ETFs, Formatting and Tech Support

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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"Manifest destiny for ETFs."

Here's a fun little puzzle:

Stocks now tend to move close in alignment with each other most of the time, and then divert sharply in response to corporate announcements. News has always had an impact on stocks, but this pattern has grown far more pronounced since the advent of ETFs, according to Mr Birinyi. “The flow of ETFs will mask any issues in a big company’s business. The flow from ETFs into IBM, for example, is more appealing to investors than IBM’s business. Therefore you get greater reactions to corporate announcements whenever they happen.”

On the one hand, exchange-traded funds just buy everything in the index indiscriminately, not caring about the underlying facts about any particular company, so all the stocks tend to move together. On the other hand, when there are new facts about one particular company, that company's stock moves rapidly to reflect the new facts.

Isn't that ... isn't that fine? Like, isn't that the system working? ETFs, and index investors, and algorithmic arbitrageurs, do the sort of automatic first-pass work of keeping prices aligned: If Google stock goes up a little bit, then Microsoft should probably go up a little bit too, and so it usually does. But sometimes their prices should diverge, and if there's big enough news about one company or the other, it can be worthwhile for a value investor to buy one and sell the other and push the prices apart. The basic framework of historical correlation basically works, and is good enough for most investors most of the time, which is why I index. But sometimes -- frequently, really -- those historical relationships shift, and someone needs to update them so that the markets remain informative. 

“There’s no opportunity for people who are looking at a stock from the bottom up, rather than the top down from an ETF,” says Laszlo Birinyi, but others disagree:

Yet it appears that many of the professional investors decrying the rise of the ETF have failed to identify the irony in their complaints: that those who live and die on their ability to exploit market distortions and mispriced assets are so troubled by products they argue are creating exactly the type of distortions they aim to profit from. The rise of the exchange traded fund, far from resulting in the death of the discretionary investor, may, in fact, present an increasingly fecund environment to find undervalued securities.

That's all from this delightful Financial Times series about exchange-traded funds, which touches on many other issues that we've talked about before. For instance, bond market liquidity:

Yet as ETFs have grown, so have the worries about them. Could ETFs’ dominance create new systemic risks, or trigger another market crisis? Because the securities they hold are often not as liquid as the ETF itself, there are risks of mismatches and forced sales.

This has never really bothered me, since ETFs do redemptions in kind and so are less likely to face runs than regular mutual funds are. They are lessof a bond-market-liquidity problem, and more of a solution:

For bond investors, the ETF offers something more: an all-to-all technology to buy and sell the bundle like a stock. The investor trades directly with other investors on an equity exchange, at a public price, open to retail and institutional on the same terms. This is a transformational concept in the bond markets. A market dependent on middlemen has begun to offer a supplementary way to trade. What was opaque, over the counter, and principal-driven is moving towards brightly lit, standardised and agency-driven.

Elsewhere in ETFs, don't worry, you'll still be able to trade triple-levered oil exchange-traded products even after Credit Suisse AG retires some exchange-traded notes.

Kids these days.

Here is James Forsyth on what it is like to be an officer of the Oxford Union and then graduate into the cold unfeeling world of elite jobs:

“You are 19 years old, with zero work experience and find yourself with actual responsibilities, hobnobbing with people who are extraordinarily successful.

“Then you become the most junior analyst at McKinsey or JPMorgan and spend your time creating powerpoints and being berated for not having the axes in the right format. It’s a hell of a comedown. That is such a shock to the system that it might compel you to think: actually I want to do something that is more within my own control. It’s the contrast between what you do at the union and the real workplace that compels a lot of people to take a more alternative path.”

This is one of the biggest problems facing the investment banking industry: You want to get the best young candidates you can find, but you also want them to format the axes correctly. If they have been too spoiled by their early success to get the axes right, you have to lower your standards and hire weaker candidates, or live with the sloppy work created by your precious flowers. Back in my day, we dealt with this problem by fostering a broad conspiracy to pretend that junior investment bankers did important work and were somehow masters of the universe. But with the crisis and the tech boom, that conspiracy is harder to maintain, and the ramifications for the industry are just beginning to be felt.

Tech support insider trading!

Oh yeah:

From at least March 2013, Ly was employed as a Senior IT Support Technician in Expedia’s Corporate IT Services Department. As an IT employee, Ly assisted other Expedia employees in resolving various computer software, email, and Internet/network issues. In performing these job responsibilities, Ly was entrusted with IT administrative access privileges (i.e., a username and password (“credentials”) designated for Expedia’s IT personnel) and, on occasion, various employees’ corporate computer network credentials. These credentials authorized Ly to gain remote access to an Expedia employee’s company computer upon Expedia’s request.

