Index-Fund Bans and Hedge-Fund Data

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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How should index funds be illegal?

We have talked before about the delightfully odd theory that ownership of multiple firms in the same industry by diversified mutual funds is an antitrust problem. Those funds care about industry profits, not individual companies' success, and so push companies not to compete too hard, leading to higher prices for consumers. And, the theory goes, this is the sort of industry-wide collusion that antitrust law was supposed to prevent. I sometimes shorthand this theory as "index funds are illegal," which seems to rub its proponents the wrong way. Index funds are popular, and have a lot of academic and governmental support. If your clever new academic theory is that they should be banned, then your theory probably isn't going places.

But whatever; here's a new paper from three proponents of the theory -- Eric Posner, Fiona Scott Morton and E. Glen Weyl -- describing how they would go about banning index funds:

Investors in firms in well-defined oligopolistic industries must choose either to limit their holdings of an industry to a small stake (no more than 1% of the total size of the industry) or to hold the shares of only a single “effective firm.” Investors that violate this rule face government litigation.

The "single effective firm" thing means roughly that an investor can own stock in firms that have as much as the average firm's market share in the industry (so in a four-firm market, you can own shares in companies with up to 25 percent market share). Mutual funds can diversify across industries, and individuals can diversify within industries by owning shares of multiple mutual funds. Fund companies' shares would be aggregated, so two different funds with different portfolio managers at the same fund company would be counted together.

The benefits of this solution are that institutional investors will hold only one large, or a few small, firms in an oligopoly and will therefore have a financial stake in their firm doing well, even if that comes at the expense of rival firms in the industry. They will exercise their corporate governance abilities to achieve better performance of their portfolio firms, not the industry. The strategic advice the institutional investor provides and the influence it has on executive compensation will reflect these goals.

They explicitly note that index funds would be illegal: "Many mutual funds have sold products to consumers, such as S&P tracking funds, that they could not legally offer at large scale and comply with our policy." (I guess, like, Vanguard could have a fund that invests in the alphabetically first company in each industry, and BlackRock could invest in the second, etc., so if you bought all of the firms' index funds you could own the whole index? It's not really the same.)

It is all tantalizingly close to being plausible -- it would only apply to industries designated as oligopolies by regulators, it could be done in a way that doesn't reduce the benefits of diversification too much -- and yet it is not plausible. What it demands, essentially, from mutual funds is stock-picking: If you can only invest in one firm per industry, you have to decide which firm it is. You have to justify that decision to your directors and investors. You have to do research, make up your mind, update your research constantly, and be ready to trade if you change your mind. That is all probably useful work! But it costs money, and tracking error. The paradise of low-cost index investing, which investors have entered into so recently, would be closed off to them if this proposal ever became the law. I don't see it happening.

Data.

I am such a sucker for big-data-and-machine-learning-in-hedge-funds stories, and here's a great one from Saijel Kishan at Bloomberg:

Last year, when Chipotle Mexican Grill Inc. was rocked by waves of customers with foodborne illnesses, some hedge funds misread the impact on sales. They relied heavily on foot traffic from location apps that showed a dramatic decline while overlooking credit card transactions that revealed customers had meals delivered during the colder months, Zatreanu said.

Ha! I would read a book about that anecdote. How did it happen? Is location data just such a fun novel data set -- you can see where people are! as opposed to boring old actual sales receipts -- that it is overly prominent in investors' minds? Or did their minds not enter into it, and did the hedge funds' computers overweight the location data? Why? Was location data historically more predictive than -- again -- actual sales receipts? (Fine, credit card receipts.) Is this all so new that no one had yet factored in the concept of winter

Zatreanu is Matei Zatreanu, formerly of King Street Capital Management, now of Augvest and System2, and he "offers this advice to hedge funds: give data scientists more gravitas." He complains about funds that rely on interns for data analysis, or hire scientists to do clerical work, and "advises firms to break down the walls between managers and quants":

“A lot of funds are just checking the box and saying they are doing data-driven investing,” he said. “For this to succeed, you need to have the buy-in from senior management who may necessarily not want change.”

Yes but. Another thing you could do is just get some data scientists together, do some data science, figure out how to beat the market with all that data, and then maybe hire a finance guy to do the menial stuff like actually putting on the trades. That is roughly how I think of Renaissance Technologies, and they're doing fine. If you are the senior manager of a hedge fund "who may necessarily not want change," and your firm is shifting to data-driven investing, what value are you adding?

Meanwhile, the hedge-fund humans are still enjoying themselves:

Hedge fund operators still work out of trophy offices in Manhattan’s Plaza district, Greenwich, Connecticut or London’s Mayfair. They are keeping the free lunch and snacks, ski and beach junkets, and even in-house yoga. And they continue to lavish portfolio managers with multi-million dollar pay, all in the face of poor performance and declining fees.

“These guys aren’t living in reality,” said Brad Balter, chief executive of Boston-based hedge fund investor Balter Capital Management.

