Index Funds, Quants and Hedging

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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Jack Bogle.

The consensus that Index Funds Are Good is pretty universal, but also kind of boring. It turns out that the right way to invest is to ... do nothing? To do exactly what everyone else does? To just stop paying attention? Indexing is low on action, low on personality, low on fees, low on excitement. It is good for you, but a bit bland.

The Index Funds Are Bad camp, on the other hand, is full of wacky fun. There is, for instance, the view that index funds are illegal because they violate antitrust laws, a view that is so counterintuitive that its proponents insist that they don't mean it. (To be fair, they also want to ban a lot of active mutual funds; their objections are to cross-ownership, not indexing itself.) Or there is the even weirder view that indexing might be "worse than Marxism," because at least in a Marxist economy you have a central planner deciding how to allocate capital, while in a world run by index funds you have no one to decide. 

The theory that index funds are good is so straightforward that anyone can grasp it in a sentence. (Active managers will on average get the market return, and you can't predict which managers will be above average, so you might as well just take the market return with lower fees.) There is no one theory of why they are bad. There are multiple theories, and you need a deep grounding in a specialized theoretical apparatus to even understand what those theories are talking about. (They're a bit like Marxism that way, come to think of it.) They inspire dystopian fiction. They are more fun to talk about.

Michael Regan interviewed Vanguard Group founder Jack Bogle for Bloomberg Markets last week, and I suppose it would be tempting to be like "so, Jack Bogle, index funds are pretty good, right?" "Yup, pretty good." "Thanks for your time." I mean, it is pretty straightforward. And there's a little of that -- "the math is the math, and I think the mathematics are inarguable," says Bogle -- but they also get into some of the more abstruse critiques of indexing.

And Bogle laughs at them. Here he is on the "index funds are Marxism" critique:

First, take the simple part. The stock market has nothing—n-o-t-h-i-n-g—to do with the allocation of capital. All it means is that if you’re buying General Motors stock, say, someone else is selling it to you. Capital isn’t allocated—the ownership just changes. I may be an investor, you may be a speculator. But no capital goes anywhere. This is basically a closed system. You have new IPOs and whatnot, but they’re very small compared to this vast thing we call a market, which is now around $24 trillion. The allocation of capital? That’s just nonsense. 

That, by the way, is the sort of thing that's easier to say when you run an index fund. If you are charging people a lot of money to pick the best stocks, then -- leaving aside the issue of whether your picks actually outperform the market -- you probably want to have some sort of social justification for what you do. That is not a strict requirement, but saying "I am a billionaire because I make markets more efficient by trading stocks and sending price signals that indirectly lead capital to be allocated to its best uses" just sounds a bit better than "I am a billionaire because I am good at a meaningless zero-sum gambling game." (Never mind "I am a billionaire because I am average at a meaningless zero-sum gambling game, but good at marketing.")

Or here is Bogle on passive investing and governance:

“The old Wall Street rule was, ‘If you don’t like the management, sell the stock.’ The index funds can’t follow that rule, so there’s only one rule left: “If you don’t like the management, fix it.” Vote, talk, discuss, cajole, applaud — and that’s actually starting to happen in a major way.”

Now, there is in fact a critique of index funds that says that they are too passive and neglect their corporate-governance duties, and Bogle is responding to it. But if you subscribe to the Index Funds Are Antitrust Conspiracies school of thought, Bogle's answer is further evidence against index funds. If diversified investors are voting, talking, discussing, cajoling and applauding -- then are they perhaps cajoling, etc., companies to keep prices high and avoid competing with each other? There are multiple Index Funds Are Bad viewpoints, and they don't have to be consistent with each other, so it's hard to know whether more involvement in governance is a good thing or a bad thing.

Elsewhere, here is Burton Malkiel on the Marxism stuff. He begins: "Index funds have long been ridiculed by active mutual-fund managers," and I suppose for veterans like Bogle and Malkiel, that probably feels true. But if your focus is more recent, it feels like the reverse. Active mutual-fund managers have spent years being comprehensively ridiculed by -- and losing market share to -- index funds. It's pretty easy! On average, the active managers will underperform the index funds; that's just math. If the active managers want to ridicule the indexers now, they need more complicated insults. 

David Harding.