Guess what he did with that access?

The SEC alleges that Jonathan Ly, who worked in Expedia’s corporate IT services department, illegally traded in advance of nine company news announcements from 2013 to 2016 and generated nearly $350,000 in profits. 

That's from yesterday's Securities and Exchange Commission case against Ly, which he settled by agreeing to pay about $376,000. He also pleaded guilty to criminal charges. How are there not hundreds of cases like this? If you spend your days cleaning up for entitled executives after they click on phishing e-mails, wouldn't you occasionally peek at what they have on their computers? And if it's juicy, wouldn't you do something about it? It's possible that I have watched "Office Space" too many times, but I feel like if the IT guy successfully trades on inside information that he obtains while fixing executives' computers, he should get a high-five, not a criminal conviction. This is of course not legal advice. Legally this is pretty much the core of insider trading. It just seems like there ought to be a tech-support exception.

Indexing, buybacks and investment.

Here's a paper by Germán Gutiérrez and Thomas Philippon that supports both the "stock buybacks are bad" and the "index funds are evil" hypotheses:

We find fairly strong support for the competition and short-termism/governance hypotheses. Industries with less entry and more concentration invest less, even after controlling for current market conditions. Within each industry-year, the investment gap is driven by firms that are owned by quasi-indexers and located in industries with less entry/more concentration. These firms spend a disproportionate amount of free cash flows buying back their shares.

One story you could tell about index funds is that they are "the ultimate long-term investor": They own the whole stock market forever, and so their preference is for general long-term economic growth. Ruthless cost-cutting that helps one company gain market share does nothing for them, since they own all of its competitors; their preference is just for investment that will grow the overall size of the pie. Index funds may not be great for price competition, but they should be good for innovation.

But, nah, it's just buybacks: Indexing and quasi-indexing are associated not only with concentrated industries but also with more buybacks and less investment. One possible story is that indexing -- the most generic and academic investing approach -- is associated with the most generic and academic principles of good corporate governance, in which discipline is imposed on corporate managers by returning cash to shareholders rather than leaving it to the managers to build empires with. Of course some managers really should be trusted with tons of money to build an empire, because they'll be good at it, but indexers are not going to be great at making those, or any, distinctions.

Blockchain blockchain blockchain.

The idea of smart contracts is that they are self-executing: You and I agree to exchange some series of payments or whatever over the blockchain, and then the code just makes those exchanges happen, with no further interference from us or from lawyers. And so Elaine Ou writes: "Asking whether smart contracts can be legally binding is like asking whether submarines have gills or blowholes." Legal bindingness is not the point of smart contracts; the point of smart contracts is to avoid legal questions altogether. "The whole point of a smart contract is to NOT go to court." 

But that's the whole point of a regular contract too! Contracts only ever end up in court when something has gone wrong. It's just that regular contracts come with a whole set of background principles of contract law that set everyone's expectations about what will happen if the world doesn't turn out as the parties expected. Smart contracts often come instead with a sort of techno-utopian absolutism that assumes that, if the world doesn't turn out as the parties expected, then whatever the computer ends up doing is fine, because we have all agreed in advance to fetishize "immutable, unstoppable, and irrefutable computer code." 

I personally think that that's no way to live. But people who use smart contracts on the blockchain also tend to live in some human jurisdiction, and in that jurisdiction there are courts, and those courts decide whether smart contracts are enforceable even if they've already been executed. So Ou mentions smart contracts with automatic enforcement, like "Make your car payments on time or else your ignition won’t start," or "Deposit a quarter or else you don’t get a candy bar." But people go to court over stuff like that all the time! Just because your contract has enforced itself automatically, that doesn't mean that courts don't get any say. They can order you to un-enforce it, or to pay damages for enforcing it wrong. You can't avoid the law just by saying that you want to, even if you say it on the blockchain.

Elsewhere, here's a Federal Reserve Board discussion paper on "Distributed ledger technology in payments, clearing and settlement." And: "As Fintech Comes of Age, Government Seeks an Oversight Role."

Self-driving store.

Amazon.com Inc. has a new store in Seattle called Amazon Go where you can just walk in, take stuff, and walk out. There are cameras and sensors and buzzwords ("sensor fusion," "deep learning") that let the store achieve consciousness of what you are taking from it, and send you a bill on your phone. There's a video. It looks pretty neat, though I have to imagine there will be glitches, and when there are you will just have to sort of shout into space like a maniac. "No, I already put the yogurt back! Store! Store! Pay attention to me!" 