And elsewhere, here is Benedict Evans on "computer vision" and machine learning:

Now, suppose you buy the last ten years’ issues of Elle Decoration on eBay and drop them into just the right neural networks, and then give that system a photo of your living room and ask which lamps it recommends? All those captioned photos, and the copy around them, are training data. And yet, if you don’t show the user an actual photo from that archive, just a recommendation based on it, you probably don’t need to pay the original print publisher itself anything at all. (Machine learning will be fruitful grounds for IP lawyers.)

And: "AI academic warns on brain drain to tech groups."

Philidor.

One thing that I sometimes think about is that there is weirdly little in the way of actual white-collar law. Basically the illegal thing is "fraud," and all sorts of very different actions -- insider trading, pyramid schemes, bribery, lying to investors to raise money, etc. -- are all analyzed under that very generic term. It's like if the law of violent crime was just "don't touch anyone in a bad way," and then there were a bunch of court cases interpreting which ways of touching are bad (murder, assault) and which aren't (self-defense, handshakes), and some sentencing guidelines fitting the punishment to the harm, and you generally had to guess about which things were bad. That's not how it works. Legislators think about various sorts of violent crimes that they want to forbid, and write reasonably specific rules forbidding them, and we all kind of know what they are.

"Fraud" is different. Andrew Caspersen, for instance, committed real, real fraud: He called up some charities he knew, promised to invest their money, and then just stole it. That's bad! But in the eyes of the law, it is pretty much equivalent to insider trading, a considerably more victimless crime, and one you can commit by accident. (If you trade on your analyst's research, and your analyst did his research by bribing insiders, and you should have known that, you might be guilty.) If you were constructing a perfect society, I'm not sure why you'd conclude that those two things were the same thing. But we somehow have.

Another thing that is the same thing is whatever those guys at Valeant and Philidor were allegedly up to. That is: Allegedly Gary Tanner of Valeant Pharmaceuticals International, Inc., helped Andrew Davenport of Philidor Rx Services LLC get a lot of business from Valeant, and then allegedly convinced Valeant to buy Philidor, and then Davenport allegedly kicked back $10 million of the purchase price to Tanner. That sounds like bribery, and is what we call "honest services fraud," and it's essentially the same crime -- federal mail/wire/securities fraud -- as insider trading or, you know, actual fraud. 

I have to say, the charges against Tanner and Davenport are a bit murky, and, you know, there was a lot going on at Valeant. The explanation may be more complicated and nuanced than what's in the government's complaint. But if you do believe everything that the government alleges against them, then it seems ... pretty bad? Like, closer to real fraud than to insider trading? But here is Peter Henning, who is skeptical:

Unlike the typical kickback, he can argue that his share of the deal was a means to bring both sides together in a mutually beneficial arrangement. Thus, Valeant was not so much a victim of a bad deal as a willing participant that received the benefit that it sought by gaining control of an important conduit to sell its drugs and avoid losing sales to lower-cost generics.

That argument would not put a seal of approval on what Mr. Tanner did, and arranging to make almost $10 million off a deal without first disclosing it to your employer is likely to be considered a breach of duty if Valeant sued him. But whether the federal fraud statutes should be used to police a dispute about a private employment relationship is a different question, especially when the defendants face a potential sentence of up to 20 years in prison if convicted of the fraud charge.

I mean ... sure? "But whether the federal fraud statutes should be used to police" corporate bribery is also an interesting question, or I guess a more interesting way of putting the same question. One possible answer is "yes, corporate bribery is bad, let's police it with whatever we've got." Another is "no, this was fine, I have no problem with this." My preferred answer is more like: Let's actually write a law specifically forbidding corporate bribery, and then use that instead of the fraud statutes.

Blockchain blockchain blockchain blockchain.

My basic theory of using blockchain technology to improve settlement processes at banks is (1) sure, why not, and (2) the fad for blockchain has a nice sociological benefit, which is that senior people will pay more attention to improving back-office processes if you just shout the word "blockchain" at them a lot. But you gotta strike while the iron is hot! The blockchain consensus is already fraying a bit:

Goldman Sachs has left the powerful R3 blockchain consortium, in a sign of tensions emerging as the big banks try to place their chips on a technology that could cut tens of billions of dollars of costs from the financial sector.

An R3 managing director points out that Goldman's loss is no big deal, because R3's large consortium still provides powerful network effects: "How good would a fax machine be if you had no one to communicate with?" Wait: How good is a fax machine anyway? Is this ... are they going to run the blockchain on fax machines? Elsewhere: "Bitcoin was supposed to change the world. What happened?"

Congrats everyone!

We did it:

The S&P 500 Index rose 0.8 percent to 2,198.19 at 4 p.m. in New York, for its first record since Aug. 15. The Dow Jones Industrial Average advanced 88.62 points to 18,956.55 to a fresh high, while the Russell 2000 Index capped a 12th day of gains in its longest rally since 2003. The Nasdaq Composite Index added 0.9 percent to its highest level ever.