Another way to go is you can be an active manager, but epistemically modest:

The aim is to exploit a large number of weak predictive signals, he says: “We don’t expect to find any strong relationships between data and the price of the market. That may sound counter-intuitive but if there are strong relationships, someone else is going to be exploiting those. Weak relationships are where we have a competitive advantage.”

Weather strategies are one feature of Winton research, including analysis of cloud cover and soil moisture levels to predict the prices of agricultural commodities. Other important indicators, for which maths can uncover value not fully reflected in market prices, include seasonal factors and inventory levels across supply chains. 

That's David Harding of Winton Capital, a $32 billion London quant fund, though it could equally well be Peter Brown of Renaissance Technologies, the Long Island counterpart that we discussed last week. (Brown: "if there were signals that made a lot of sense that were very strong, they would have long ago been traded out." He also mentions the cloud thing.) There's a lot of competition even for the weak signals. It would be funny if there were some strong intuitive signals that persist because every smart quant fund assumes that someone else is exploiting them. 

I suppose Bogle is right that many financial markets aren't really in the business of allocating capital. But they are at least in the business of conveying information, of synthesizing facts in the world into price signals that help people make decisions. The basic discomfort behind the "worse than Marxism" stuff is that index funds have given up on that project; they don't care about adding to the information content of prices. To finance people, that seems unsporting, a refusal to participate in the game. But we live in a world where index funds are ascendant, and where the financial industry is not especially trusted to convey information.

On the other hand, we also live in a world where smart scientists use fast computers to hunt out weak signals about soil moisture or whatever. The story of Winton and Renaissance and so forth is sort of the opposite of the story of indexing: While index funds give up on the project of seeking information to incorporate into prices, the quants take it to new extremes. We live in a golden age for the incorporation of information into financial prices, and also an age that rejects the whole idea.

Volcker, etc.

This can't be that big a surprise:

We analyze the Volcker Rule’s announcement effects on U.S. bank holding companies. In line with the rule and the banks’ public compliance announcements, we find that those banks that are affected by the Volcker Rule already reduced their trading books relative to their total assets 2.34% more than other banks. However, the announcement of the rule did not reduce the banks’ overall risk taking. To keep their risk targets, the affected banks raised the riskiness of their asset returns. We also find some evidence that the affected banks raised their trading risk and decreased the hedging of their banking business.

There's a model of banks that is like:

  1. They are morons.
  2. They want high returns.
  3. High returns come with high risks.
  4. They will take the highest possible risks, to get the highest possible returns.
  5. This will blow them up.
  6. The only constraint on their risks -- the only way to avoid blowing them up -- comes from regulation. They will take every possible risk, up to the limits set by regulation.

Look, there is some evidence for that view! But it can't be really right; lots of bankers have long careers and slowly-vesting compensation, and would prefer that their banks not blow up. The alternative model is something like:

  1. Banks have some more or less intelligent way of managing risk.
  2. They optimize their risk levels based on their own views of proper risk management.
  3. Regulatory leverage/trading/whatever constraints are just another thing.
  4. Once the banks have their own view on the right level of risk, they just have to work around the regulatory limits to achieve the risk levels they want.

So consider that banks may have "decreased the hedging of their banking business." Remember the London Whale? One reaction people had to the Whale was that hedging is bad. The Whale led directly to a sort-of-ban on "portfolio hedging" under the Volcker Rule, as people concluded that "hedging" was just a euphemism for "disguised additional risk-taking." (Look, there was some evidence for that view! For the Whale, anyway.) If your model of banking is the first one -- moronic risk-maximizing -- then of course that's what "hedging" means; in that model, banks would never really hedge, because they just love risk so much. If your model of banking is the second one -- self-directed risk management -- then it seems weird to restrict hedging. But here we apparently are.

Elsewhere: "Bank Regulators Seek ‘Miracle’ Deal on Capital Before Trump." Every time I read a story about how regulators are racing to finalize some rule or other before Donald Trump gets into office and kills it, I am touched by their faith in institutions, or in institutional inertia anyway. Like, he could just reverse the rule, right? 

Extended life.

Here is the NASDAQ Stock Market LLC's rule filing for its proposed "Extended Life Priority Order Attribute," which would give priority to orders that promise to stay in force for at least one second. We have talked about this order type before, and I was fond of it; it seems like a good rough way to segment "customers" from "dealers," and to give some priority to the customers:

In some loose approximate sense, if a customer shows up and wants to buy stock, then she should get priority over a dealer who also wants to buy that stock, because, you know, she actually wants to buy the stock. The dealer is just churning inventory for a few milliseconds. 

