Market Integrity and Hedge-Fund Morale
Look, if you are an investment banker with inside information about upcoming deals, you shouldn't tell your brother about them, and he shouldn't tell his brother-in-law, and the brother-in-law shouldn't trade on that information. I think we can all agree on that. The Supreme Court pretty clearly can:
Taking up the conviction of onetime Chicago grocery wholesaler Bassam Yacoub Salman, the justices weighed Wednesday whether someone can be sent to prison for making trades when the insider who provided the tip wasn’t looking to make any money. A majority of the eight justices indicated a willingness to uphold the conviction.
The issue with Salman's conviction is the requirement -- from a 30-year-old Supreme Court case called Dirks, reinvigorated by a federal appeals court's 2014 Newman decision -- that, for trading on an insider tip to be illegal, the tipper has to receive some "personal benefit." What benefit did the banker get by giving information to his brother who pestered him for it? It wasn't money. "He is no longer being pestered," said Justice Ruth Bader Ginsburg. "Isn’t that a benefit?" Ehhh. "To help a close family member is like helping yourself," said Justice Stephen Breyer. That seems better. The core of insider trading law is that it punishes corrupt insiders who use corporate information for their own gain. Selling that information -- giving it to someone who trades and gives you a kickback -- is obviously corrupt. Giving it to your brother so he can make money is almost as obviously corrupt.
The problem is that prosecutors also want to use insider trading law to send people to prison because they talked to the investor-relations person at a company, or employed an analyst who talked to the investor-relations person at a company, or employed an analyst who talked to another analyst who talked to the investor-relations person. Investor-relations people -- and corporate executives generally -- are supposed to talk to their investors, and the investors are supposed to talk to the company, so it seems a little arbitrary to send some of them to prison for it. The personal-benefit test -- did the insider sell the information to the analyst in exchange for a bribe, or did he just give it to him as part of his job, or in some way adjacent to his job? -- is a decent way of separating out corrupt insider trading (bad) and rigorous investment research (good). It's not a perfect standard, but it does provide some helpful clarity so that investors can do their jobs without running too much risk of prison.
But the Supreme Court is not reviewing Newman, an analyst-and-IR-guy case; it's reviewing Salman, a brother-and-brother case. And I worry a little that the intuitions the court will get from these dumb brother cases will not be helpful in thinking about sensible regulation of the capital markets. Here's some of yesterday's discussion of Newman:
Justice Stephen Breyer said that ruling had changed decades-old rules for insider trading by requiring prosecutors to show that the insider received a concrete benefit. Salman’s lawyer is urging the court to adopt that standard nationwide.
"Obviously the integrity of the markets are a very important thing for this country," Justice Elena Kagan told the lawyer, Alexandra Shapiro. "And you’re asking us essentially to change the rules in a way that threatens that integrity."
I never know what people mean by "the integrity of the markets," but when prosecutors and judges say it, I worry that their vision involves pure introspection, and that they're trying not to think about the fact that corporate managers talk to their shareholders all the time. A rule that forbids bankers from tipping their brothers about inside information seems, sure, good for markets. A rule that sends investors to prison for talking to corporate investor-relations employees seems bad for markets. The trick is to write the first rule but not the second, and if you focus only on the brother cases you run the risk of getting it wrong.
Should you have a top-down or bottom-up view of the current state of hedge fund malaise? Are the problems essentially macro problems, common to the industry as a whole? Low rates and high correlations make outperformance difficult, institutional investors have rebelled against high fees, and the past few decades of growth have saturated the industry and driven down returns for everyone, that sort of thing? Or is each unhappy hedge fund unhappy in its own way, and is the explanation always about a particular series of mistaken investment decisions and personnel departures?
Here's a mostly bottom-up view of the gloom at Brevan Howard, which includes elements like pulling back from a big bet on Brexit, a master fund that grew too big, the departure of founding partner Chris Rokos, and a change in "the policy on travelling to conferences to deter those who were thought to be abusing the system." "Mr Howard insists that morale is 'excellent', though 'everyone would be happier if recent fund performance had been better'." Brevan Howard is mostly a macro fund, though, and I sort of want its performance introspection to be macro too, not "this is what's gone wrong here" but "this is why the conditions for success have changed."
Elsewhere, Elliott Management is trying another activist fight at Samsung. And "Goldman Sachs Group Inc.’s retirement plan is pulling about $300 million from Leon Cooperman’s Omega Advisors Inc." (Disclosure: Some of my retirement money is still with Goldman Sachs, with a tiny fraction of it in an Omega fund. Not anymore I guess.)
