ETFs and U5s
ETFs and hedge funds.
I was once talking to an exchange-traded fund provider and I suggested what I thought was a clever idea to slightly juice the performance of an index ETF. (I was probably wrong, but never mind that.) She did not seem interested, and I was a bit surprised. If the index returns 8 percent, and your fund returns 8 percent, that's great, but if you return 8.1 percent, isn't that better?
But I eventually realized that it's not that simple. The point of most ETFs is not to provide absolute performance. More important is for the ETF to capture some sort of thesis or asset class, and then accurately track its performance. People use ETFs for different reasons, and the thing that makes an ETF most widely useful is predictably doing exactly what it says on the tin. That way, if you are using it to express a view on credit, or to capture a specific set of factors, or whatever, you will get exposure to precisely the thing that you want, and not to any extraneous factors that might mess up your thesis.
Especially: A lot of people sell ETFs short. Bloomberg tells me that people are short 241 million shares ($50 billion) of SPY, the SPDR S&P 500 ETF Trust, out of 908 million shares outstanding. Being short SPY is a convenient way to bet against the stock market, or to hedge your single-stock long bets. If SPY suddenly started outperforming the S&P 500 index, because its issuer found a clever trick to juice performance, then everyone short the ETF would be annoyed. They want the pure index performance, because they're betting against it. And they are, in a sense, customers of the ETF too.
Anyway yesterday Goldman Sachs Group Inc. launched an exchange-traded fund based on its list of hedge fund "Very Important Positions" (basically: stocks that appear in a lot of hedge funds' quarterly 13F filings), and everyone had a good laugh. Here is the Financial Times's Lex column:
Like gout or having to pretend you like opera, hedge funds are a rich person’s privilege the rest of us should not envy. Yet on Thursday, Goldman Sachs launched an exchange traded fund based on “very important positions”, the shares that hedge funds hold. In light of the industry’s performance, this might seem an act of malice, democratising an exclusive way of being ripped off.
Lex comes around -- at least the fees are low -- but I think it is simpler than that. (Oh, disclosure, I used to work at Goldman.) If you want to bet on hedge funds' favorite (publicly disclosed, somewhat outdated) stock holdings, this ETF is a convenient way to do that. Perhaps that's a foolish strategy. But if you want to bet against hedge funds' stock holdings, this ETF is also a convenient way to do that. ("The industry itself is often criticised for idea overlap, piling into the same 'hedge fund hotels,'" writes Mary Childs.) Or if you have some relative-value trade between hedge-fund holdings and something else. The point is that Goldman has made a thing and you can buy the thing if you think it's good, or sell the thing if you think it's bad, and it is another potentially useful tool for expressing financial views. If you think hedge funds are dumb and bad, then this ETF gives you a great opportunity to express that view with money.
Elsewhere, Crispin Odey's investors are expressing their views by taking their money out of his fund. "He still has a good track record and he is a contrarian," says a contrarian. And: "Is Alpha Dead?"
Oh and here is some near-future dystopian fiction about active management from Josh Brown, which is the second piece of near-future dystopian fiction about active management that I've read recently. (Here's the first.) I am contemplating opening a literary review that just publishes dystopian fiction about investment management. Maybe I could get Robert Harris to contribute. I am pretty sure this will be a huge commercial and artistic success.
Here is a little puzzle I have been thinking about recently. Let's say you are a bank manager and some bright enthusiastic young person applies for a job as a private banker. You interview her, she seems great, but then you check her U5, the Financial Industry Regulatory Authority form that her previous employer filed when she left. It's from Wells Fargo & Co., and it says that she was fired for opening accounts for customers without their permission. You know that Wells Fargo opened a lot of fake accounts, and fired 5,300 people for doing it. But you also know that a lot of people -- most notably three Democratic senators including Elizabeth Warren, who sent Wells a letter yesterday -- think that Wells Fargo may have lied on a lot of those U5s, retaliating against whistle-blowers by claiming that they had faked accounts. (There's a recent Planet Money episode about it.) So you ask your candidate what's up, and she looks you in the eye and says that she never opened a fake account, but was fired for having too much integrity. What do you do?