But, as always, if you have read the rule filing and noticed a way to game it for nefarious purposes, please do let me know. Meanwhile I enjoyed this language from the filing:

Innovation is in Nasdaq’s DNA, beginning with the development of electronic trading and continuing today as we seek to bring new ideas to the financial markets, such as streamlined proxy voting using blockchain technology, strengthening investor protection through Limit Order Protection, and enhancing investor confidence in the Opening Cross. Nasdaq has not shied away from experimenting with new market structure in an effort to further refine our markets. The change proposed herein is another step forward in a long line of innovations Nasdaq has brought to the U.S. financial markets.

Emphasis added because: blockchain blockchain blockchain!

Wells Fargo, charming as ever.

Ah yes:

Wells Fargo has asked a Federal District Court to order dozens of customers who are suing the bank over the opening of unauthorized accounts to resolve their disputes in private arbitrations instead of court.

I actually have some sympathy for this. The right way for Wells Fargo & Co. to resolve the fake-accounts thing is for it to do a thorough review, find all the fake accounts, offer restitution (of any fees it charged, and also some payment for damaged credit scores, etc.) to any customers who were found to have fake accounts, and then, if the customers disagree with Wells's assessment, work out that disagreement in some sort of informal setting. And in fact Wells's settlement with the Consumer Financial Protection Bureau over the fake accounts includes a "Redress Plan" requiring Wells to identify all affected customers, notify them, and repay them. 

Obviously it's hard to trust Wells Fargo to do this right, though. On the other hand, the class-action lawsuit approach has its own issues. The way consumer class actions go, this one will probably end up with millions of Wells Fargo customers -- affected or otherwise -- getting a free year of credit monitoring or something, and plaintiffs' class action lawyers getting millions of dollars of fees. (Or, there's some chance that it ends up with massive punitive damages being paid to millions of customers who never noticed their fake accounts.) I can see why Wells would object. And yet this is not a great public-relations look.

Elsewhere, here is a profile of CFPB Director Richard Cordray, a "five-time 'Jeopardy' champion" who can't really be looking forward to the Trump administration.

People are worried about unicorns.

Here's a good niche unicorn worry, about Indian ride-hailing company Ola, which is raising money at a $3 billion valuation after previously raising at $5 billion:

If the deal goes through, Ola would become the first Indian unicorn -- a startup valued at a billion-dollars or more -- to accept funds at a lower valuation, in what’s known as a down-round.

People are worried about Indian unicorn down-rounds! Meanwhile Stripe Inc., an Irish-American unicorn, "has raised another round of private funding that values the company at just under $9.2 billion," which is "nearly double what Stripe was worth nearly a year and a half ago."

Elsewhere, here is "Corporate Governance: A Comparison of Large Public Companies and Silicon Valley Companies." (There are a lot more dual-class stocks and staggered boards in Silicon Valley.) And here is Anna Wiener on diversity in tech recruiting:

“The brogrammer culture, the hoodies, the flip-flops, the ‘Revenge of the Nerds’ type of vibe,” Stephanie Lampkin, the C.E.O. and founder of Blendoor, a “blind recruiting” app, said over the phone earlier this month, “I think is a significant contribution to why a lot of women and minorities have been pushed out.”

The basic model of startup work culture seems to be "hanging out with your friends," and it's hard to scale that model into a diverse workforce. 

People are worried about bond market liquidity.

This is not really a people-are-worried-about-bond-market-liquidity story but I cannot resist:

We understand that some of Goldman’s more senior U.S. traders are planning to come in on Friday specifically to take advantage of the dearth of experienced hands at other banks. “The Friday after Thanksgiving is the only day that every desk is staffed by new analysts and associates,” says one insider. “For aggressive hedge funds, it’s like shooting fish in a barrel. They can take advantage of the illiquid random prices and run over all the bank newbies. Some funds make their month on the Friday after Thanksgiving.”

With this in mind, some of Goldman’s senior traders who’ve had a bad month and need to make up their numbers are said to be coming in on Friday. “It’s an opportunity to take advantage of other banks,” says the insider.

Who knew that you could get Black Friday discounts on bonds? Elsewhere: "Bond-Market Carnage Breeds Few Bold Predictions for Rebound."

Me last week.

I wrote about stabilization and lock-ups in initial public offerings.

Things happen.

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