Bank Platforms and Hedge-Fund Fees

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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Simon!

This article about Goldman Sachs Group Inc.'s Simon platform is an amusing mix of old and new Wall Street. First the new: Simon, a program for designing and selling structured notes, has a cool-app vibe, and Goldman has given it away to third-party brokerages and opened it up to third-party issuers in a bid to make it a universal platform rather than just a proprietary tool. Also:

Simon was developed in a section of Goldman’s trading floor that has glass walls that double as whiteboards and a putting green in the corner. Within the app, a cartoon character helps brokers understand the debt offerings and design their own structures.

But it's not all whiteboards and putting greens; look past the surface, and Simon obviously comes from an investment bank, not a hip financial technology startup. For one thing, I mean, it's for selling structured notes; most fintech is not focused on issuing bespoke derivatives. Also "Simon" is not just a cutesy "my consumer product has a first name, it's S-I-M-O-N" thing, like Oscar and Earnest and Harry's and Casper and, sure, Marcus. Oh no: It is also an awkwardly constructed acronym. It's "Structured Investment Marketplace and Online Network." That's the Goldman Sachs I know and love. (Disclosure: I used to work there, building bespoke derivatives, and bestowing acronyms upon them.) If I had designed Simon, its logo would be a cute cartoon squid named Simon, with a little sailor hat and a big smile and just the tiniest bit of blood dripping from its tentacles. 

Anyway the moral of the story is pretty straightforward:

It is a fresh example of investment banks seeking new ways to make money as superlow interest rates and tougher regulation crimp profits. In some cases, banks like Goldman are transitioning from swashbuckling traders to toll-taking middlemen, taking less risk to earn smaller fees.

There is an obvious regulatory drive toward this sort of thing: The Volcker Rule, capital requirements, etc., make it relatively less attractive for banks to use their own balance sheets to do risky trades, and relatively more attractive for them to control the pipes through which those trades move. But let's not exaggerate that: Simon is in large part a marketing tool to help Goldman use its own balance sheet to do more principal trades. 

The other thing going on here is sort of cultural. Banks just want to be tech companies. Tech companies are rich and successful and culturally dominant and basically well-liked; banks have lost a lot of cachet and centrality. Even within the financial industry, much of the buzz is about fintech startups, which at least have a positive optimistic story to tell, instead of the endless parade of misery that comes out of most banks.

Also, tech companies recruit with stock options and air hockey and casual dress codes and a vision of changing the world; banks have trouble competing. The way that they used to compete was by offering a different experience: Sure, you might have to wear a collared shirt, but if you are good one day you can make $100 million trading bonds. There is less of that now, for Volcker and other reasons. The old model of cool at investment banks -- the big risk-taker who does huge trades -- has been deprecated. The tech-industry model of cool -- putting greens, open-access platforms -- is conveniently available to replace it.

Hedge funds.

I could never be a hedge fund manager for many reasons, one of which is that if I lost clients 16.6 percent one year, and 17.4 percent the next, I would pretty much curl up in a whimpering ball and never talk to anyone ever again. When Bill Ackman does that, he looks around and thinks: You know what, when I'm back on top, I should get a bigger share of the profits I generate.

Pershing Square will offer starting Jan. 1 a new share class to existing and future clients in which it will not charge any performance fee on gains less than 5 percent; after that, the performance fee will be 30 percent.

No, to be fair, the change was the investors' idea -- Pershing Square Capital Management told clients that "certain investors" had "expressed interest in retaining a greater share of returns in low to moderate return scenarios in return for rewarding us with a greater share of returns in higher return scenarios" -- though again that displays a sort of farsighted optimism that I probably wouldn't be able to muster if I were in their shoes. The default now is 20 percent on all profits now, meaning that the breakeven in the new option will be a 15 percent return. ("Pershing Square has averaged gains of about 15 percent net of fees since inception in 2004.") There's also a 1.5 percent management fee, and a high-water mark set quite a long time ago, making the exact division of the spoils somewhat academic at this point.

There has been a lot of complaining about hedge-fund fees, and a general sense that they will have to get lower; Pershing Square's approach -- to adjust the math rather than meaningfully lower the absolute amount -- looks a little like an effort to stave off those demands. ("This is like driving a car the wrong way down a one way street," says a guy, arguing that "incentive fees are headed toward 10 percent with the addition of hurdles, not 30.") But that complaint is usually coupled with one about disappointing hedge-fund performance, that funds are charging high fees without really distinguishing themselves. Pershing Square's recent performance isn't disappointing; it's terrible. Which, you know, is something: Pershing Square, with its concentrated activist bets, really is adding something to your portfolio that you couldn't replicate in an index fund. Right now what it's adding is huge losses. But as a justification for charging premium fees, a bad distinction might be better than no distinction.