Credit Suisse is paying $90 million to settle Securities and Exchange Commission charges "that it misrepresented how it determined a key performance metric of its wealth management business" in a frankly pretty boring way. Credit Suisse's wealth management business had assets under management (which it managed) and assets under custody (which it didn't), and sometimes reclassified assets from AUC to AUM based on a customer's intent to have it start managing them. Moving assets from AUC to AUM increased "net new assets," a metric that Credit Suisse used to talk up how good business was. But this measure is subjective, and sometimes, the SEC found and Credit Suisse admitted, it concluded that assets were "net new assets" not based on actual customer intent but in a way that "was reverse-engineered to meet targets."
One thing to consider here is how much shareholders care about a bank's non-financial performance metrics. A manager's shareholders like to see AUM growth -- net new assets -- mostly because it increases the amount of revenue that the manager can make. But Credit Suisse didn't lie about its revenue; it just misrepresented its asset growth. Asset growth without revenue should not, in the most abstract and efficient-markets-y sense, matter to investors: If you grow assets but charge less on them (because some of the new assets aren't "real" assets under management), then that's no better than not growing assets and charging the same amount. And yet Credit Suisse did it, and was fined $90 million for it. There are obvious throwbacks to the Wells Fargo scandal, where bankers made up unprofitable fake accounts to boost cross-selling figures. There's no reason that investors should have wanted the fake accounts, or should have rewarded high cross-selling figures not accompanied by revenues. But Wells Fargo did it anyway. Someone must have thought it mattered.
Elsewhere: "You Think Wells Fargo's Bankers Are Bad? Take a Look at Its Brokers."
It does seem a bit awkward that the Johnson family, who run Fidelity Investments, also have a private venture capital fund that sometimes competes with Fidelity?
Reuters analyzed 10 pre-IPO investments since the beginning of 2013 by the Johnson-led venture capital arm. The analysis found that, in six of those cases, Fidelity’s mass-market mutual funds made major investments later and at much higher prices than the insiders’ fund, resulting in lower returns for Fidelity fund shareholders. In the other four cases, Fidelity funds did not invest at all in companies in which the Johnson-led venture arm already had a sizable stake.
"What they’re doing is not illegal, not even unethical," says one guy, but "it’s hard to imagine a clearer corporate conflict of interest," says another. But the Johnson family has made private investments for decades, and until recently the conflict of interest would have looked pretty negligible. The mutual funds invested in public companies, the family's venture funds invested in private companies, and there was never any overlap: You'd never need to argue about which opportunities should belong to which fund, because the public/private distinction was so simple and obvious. (I suppose you need policies for what happens when the venture-owned companies go public, but that doesn't seem like an insurmountable problem.) But in the modern world of giant unicorns, public mutual funds -- including Fidelity funds -- invest in private companies all the time. In one case, "several of Fidelity’s mutual fund rivals, including American Funds and BlackRock Inc, did just as well or better on the Ultragenyx play by investing at about the same time as the Johnsons" -- while Fidelity's funds didn't invest until after the company went public. That is a bad look, but it's not a look you'd have anticipated even a few years ago.
Elsewhere, "as the cost of investing in stock and bond ETFs that offer plain vanilla market exposures tumbles, one analyst sees so-called smart-beta funds as the next front in the money-manager price war." Would anyone bet against that prediction?
Humans, am I right?
A big objection to the modern world of high-speed electronic trading is that sometimes you get bizarre discontinuous price moves as the algorithms react to information in ways that are individually, locally rational but that don't make sense from the broader system. One minute a stock is trading at $20, a few seconds later it's at $10, and then almost immediately it's back at $20.
Anyway here's a human:
As of 3:59 p.m. Monday, shares of Versum were trading around $25.63. But the designated market maker in charge of the stock, Don Himpele of IMC Financial Markets, closed the shares at $28 at 4:05 p.m., an increase of more than 9%. The decision caused losses for several firms that had entered large orders during the closing auction because the stock dropped back to a lower price range Tuesday morning, according to the people familiar with the matter. The trade would likely have been profitable for IMC, the people said.
The New York Stock Exchange is investigating, and "will seek to determine why he chose such a high price for the shares during the auction and didn’t wait for more orders to accumulate." Himpele achieved some previous fame on August 24, 2015, when he "chose to open shares of private-equity firm KKR & Co. at $10, about half the $19.55 at which they closed the previous Friday despite there being no significant news affecting the company," and despite those shares trading in the high teens on other exchanges at the open. The NYSE is the only U.S. exchange with a "hybrid model" in which computers do most of the trading, and humans do most of the standing around being extras on financial television shows, but the humans do run opening and closing auctions. "The NYSE said the system makes trading more orderly" than would delegating the auctions to the machines. And sometimes it doesn't.
Bond prices go up when interest rates go down.