Wouldn't you be tempted to hire her? Wells Fargo's fired bankers seem not to be the villains in the fake-accounts story; they're more the victims, and it's almost your obligation to help them -- especially the ones who were fired in retaliation for whistle-blowing. And yet the main thing that Wells Fargo is in trouble for is missing red flags about the fake accounts. The U5 is one of those red flags. Those senators noted that the U5s listing account forgery as a reason for termination "confirm that Wells Fargo had ample information about the scope of fraudulent sales practices occurring at the bank long before the CFPB settlement" -- even as they also asked if those U5s were themselves misleading. If you go and hire a former Wells Fargo employee, who was (ostensibly) fired for faking accounts, and then she fakes some accounts at your bank -- weren't you on notice? Didn't you see a red flag and willfully ignore it?
I don't know. There's a lot of risk aversion built into our bank regulatory, and litigation, systems. Giving someone a second chance because you think that the huge red flag in her file might be a mistake, or a lie, does not seem like a risk that a lot of banks would want to take.
Tim Sloan told an investor conference on Thursday that Wells would avoid “overcorrecting” for the debacle. “Can we continue to grow using the same strategies, in particular cross sell? The short answer is yes.”
“There’s nothing wrong with cross sell done right.”
Oh! Um! That strikes me as ... right? Like, if you have an overly aggressive sales culture that faked millions of accounts to meet sales targets, things that you might do to fix it would include toning down the aggressiveness, reminding people of the compliance rules, developing systems to check if new accounts are fake, etc. But just saying "you know what, selling stuff wasn't working for us, we're going to stop selling stuff," does not seem like a particularly good plan. I think there is a sort of public/political/media reaction to the Wells Fargo scandal that puts the blame on the concept of selling banking products, and wants to fix the problem by making Wells stop selling banking products. But Wells remains a business, and it will have a tough time succeeding as a business if it just stops marketing its products.
We talked a little yesterday about market data revenues for stock exchanges, specifically in the context of the Chicago Stock Exchange's proposed speed bump. But here is a deeper dive on the fight over market data revenues, which some people think are almost inherently immoral:
"Exchanges don't create any unique content — market data is generated by their members and other market participants including real investors — so it's very hard to believe that exchanges can perpetually charge their members more every year to look at the members' own data," Brad Katsuyama, CEO of IEX Group, told Business Insider.
"The elephant in the room is that Wall Street rewards subscription-based business rather than transaction-based business," says Doug Cifu of Virtu Financial Inc. The basic problem is that if you are a high-frequency trading firm you kind of have to be a completist about market data: You need full order-book information from every exchange, and you need to get it as fast as possible, because if you don't someone else will get ahead of you. That means that a small exchange can make a lot of money charging everyone for data even if it isn't a very good exchange and doesn't execute many trades, and it means a large exchange can constantly add slightly faster connections at much higher prices and be assured that its core customers will have no choice but to pay for them. The absolute value of the new services might not justify the price, but the relative value means that the exchanges can demand almost any price.
Meanwhile at the Commodity Futures Trading Commission: "The main US derivatives watchdog is poised to make changes to proposed rules for automated trading after a backlash from the futures industry."
Here is a cool story about reinsurance. Workers' compensation insurance for small businesses is a relatively simple product. Insurers file their plans with state regulators, and have simple fixed rates. But those plans have the problem that many insurance products have: moral hazard. If you buy insurance that pays out whenever your workers have an accident, you have less incentive to prevent accidents. So instead some companies buy plans in which the premiums get higher as claims go up, so they share the risk. But those products have their own problems:
Such so-called loss-sensitive plans could save money if an employer operated without major accidents, but they could be pricey to set up and so complex that they were better-suited for sophisticated businesses with resources to handle the expense if claims piled up. That’s why some states have been reluctant to let insurers sell certain types of loss-sensitive coverage to small firms.
But a company called Applied Underwriters came up with a clever work-around. It sold small businesses a fixed-cost product, but then also entered into a separate "reinsurance participation agreement" in which the businesses would reinsure some of Applied's losses. If there were no claims on the regular policy, there'd be no claims on the reinsurance agreement, and the company would save money. (Presumably the fixed-cost product was underpriced relative to one without this setup.) If there were lots of claims, the company would pay a share of them through the reinsurance agreement. It's a loss-sensitive plan sliced into two pieces, one of which is simple and filed with the regulators, and the other of which is complicated and just between the parties.
