineers to work with the bank and take advantage of the latest developments in blockchain.

Just be careful, JPMorgan! The last big high-profile Ethereum project ended up getting hacked and having most of its money stolen, or perhaps not stolen: Perhaps it is not possible to "hack" a smart contract, conceptually, and if the contract gives you the money, that must have been what it intended. That would be a great excuse for a big bank, actually. "What do you mean this mortgage-backed security didn't perform as advertised? It performed exactly as its code said it would. There's no problem here." You can see why banks might be interested in smart contracts.

Meanwhile here's Bill Gross:

“Bitcoin and privately agreed upon blockchain technologies amongst a small set of global banks are just a few examples of attempts to stabilize the value of their current assets in future purchasing power terms,” he wrote. “Gold would be another example -- historic relic that it is. In any case, the current system is beginning to be challenged.”

That's from a new Investment Outlook today that starts in Gross's country club locker room, "a fascinating 19th hole observatory where human nature and intelligence often come into conflict." I ... am not sure ... that close observation of country club locker rooms is the best way to gain investing insights, but whatever works.

Bankruptcy is expensive.

Here is an article about how the Caesars bankruptcy has cost more than $300 million in fees for lawyers, bankers and consultants. I guess that seems high? It's an $18 billion estate, so we're talking 1.7 percent in fees, which would be on the high side for a mergers-and-acquisitions deal, but this was probably more work (and more contentious). There is a certain cheap irony in how expensive corporate bankruptcy is, but professional services cost money, and they don't get cheaper just because the company buying them has a lot of debt. In corporate finance theory, "bankruptcy costs" are what deter firms from becoming too levered and too risky, so in a sense they should be expensive and miserable. This irony, however, is full and rich:

To keep an eye on the fees, the bankruptcy court appointed a fee examiner—University of Nevada, Las Vegas, law professor Nancy Rapoport. Court papers show she has received nearly $409,000 to date for digging into the various bills and pointing out areas of concern, such as overuse of expensive partners for work that could be performed by cheaper lawyers.

For, like, $5,000, I would be happy to review her bill and kibbitz about it with the court. And then for $50 someone could review my bill.

Tick secrecy.

Here is a story about high frequency traders who worry that the Securities and Exchange Commission's test of wider tick sizes for small-cap stocks "will force firms to publicly expose detailed trading data with only the thinnest veil of anonymity, allowing competitors to reverse engineer how their prized trading algorithms work":

“It’s going to take someone exactly three seconds to figure out who’s who,” said Jamil Nazarali, head of execution services at Citadel Securities, which is the market-making arm of billionaire Ken Griffin’s Citadel LLC. Trading firms will “likely change their behavior to protect their intellectual property,” making the test’s results less meaningful, he added.

Others are more skeptical, but never mind that. The fun claim here is not that high-frequency traders will have to disclose their actual trading algorithms, but rather that their orders to buy and sell stock on stock exchanges -- which are public, but anonymous -- will be disclosed, and will be enough to reverse-engineer their algorithms. (The pilot program also calls for disclosure of market-maker profitability data, which has the potential to be embarrassing.) I suppose the irony is that the main criticism of high-frequency traders is that they are too good at observing public order information and quickly figuring out the intention behind it, so they can "race ahead" of "real" investors to buy and sell shares first. The questions of who owns order information, and what uses can be made of it, always seem to be hotly contested.

People are worried about unicorns.

Here's a profile of unicorn breeder Sam Altman, the president of Y Combinator and co-founder of OpenAI, which has me worried. Here's how Altman replies when asked about his hobbies:

“Well, I like racing cars,” Altman said. “I have five, including two McLarens and an old Tesla. I like flying rented planes all over California. Oh, and one odd one—I prep for survival.” Seeing their bewilderment, he explained, “My problem is that when my friends get drunk they talk about the ways the world will end. After a Dutch lab modified the H5N1 bird-flu virus, five years ago, making it super contagious, the chance of a lethal synthetic virus being released in the next twenty years became, well, nonzero. The other most popular scenarios would be A.I. that attacks us and nations fighting with nukes over scarce resources.” The Shypmates looked grave. “I try not to think about it too much,” Altman said. “But I have guns, gold, potassium iodide, antibiotics, batteries, water, gas masks from the Israeli Defense Force, and a big patch of land in Big Sur I can fly to.”

Yes hmm but wait don't have a big patch of land in Big Sur. ("Altman’s backup plan is to fly with his friend Peter Thiel, the billionaire venture capitalist, to Thiel’s house in New Zealand.") "Sam is extremely good at becoming powerful," says Y Combinator founder Paul Graham. And: "I think his goal is to make the whole future." But he has rather more exit options from the future he creates than the rest of us do. Also this is funny:

Leery of tech’s culture of Golcondan wealth, in which a billion dollars is dismissed as “a buck,” he decided to rid himself of all but a comfortable cushion: his four-bedroom house in San Francisco’s Mission district, his cars, his Big Sur property, and a reserve of ten million dollars, whose annual interest would cover his living expenses.

I too would be happy to reject material wealth if I could keep a house, a country estate, five supercars and $10 million.

Elsewhere: "'If people can’t see where the industry is going, it won’t be developed by the private sector,' said Borko, who’s 30. 'There is a lot more experimental tolerance in the government.'" Them's fightin' words, to the venture capital industry.

Elsewhere: "Rover announces $40M round for pet sitting and dog walking."

People are worried about stock buybacks.

I have long since given up my dream that the 2016 election would be fought over the issue of excessive stock buybacks. (It will be fought over the issue of excessive net operating losses.) But here is a game effort by Rachelle C. Sampson to re-focus on short-termism as a political issue:

According to Bloomberg, companies spent 95 percent of their earnings on such share buybacks and dividends in 2014. We are on pace to set the record this year, with $160 billion in share buybacks in just the first quarter of 2016 — all in the face of declining earnings. It’s fairly obvious that when cash is returned to investors at increasing rates, even when a company is earning less, that the money has to come from somewhere. That somewhere is usually long-term investment. Just as it is easy for individuals to put off saving for retirement when the rent comes due or to splurge on a weekend getaway, firms feel pressure to put off long-term investing to make shareholders happy in the short term by boosting stock price.

There's a certain nostalgic charm to this argument, since the buyback boom seems to be ending, but, sure, short-termism. 

People are worried about bond market liquidity.

I don't know, there is this, about people looking for opportunities in the dislocation of prime money market funds:

Among the potential winners are “ultra-short” bond funds. They offer much of the same security and liquidity as a prime fund, but with some more flexibility and therefore often slightly higher yields. There have only been four new launches of ultra-short bond funds in 2016, in line with previous years according to Morningstar data, but there are some hints of rising interest.

Prime money market funds used to always be priced at $1 per share, but which will soon have floating net asset values. So people are leaving them for government money market funds, which can still have a fixed NAV. But might they also leave prime funds for ultra-short bond funds, which are a lot like prime money market funds except that they've always had a floating NAV? (And that they can be a little longer-term, riskier and yieldier?) Sure, why not. That is probably good or bad or whatever for short-term bond liquidity.

Me earlier.

I wrote about Morgan Stanley's little cross-selling scandal.

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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