Active Funds and Hidden Commissions
Should active management be illegal?
Look, you know the things:
- The average active manager will underperform the average passive manager, because of fees.
- You have no particularly reliable way of knowing whether any particular active manager will be better than average, because of non-persistence.
- Therefore, if you choose to invest your money with an active manager, you will probably do worse than if you had chosen a passive manager.
These things aren't necessarily true -- AQR's Lasse Pederson has a recent paper challenging thing 1, and Capital Group's Timothy Armour has an article challenging thing 2 -- but they are pretty widely believed. Really they are the main things that people think about the investment management business these days. Active management, on this line of thinking, is just the wrong choice.
Of course there is no law against making the wrong choice; if you want to hire an active manager to manage your investments, go right ahead. But if you are a fiduciary for someone else, there are rules. You have duties of care and loyalty; you are supposed to make the right choice for your investors, not the wrong one. And if we all agree that active management is the wrong choice, then where does that leave you?
I don't know. Here's a theory:
Over the past decade, Jerome Schlichter, a plaintiffs’ lawyer, has been suing corporations and, more recently, colleges and universities, contending the employers breached their fiduciary duty by allowing unreasonably high fees in their 401(k)-style plans.
Mr. Schlichter’s cases, 40 in the past decade including 15 this year, “are not saying that active management is per se imprudent,” he said. Instead, they put the burden on a plan to show there is a reasonable likelihood an investment will beat the market persistently after fees—“a pretty big burden of proof,” he said, given active management’s costs and record.
He's "not saying that active management is per se imprudent," he's just saying that it's presumed imprudent until proven otherwise. He is perhaps an outlier, but not that much of one. Yesterday the New York State Department of Financial Services released a big report finding that "the New York state comptroller’s decision to stick with hedge funds despite their poor returns has cost the Common Retirement Fund $3.8 billion in fees and underperformance." Here is DFS Superintendent Maria T. Vullo:
“Pension fund managers across the country have cut or eliminated exposure to these overpriced and underperforming investments, while the Office of the New York State Comptroller has stood still and spent pension system funds chasing performance that continues to fall far short,” said Financial Services Superintendent Vullo. “Just last week, the Comptroller admitted that hedge funds are not delivering the returns to even come close to justifying the sky-high fees that these fund managers have been charging the pension system for years. Hedge fund managers continue to reap hundreds of millions of dollars in fees, regardless of their performance, which is a rip-off at the expense of pensioners.”
New York's hedge fund investments, on this theory, are not a plausibly prudent way to seek outperformance or uncorrelated returns or hedging or anything else worth having. They are just a mistake, something that no fiduciary should want, a poor (and expensive) substitute for the only correct investment. "Even simply putting the System on autopilot by investing in index funds would have saved billions of dollars," says the report.
That little anecdote about Jerome Schlichter, the guy who sues fiduciaries for using active funds in their 401(k)s, comes from a big Wall Street Journal package about the rise of indexing and the decline of active management. There are some interesting charts. There is some resistance from investment managers, like that Timothy Armour article on finding a good active manager, or this from Michael Roberge of MFS on diversifying among active and passive funds. There is a story about how the favorite stocks of active managers tend to underperform other stocks. But what jumps out is the air of inevitability around passive management, and the defensiveness of the active managers. There is a sense that, if active management isn't exactly "per se imprudent," then it's getting there -- that Schlichter and Vullo are not too far off in thinking that fiduciaries who pay for active management are automatically suspect. "In short, the idea of the 'active manager' is rapidly losing its intellectual legitimacy."
This is weird! Not only because too much certainty and triumphalism is rarely a great look in dealing with any investing question, but also because we can't really all index. That way Marxism lies, supposedly. (Also, while active management may be suspect as a matter of fiduciary duties, passive management may be suspect as a matter of antitrust law. You can't win!) You might imagine that people who run massive pools of capital have obligations, not just to their beneficiaries, but also to society, to try to allocate capital correctly, instead of just indexing and hoping that someone else will do it. A world where only outlaws and day-traders actually pick stocks -- where responsibly managed institutional money is constrained to indexing -- would be a bit strange. But right now it seems to be where we're heading.