Meanwhile Point72 Asset Management's training program is super popular:

The 12-month training course, which ran for the first time last year, is designed to train financial analysts and is easily the biggest in the hedge fund industry. It has been flooded with applications, according to Jaimi Goodfriend, director of Point72 Academy, with 7,200 received for about 15 positions for the next intake.

“Now our competition isn’t Goldman, it’s Facebook or Google,” Ms Goodfriend said. “And once they’ve gone in that direction, we can’t get them.”

The old model of cool at investment banks -- the big risk-taker who does huge trades -- is alive and well at hedge funds, and once-and-future-hedge-funds like Point72. But it's vanishing from the investment banks themselves, so if you are Point72 and you need your next generation of risk-takers, you need to train them yourself.

Weltschmerz.

On Friday, Der Spiegel had a big feature story about how Deutsche Bank AG lost both its national identity and a staggering amount of money:

It is a story about how Hilmar Kopper, Rolf E. Breuer and Josef Ackermann, the leaders of Deutsche Bank during those fateful years, essentially turned over the bank to a hastily assembled group of Anglo-American investment bankers before Anshu Jain, the prince of these traders, rose to the top and spent three more years sailing the bank full-speed-ahead into the shoals.

The decision to be less German and more Anglo-American seems to have been conscious and deliberate, but it also left the bank with a sense of ... Angst? Ennui? Sehnsucht? Something bad anyway:

The German-ness of Deutsche Bank also had a significant role to play over the years. It looks as though Deutsche Bank managers wanted to free themselves from Germany's reputation for provincialism -- and went so overboard the consequences can still be felt today. Because once they successfully managed to expunge everything that was German about the bank, it suddenly seemed helpless and empty, aimless and confused.

There is a lot more, including this horrifying do-you-know-who-I-am anecdote about Deutsche Bank global markets pioneer (and mentor to former chief executive officer Anshu Jain) Edson Mitchell: "On one occasion, when he wasn't recognized by a Deutsche coworker in Frankfurt and asked who he was, he replied: 'I'm God.'" And there is this accounting for Deutsche Bank's global markets division since 2001, when Jain became its head:

In the 15 years between 2001 and 2015, Global Markets earned 25 billion after taxes. But a majority of the more than 12 billion euros that have been paid out by the bank since 2012 due to the bank's legal troubles must be subtracted from this: fines, damages and penalties. The bank has set aside an additional 5.5 billion euros, but analysts believe that the bank could need up to 10 billion for the payments.

That, though, would mean that almost the entire profit earned by Global Markets would disappear. The huge investment bank experiment would result in a goose egg, or, even worse, a lasting burden.

What do you think, generally, is the expected value of an investment bank, to shareholders? Like imagine a bank, at some point in the last 30 or next 30 years, debating about whether or not to start an investment banking and markets division. Obviously there will be startup costs, but the near-term expected value should be high, just because if you are launching into the markets business it's because everyone else is making money in that business. And eventually your markets division will lose a lot of money or come in for some huge fines or both. And one day you might close it down. And the question will be: Were the good times worth the bad ones? Just on a net present value of cash flows basis, over the lifetime of the business?

Elsewhere: "Deutsche Bank to sell $400m stake in Las Vegas gambling group."

Annuities.

Here is an article titled "Even Math Teachers Are at a Loss to Understand Annuities," in which the reporter dutifully went out and found a math teacher to assert that a particular annuity contract was "mathematically ambiguous" and that "It is not being transparent there that is infuriating to me as a mathematician." Honestly knowledge is specialized, and high-school math is not the secret esoteric skill that will allow you to understand complex financial transactions; I am a former derivatives structurer and I find annuities terrifying. This complaint is more compelling:

Craig McCann, a former economist for the Securities and Exchange Commission, has built a computer model that is intended to make those calculations. He has employed close to a dozen people with Ph.D.s in math to dissect indexed annuity products as part of his firm’s work, which provides analyses for regulators and litigators representing investors. He said it took years for his team to master them.

“No agent selling these or investors buying these has the foggiest idea of how these work,” said Mr. McCann, who reviewed Ms. Lindert’s contracts.

It's one thing if a math teacher finds the product confusing. It's another if a former SEC chief economist finds it confusing. And it's really awkward if -- as McCann asserts, and as I am inclined to believe -- no one buying or selling the product knows how it works. What do you do with that information? It's not enough to say that the marketing agents should just try harder to understand (it's genuinely hard!), or that they should have a fiduciary duty to their customers. You need some set of expectations on the people who do understand the products, the ones designing them: that the products will work more or less as advertised, and that the features that a buyer should care about will be clearly and straightforwardly disclosed.

Oh no.

Oh no:

Muller asked Ken how the new dating life was going, to which Ken responded: "I want their body, they like my money." And so it works out.

Muller and one of his female singers then broke out into an upbeat duet.