Wouldn't it be funny if I wrote "bond prices go up when rates go up" and got 10,000 e-mails about it? Anyway, no, prices and rates move inversely. Perhaps you know this because you have read a financial news story over the last few decades, and it is a core tenet of journalistic ethics that every financial news story needs to contain a sentence asserting that bond prices going up when rates go down. And yet:
"When the survey asked investors what happens to bond prices when interest rates go down, over half (54%) admit they don't know," a release detailing the survey said (there's a direct relationship between bond yields and the interest rates set by central banks). "Only 22% correctly identified the inverse relationship whereby bond prices typically go up when interest rates go down. Another 17% think the two move in the same direction."
The "investors" here are "1,021 adults who live in a household with $10,000 or more in savings and/or investments," not, you know, bond-fund managers. I am increasingly skeptical of "financial literacy" as a concept. It's always treated as a synonym for knowing some finance-101 trivia, like "bond prices go up when rates go down," or "if I invest $100 at 10 percent interest compounded annually, after two years I will have more than $120," or whatever, and it seems neither necessary nor sufficient for anything. You could have a perfectly functional retirement savings plan that involves saving a lot of your income, putting it in cheap target-date funds offered by a reputable provider, and not thinking about it too much -- all without having the least grasp of how bond prices move with yields, or what yields are, or what bonds are. But knowing how bond prices move with yields will not do much to save you from Ponzi schemers, or frankly from just not saving enough money.
It seems to me that there are about two deep financial literacy questions:
- Does your plan to finance your future lifestyle rely on miracles occurring?
- If I offer you a 20 percent annual risk-free return, am I lying?
If you can answer those questions confidently and correctly, you can think that bond prices get purple when interest rates are hexagonal, and you'll be fine.
Elsewhere here is Ray Dalio on the "big squeeze":
Holders of debt believe that they are holding an asset that they can sell for money to use to buy things, so they believe that they will have that spending power without having to work. Similarly, retirees expect that they will get the retirement and health care benefits that they were promised without working. So, all of these people expect to get a huge amount of spending power without producing anything. At the same time, workers expect to get spending power that is equal in value to what they are giving. They all can’t be satisfied.
People are worried about unicorns.
Theranos, the Blood Unicorn (Elasmotherium haimatos), is ... getting out of the blood business? No, I'm kidding, it "will shut down its blood-testing facilities and shrink its workforce by more than 40%," but there will still be blood:
In a statement posted on Theranos’s website late Wednesday, Ms. Holmes said: “We will return our undivided attention to our miniLab platform. Our ultimate goal is to commercialize miniaturized, automated laboratories capable of small-volume sample testing, with an emphasis on vulnerable patient populations, including oncology, pediatrics, and intensive care.”
I mean, yes, technically, one of the blood-testing facilities "has been closed since regulators decided in July to revoke Theranos’s license to operate the facility," but they're closing the other one too. They also seem to be taking a mulligan on ... the entire company? Like, Theranos's story was that it had innovative devices and a lab that could do accurate tests on very small samples of blood. Then the Wall Street Journal started raising questions. (Questions like: Did it?) And now Theranos has scrapped its test results, its labs, everything, and decided to re-focus on the miniLab, a brand-new device that has not been approved for use and that is an evolution of the Edison device whose test results Theranos voided. It's quite a pivot.
On the other side of the Enchanted Forest, here is Farhad Manjoo on MailChimp, the e-mail company and podcast sponsor that has taken a different approach from a lot of tech startups, including by always being profitable and never raising venture capital funding:
If you want to run a successful tech company, you don’t have to follow the path of “Silicon Valley.” You can simply start a business, run it to serve your customers, and forget about outside investors and growth at any cost.
Elsewhere, my Bloomberg Gadfly colleague Shira Ovide worries that "Uber May Be Making Too Much Money." Here is the story of the rise of Didi ("engineers were holed up in Didi’s cramped offices for so long and worked so hard to resolve their issues that a classmate had to have his contact lenses surgically removed") and its victory over Uber in China. Here is Henry Farrell on surge pricing, libertarianism and epistocracy ("... the characteristic stance of libertarians who were struck at an impressionable age by economics 101 with the force of a revelation, a revelation that they were right all along"). And: "It Looks Like a Unicorn Exploded Inside This Pastel-Colored, Unicorn-Themed Café."
People are worried about bond market liquidity.
This Bloomberg Markets segment has nothing really to do with liquidity, but it does feature a guy saying "I'm a bond guy, we're always worried about something," which I feel like is an important thing to keep in mind in this part of the newsletter. Anyway, mark your calendar, because the New York Fed is running its second annual conference on "The Evolving Structure of the U.S. Treasury Market" on October 24, and I'm sure there will be a lot of worrying about liquidity.
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