If I tell you to buy a stock, just as a friend, and I neglect to mention that I'm getting a 10 percent commission from the company, is that fraud? The answer is no! (Not legal advice.) I suppose that is counterintuitive. Here's Peter Henning on a Securities and Exchange Commission case against Texas Attorney General Ken Paxton:
In rejecting the S.E.C.’s claims, Judge Mazzant wrote that the “case is not about whether Paxton had a moral obligation to disclose his financial arrangement with Servergy to potential investors.” Instead, the judge concluded that he “did not have a legal obligation” to do so, which meant there was no fraud.
One might hope that a friend, or a member of an investment club, would take care to disclose important information like receiving a commission for lining up new investors. The law, however, does not impose such a duty generally in the absence of evidence that the person assumed control over the investments of others or occupied a position as an investment adviser or broker.
We talk all the time around here about the gap between general perceptions of good honest sales practices, and what the law actually requires. You want to befriend some naive customers and sell them risky derivatives that they don't quite understand at a fat markup? You can do that. It's rude, but it's not illegal. You want to sell bonds to customers and lie about the price you paid for them? Probably don't do that -- that's probably illegal -- but it's a grayer area than you might expect.
The disconnect between public expectations and the law ... seems like a problem, no? One reason that we don't mind too much when used car salespeople say "you're killing me, I'm giving you this car for less than what I paid for it," but we do mind when bond salespeople do that, is just that everyone expects used car salespeople to lie a bit. The used car salesman is proverbial. But if we expect financial salespeople to be fiduciaries, to keep our best interests in mind and tell us about any conflicts of interest that they might have, then we will often be disappointed. So, over time, the law will probably move closer to our expectations.
Elsewhere, here's the story of how Andrew Hall, the former Phibro commodities trader, allegedly bought a lot of forged Leon Golub paintings from a local art history professor.
One way in which Bridgewater Associates ensures the fanatical loyalty of its employees is by hiring only people who are interested in its brand of radical transparency and then subjecting them to an "intellectual Navy SEALs"-style program that indoctrinates them into the Bridgewater Principles. But another way is that it just has a really tough non-compete clause:
In the contract reviewed by The Times, Bridgewater stipulated that current employees inform the president of the firm of any new employment opportunities and added that the firm would let the employee know as soon as possible if it objected to the new job.
For two years after leaving Bridgewater, the firm can ask a former employee to provide an update on the new job up to four times a year to ensure the former employee was not working for a rival.
If you can't leave for another financial job, then you might start to tell yourself that you enjoy being recorded all the time and getting constant real-time feedback about everything that you're doing wrong? I mean, what is the alternative? Anyway, after former Bridgewater employee Christopher Tarui sued for sexual harassment, "the National Labor Relations Board filed a pending administrative action against the firm this summer saying Bridgewater 'has been interfering with, restraining and coercing' employees from exercising their rights" with its restrictive employment agreements. Though, oddly, the NLRB is not worried about the non-compete: Instead, it "has set its sights on several aspects of Bridgewater’s employment contracts, including the confidentiality agreement, a nondisparagement clause and a compulsory arbitration provision." I would think that the non-compete would be the biggest thing restraining Bridgewater employees from exercising what is realistically their most important labor right: the right to quit.
Elsewhere in non-competes, or their opposite, here is a delightful caper involving the Protocol for Broker Recruiting, in which (initially) three big firms agreed not to sue each other when brokers jumped from one to another and tried to take clients with them:
The pact was devised in 2004 by three firms -- Merrill Lynch & Co., Citigroup Inc. and UBS Group AG -- in the name of reducing litigation and giving customers a choice when one big firm poached from another. Morgan Stanley, which declined to comment, joined the protocol two years later.
But over the years, the protocol has had an unanticipated effect by offering a blueprint to brokers with an entrepreneurial bent: have someone set up a shell company, have the company sign the protocol, and then take over the company without fear of a lawsuit.
And so brokers currently employed at, say, Morgan Stanley, will have a nominee set up the shell company, quit their jobs, take client phone numbers with them, take over the shell company, and then spend "a frantic weekend on the phone trying to get them to switch to their upstart" firm. Unsurprisingly this happens a lot:
“Advisers have seen colleagues with smaller books than them do this and have astounding success,” Hamburger said. “They think ‘If this idiot can do it, I can too.’”