"You want my body / she wants my money... maybe we can find love," the two sang. "I know you've been looking for some real satisfaction/ It could be a mutually beneficial transaction / Why don't we solidify our animal attraction?/ Come on baby, let's do this trade."

Muller is Pete Muller, the hedge fund manager (PDT Partners) and, I guess, musician. "Ken" is a "recently divorced hedge fund billionaire" who may or may not be the person you're thinking of. There is video of the duet. Some good rules of thumb for hedge fund managers are (1) don't get divorced and (2) don't write your own songs and then sing them in public.

People are worried about unicorns.

People in the Army are worried that Palantir Technologies Inc., the Spy Unicorn, doesn't know how to dress at the Pentagon:

They told Palantir: “Don’t come to the E-ring without a tie unless your name is Gates or Buffet,” said the person, referring to the portion of the Pentagon occupied by senior officials. “They couldn't get over the tie thing. They didn't care about the technology.”

I don't know, I often find myself sympathetic to the old stick-in-the-muds who care about dumb stuff like dress codes. The Army seems to be an organization that is big on rules. I have never been in the Army, but I have seen movies about it, and I gather that soldiers spend a lot of time in basic training shining their shoes, and being yelled at when their shoes aren't shiny enough. I assume that this is not driven primarily by aesthetic considerations. Rather it is to inculcate a culture of precision, attention to detail, and obedience that can be useful in critical situations. You'd hate to commission a tech company to make a deadly drone, and then watch the drone kill the wrong people, and have the tech company say "come on, man, look how cool those lasers were. You can't get over the killing-the-wrong-guys thing; you don't care about the technology." Making cool, innovative, exciting, move-fast-break-things technology is nice, but it is not the only thing that matters. Sometimes it is very important not to break things. Sometimes you should put on a tie. Anyway Palantir is in some sort of fight with the Army.

Elsewhere, self-driving-car startup Comma.ai cancelled its first semi-autonomous-driving product because the U.S. National Highway Traffic Safety Administration asked some questions and because, in the words of Comma's founder: "Would much rather spend my life building amazing tech than dealing with regulators and lawyers. It isn’t worth it." That's a good tech startup motto, particularly for unicorns working in heavily regulated sectors. Still elsewhere: "Uber’s New Goal: Flying Cars in Less Than a Decade." And: "Study Finds Racial Discrimination by Uber and Lyft Drivers."

People are worried about duration.

"For Superman, it was kryptonite," begins this article. "For bonds, the weak point is more insidious." It's duration!

Normally, a selloff in bonds would be cushioned by a constant stream of income from the regular interest payments they produce. But in Germany, thanks to the rally that drove yields lower throughout the first half of this year, the 10-year bond pays no coupon. That means its price is ultrasensitive to movements in yields. In bond-market jargon, it has a high duration.

People are worried about bond market liquidity.

Here is a story about how Apollo Global Management LLC "is betting against some corporate bonds on the theory that their value is being inflated by index buyers who are glossing over differences between individual borrowers," as exchange-traded funds buy bonds because they are in the index, not because they are good credit risks. This is an opportunity for Apollo. Meanwhile in the equities market, lots of hedge-fund managers are complaining that too many index funds and ETFs are buying stocks because they are in the index, not because they are good investments, and that that is making it harder for active managers to find good investments. ("In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical," complained Nevsky Capital, in shutting down.) I suppose this question -- does the rise of indexing create opportunities for active managers, or destroy them? -- is the great philosophical investing debate of our time, though there's probably room for both sides to be right. Indexing could create a lot of mispricing opportunities, but also cause them to persist longer than you'd like.

Elsewhere, there were a lot of outflows from high-yield ETFs last week. And in the Treasury market, "Banks Are Hoarding $2.4 Trillion of Bonds."

Things happen.

GE Deal With Baker Hughes Creates $32 Billion Oil-Services Giant. Mark Carney stands ready to serve 8-year term at Bank of England. Bess Levin is leaving Dealbreaker. Switzerland's Back to Battling Might of Global Currency Markets. Saudi Arabia’s Bond Marketing Efforts Pay Off. U.S. Bank Regulator Notifies Congress of Major Data Security Breach. 3 Japanese Shipping Companies to Merge Container Businesses. No One Saw Tesla’s Solar Roof Coming. Closet indexing. What Mathematical Models of Herding Cows Can Teach Us About Markets. China grapples with garlic price bubble. Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility. "The study’s authors could not find a single article written about a male CEO that mentioned family life." "A Chadbourne & Parke LLP attorney with a $100 million proposed class action against the firm said in a Thursday filing that she has video showing the litigation head harassing her by removing a Nelson Mandela quotation from her office wall and putting up a cartoon of 'a fat man wearing a bowler hat.'" Powder Tossed at Metropolitan Opera May Have Been Human Ashes, Police Say. A Sculptor Reaps the Rewards of Art Deals Brokered in the Bedroom. Man dresses up as his dog's favorite toy

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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