That's the first time all the indexes have hit all-time highs since 1999, and nothing bad has ever happened since.

Some Trump.

Well. Here are the New York Times, and my Bloomberg View colleague Noah Feldman, on U.S. president-elect Donald Trump's plans to violate the Constitution by accepting payments from foreign governments while he is president. Here's my Bloomberg View colleague Tim O'Brien on Trump's business dealings in India. Here's a story about his business interests in Argentina. And here's John Cassidy on what a scam Trump University was.

Meanwhile, not only is Jamie Dimon apparently out of consideration for the job of Treasury Secretary, but he has retroactively never even been offered the job in the first place. Jamie who? Never heard of him. Anyway apparently it'll be Steven Mnuchin, so look forward to that confirmation hearing:

If Mnuchin gets the nod, the world will hear more about people like Leslie Parks, who found the locks on her Minneapolis home changed during a blizzard in December 2009 after OneWest foreclosed. Or Rose Gudiel, who was evicted from her Pasadena home under circumstances she claimed were improper and inspired about 100 people to march on Mnuchin’s Bel Air, California, mansion in 2011.

On the other hand: "Bankers Ridiculed by Trump Are Already Embracing His Future Regime." 

People are worried about unicorns.

This is from last week but who cares:

I notice I am standing on a vast expanse of steel grating with bubbling lava beneath me. The room seems to expand infinitely in all directions. I am just beginning to feel the extreme heat and tearing off what is left of my shirt when suddenly something hits me in the chest like a sledgehammer. I double over, the wind knocked out of me, and feel the steel grid shaking beneath me.

As I look up from my crouched position I see a massive white unicorn charging directly towards me, its brilliant skin reflecting heat and light and its sinuous muscles rippling with rage. Its horn is razor sharp and covered with diamonds. Thick pink laser beams periodically blast from its eyes. Another beam strikes me in the shoulder and knocks me flat on my back. I skid backwards several feet and panic when I realize I’ve lost grip on my right blade.

Another beam seems trained on my skull when I instinctively lift my right wrist to protect my face. The laser beam harmlessly bounces off the face of the Asus ZenWatch 3 and disappears in to the darkness. Suddenly I realize I stand a chance.

I take a moment and marvel at the beauty of the creature.

“Such a shame I must destroy you, beast” I shout in its direction, which seems to anger it even further.

That's from a long blog post by Rob Rhinehart, the founder of Soylent, about how he raised money from Andreessen Horowitz. (The unicorn death match was part of the due diligence.) I stopped there, but I assume he killed the unicorn by feeding it Soylent.

People are worried about stock buybacks.

Here's Goldman Sachs Group Inc.'s prediction for 2017:

Share repurchases will climb 30% to $780 billion, according to the bank’s forecasts, with $150 billion, or about 20%, of the buybacks coming from repatriation of overseas cash. If their forecasts play out, buybacks will make up the largest use of cash among S&P 500 companies for only the second time in the last two decades.

In a far more innocent time, I mused that the 2016 election might be about stock buybacks. It ... wasn't. Still, elections have consequences, even for stock buybacks, and "the repatriation of overseas cash is expected to be encouraged through a one-time tax on overseas profits that have previously not been taxed" favored by Donald Trump and the Republican Congress.

People are worried about bond market liquidity.

I don't know, here is "The long-awaited bonfire of the bond proxies." When I read the headline I hoped that the liquidity crisis in bond exchange-traded funds was finally here. But, nah; it's about stocks, not bonds (or bond ETFs), and not really about liquidity. Here, try: "TIPS Liquidity and the Outlook for Inflation." Or: "Institutional Herding and Its Price Impact: Evidence from the Corporate Bond Market."

Things happen.

Litigation funding. Michael Sherwood quits as Goldman co-head of Europe. Fed Minutes Seen Setting Up December Even Before Election Bump. Fidelity Chief Abigail Johnson to Succeed Father as Firm’s Chairman. Three Big American Banks Pose Greater Systemic Risk, Regulator Says. EU to retaliate against US bank capital rules. Sunoco Logistics to Buy Energy Transfer Partners. In Reply to FCC, AT&T Says ‘Zero Rating’ Benefits Consumers. Oil Speculation Rule Gets Final CFTC Push Before Trump Takeover. Trump vows to renounce Pacific trade deal on first day in office. Law School Accreditors Raising the Bar. Daimler executive removed after ‘racist rant’ in China. Instagram is becoming more Snapchatty. No Evidence of Aloe Vera Found in the Aloe Vera at Wal-Mart, CVS. The Berry of the Future Is Fed a Specialized Diet and Picked by a Robot. Entrepreneurship porn. Affluenza rehab. Thanksgiving Eve is the best night to get lucky. Park Slope kids read to dogs at Brooklyn’s most adorable event.

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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