Here is the first-person story of Bradley Birkenfeld, the whistle-blower in the UBS tax evasion case who managed to both be sentenced to 40 months in prison and get a $104 million whistle-blower award from the government, for the same case. (Weird, right?) Here's how he got started on his life of whistle-blowing:
I honestly didn’t think too much of it until April 2005, about four years after I began working at UBS. A colleague of mine brought me a document from the UBS intranet. It was three pages and contradicted everything we were doing, explicitly saying we shouldn’t solicit clients in other countries.
I couldn’t get it out of my head. It was a full-on cover-your-ass document that made us easy scapegoats for rogue banking. If we got caught soliciting a client or doing anything else illegal — even if UBS told us to — the bank could simply say, “We told you not to do it. There it is right in the company system.”
And then -- in his telling -- he went around to his bosses and colleagues asking them what to make of this document, and they told him "Don't make a big deal about it," and he eventually quit and went to the authorities. Judging by this and the Wells Fargo fake-accounts scandal, this method of keeping two sets of policy books, as it were, seems pretty popular in banking. You write down all the correct policies, put them on the intranet where regulators can find them, and tell yourself that you have a culture of compliance. Meanwhile the people in the field are indoctrinating new hires in a different, entirely wrong, but more profitable set of policies -- and those are never in writing.
William Cohan gave some hedge fund managers some space in Vanity Fair to vent anonymously about Bill Ackman, and while there are no major revelations, some of the quotes are pretty funny. "When you have a media-driven business model and you don’t do much work on your companies, you’re hanging on by your fingernails, and that’s where he is," says an anonymous investor. Another "had my guys" look at Ackman's investment returns, and says that "if you go through all of it . . . I think he’s returned zero." (It is not clear where that anonymous investor's "guys" are getting their numbers from, though. Another anonymous source tells Cohan that, since inception, "Ackman has made his investors a compound annualized return, net of his fees, of 15.2 percent, as compared to a 7.6 percent return for the S&P 500." Or you could just look at Ackman's publicly disclosed performance figures, which show him up 17.1 percent net per year from 2004 through 2015.) There's also a story about Ackman being rude to John McEnroe on the tennis court, which is in its own way pretty impressive.
People are worried about duration.
I have a soft spot for this one, because it is just a hair's breadth away from "bond prices go down when yields go up." Anyway:
A 1 percent increase in interest rates could inflict a $1.1 trillion loss to the Bloomberg Barclays U.S. Aggregate Index, analysts at Goldman calculate, representing a larger loss for bondholders than at any other point in history. With the bank predicting the selloff in bonds has further to run, that remains "far from a tail scenario," its analysts write.
"The notional amount of duration dollars at risk is unprecedentedly large," says Goldman, which is what happens when rates stay low for a really long time.
People are worried about unicorns.
Do you think the Securities and Exchange Commission will go after Theranos for raising hundreds of millions of dollars from investors at a $9 billion valuation, before it came out that it never really had a working product? People are sometimes surprised to learn that the SEC even has jurisdiction over private fund-raising, but those people must never read SEC enforcement actions. The SEC brings enforcement cases against private companies all the time! It's just that those cases are usually pretty small potatoes, promoters using false promises to raise money from their acquaintances or retirees or whatever. You don't see a lot of SEC enforcement actions against private companies for allegedly misleading professional Silicon Valley venture capitalists in unicorn funding rounds. But that's presumably just because those VCs don't get scammed that often, not because the SEC isn't interested. And the Theranos collapse might be irresistible:
It’s a nearly ideal scenario for the SEC, which is investigating Theranos and widely expected to use a case against it to expand its mandate into Silicon Valley’s startup ecosystem. The truth is while the SEC has long been viewed as a force in the public markets, it also has the authority to chase after private companies that engage in any “act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.” And lately, Wall Street’s top cop is finding Silicon Valley too high-profile a target to resist.
“If you’re only raising couple million bucks, everyone expects your huffing and puffing,” says one San Francisco-based securities attorney. “But if you’re raising hundreds of millions to billions of dollars, why would the SEC ignore that when they’re auditing the financials of some piddly company that’s raising $50 million in an IPO?”
People are worried about bond market liquidity.
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