I am mostly telling you about this because as a former derivative structurer I found it irresistible. Like, that is how you are supposed to approach difficult problems in insurance, and in life. But if you're a state regulator who has been reluctant to let insurers sell loss-sensitive coverage to small firms, surely you won't like insurers who sell loss-sensitive coverage via a complicated secretive workaround. And some companies that did these trades complain that they didn't fully understand the deal, and that it ended up costing too much, and some state regulators have cracked down:
After a lengthy proceeding, California Insurance Commissioner Dave Jones ruled in Shasta’s favor in June, declaring Applied’s reinsurance-participation agreement illegal and void. His 70-page decision laid out how Applied had circumvented regulatory oversight to boost its profit. The insurer, he wrote, fundamentally changed the terms on a state-approved workers’ comp plan, putting the burden of claims back on the employer.
Also Applied is majority-owned by Warren Buffett's Berkshire Hathaway Inc. I don't know what you should make of that fact? On the one hand, Buffett is folksy, and reinsurance participation agreements are not that folksy. On the other hand, Buffett is one of the richest men in the world because he is an insurance magnate. These are not, like, his first reinsurance agreements.
Everything is seating charts.
In its newly opened building in central London, the Swiss banking giant UBS is looking to change the way employees view their relationship with their work spaces.
Many of its employees at 5 Broadgate in the City of London will no longer be tied to the same desk every day with a telephone and desktop computer. Instead, the company has deployed so-called thin desks throughout the building.
You don't get a real phone; you get a headset you can lug around the building as you hunt for a desk. (Traders are exempt for now, but "the trading desk is our next port of call to achieve user mobility.") Over at FT Alphaville, Izabella Kaminska is writing about "our rental serf future" as expressed in things like autonomous cars, suggesting that "the path to future profitability lies in the general population never really owning anything but rather having to rent everything or pay a subscription to an intermediary for it." But meanwhile even people with regular office jobs are slowly being thrown back into a desperate Darwinian struggle just to find somewhere to sit down.
People are fond of "Business Adventures."
I read this article frequently enough that I feel like it ought to be a recurring section, although the only people usually quoted are Warren Buffett and Bill Gates. (Here are a few prior versions.) Still: good fans! And John Brooks's collection "Business Adventures" really is terrific; the story of the Great Piggly Wiggly Corner of '23 is worth the price alone. (We have talked about it before a little: The protagonist cornered the stock, then sold it forward to lock in his profit while keeping control of the borrow. It's a move of jaw-dropping purity and beauty, though somehow it failed and left him bankrupt.) Also the story of the mini-crash of '62 is relevant to current worries about bond market liquidity. More billionaires should read it and declare that it's their favorite book so that poor Gates and Buffett have some company.
If you’re worshipping at the altar of Graham because of his elemental principles, well then you’re in the luck - the idea of trying to buy a dollar for 80 cents will never go out of fashion. It’s genius. If, however, you think his spells and incantations are going to enable you to perform miraculous feats in a relative sport like the stock market, it’s going to be a disappointment. His doctrines were almost too good, and now there are a million players armed with the ideas he explained and the software that takes them even further.
People are worried about unicorns.
If I weren't so committed to the recurring section titles, today I would have called this section: "Unicorn incest!" Because: unicorn incest!
Early startup investing by wealthy executives abounds in Silicon Valley, leaving boardrooms packed with possible conflicts and boosting the likelihood of disputes like the one threatening Oracle’s acquisition. The concern is that shareholders will end up on the wrong side of clubby deals or left in the dark altogether in cases where executives aren’t required to disclose holdings. “The rise in angel investing -- and investments by board members in venture-capital-funds -- over the past 10 years has significantly increased the frequency of this type of potential conflict," said David Lipkin, a lawyer at McDermott Will & Emery’s Silicon Valley office.
"Informally, there are lots of conflicts of interest," says Vivek Wadhwa. "It’s too incestuous."
There is a simple model in which this is all a good thing. "Conflicts of interest" is just another way of saying "useful connections." Everyone knows each other, they work together, they share best ideas, it is all collaborative, the pie grows for everyone, and the conflicts of interest don't matter that much as long as everyone is getting ahead. In practice, of course, not everyone gets ahead, and tech firms and shareholders fight over their shares of the pie as well as thinking about ways to expand it. The tech industry's underlying utopian ideology can sometimes make it hard for tech companies to just do normal corporate stuff. Governance, for instance, is tough when every director also works for a competitor or supplier.
Elsewhere, not everyone liked Slack's letter to Microsoft. And there's a Silicon Valley Venture Capitalist Confidence Index, who knew.
People are worried about bond market liquidity.
This is from last week, but the Botswana Stock Exchange and Botswana Bond Market Association recently held a conference about guess what, supporting my thesis that there is always a conference about bond market liquidity going on somewhere in the world.
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