With the decline of manufacturing jobs and the rise of the service economy, soon we'll all just be selling stuff to each other. For like a minute. Then the stores will sell stuff to us by themselves, without any human intervention. It'll be a paradise of leisure, as long as you have a way to get the money to buy the stuff. 

No one reads the documents.

Good news, though: If the documents are unreadable, you probably shouldn't invest.

We find that less readable annual reports are associated with less favorable credit ratings from S&P and Moody’s and more frequent and larger magnitude disagreements between S&P and Moody’s about the initial rating of a new bond. We also find evidence that less readable annual reports are associated with higher costs of debt financing. In terms of magnitude, we find that if a company improved its readability from the 75th to 50th percentile in our sample, then it would save approximately $440,000 annually in interest for a bond with a face value of $430 million, the average in our sample.

A good follow-up project would be to see if there's a correlation between the readability and how much the company spends on legal fees. Like, sure, improving the readability of your annual report will save you $440,000 in interest, but will you have to pay your lawyers an extra $450,000 to improve their prose? Or is it the opposite: Is the way to get more readable documents to spend less on lawyers? 

People are worried about covered interest parity.

I like to think of Money Stuff as an incubator for worries: We find the most promising new worries and give them the support they need so that they can one day become as universally worrying as, um, I guess, bond market liquidity. I've had my eye on covered interest parity for almost six months now, from the time it was an interesting curiosity through last month's paper, by Stefan Avdjiev, Wenxin Du, Catherine Koch and Hyun Song Shin, about breakdowns in covered interest parity as a signal of limits on bank leverage capacity. Yesterday those authors released an addendum, noting that "the recent appreciation of the dollar" -- which they identify with, essentially, the cost of bank leverage -- "presents an opportunity to put the main predictions to an out-of-sample test," and they in fact find that "the cross-currency basis widened for all G10 currencies." 

But the real news is this Bloomberg headline about their findings: "The World's New Fear Gauge Is Ringing Alarm Bells in the Era of Trump." Covered interest parity has risen from relative obscurity -- a worry among many, like non-GAAP accounting or stock buybacks -- to become the world's new fear gauge! I cannot help but feel a sense of pride. I feel like I can imagine what it would be like to write, over and over again, "people are worried about implied volatility in S&P 500 index options," and then wake up one day to find the VIX referred to as the "fear gauge." Congratulations, covered interest parity! We did it!

People are worried about unicorns.

Uh oh:

Tyson Foods Inc. is launching a venture-capital fund to invest in high-tech products and services that could help refresh its stable of products, which include chicken, hot dogs and hamburgers.

I don't want to alarm anyone but ... unicorn hot dogs? If the private-company tech bubble does pop, there are going to be a lot of spare unicorns around for Tyson to grind up. "Among other things, the fund will evaluate alternative sources of protein, including companies developing plant-based meat alternatives, meat grown from self-reproducing animal cells, 3D-printed meat or insect-based protein products."

Meanwhile in Uber, here is Part Four of Hubert Horan's screed against Uber, in which he argues that Uber's low-cost rides subsidized by investor funding are not evidence of those investors' charity, or naivety, but that "Uber’s Investors Always Understood That Financial Returns Required the Ability To Exploit Quasi-Monopolistic Industry Dominance, and Provided the Level of Financing Deemed Necessary." Elsewhere: "Uber in Artificial-Intelligence Drive After Buying Startup." And: "Uber Drivers Face $780,000 Fines as Taiwan Opposition Grows." 

Elsewhere, a French billionaire is building a new Enchanted Forest in downtown Paris. Here are some startup teens. And several big tech companies are delaying the release of their diversity reports until they can figure out how to make them look less depressing. 

Things happen.

Paschi Recapitalization Hangs in Balance After Debt Swap. Monte dei Paschi readied for state bailout after Renzi defeat. As Avianca Weighs Bids, Hedge Fund Plays Unusual Role: Diplomat. Shenzhen-Hong Kong Trading Link Gets Off to Slow Start. China stocks tumble as top regulator warns against 'barbaric' buyouts. Rogue Chinese renminbi exchange rate raises eyebrows. Eliminating Obama’s Fiduciary Rule Easier Said Than Done. Banks’ post-crisis consultancy spending soars to $200bn. Costs, targets and IPO in focus at Credit Suisse investor update. Pemex is teaming up with BHP Billiton for offshore drilling. American Shale Companies' Rush to Hedge Is Turning the Oil Market Upside Down. Morgan Stanley's commodities head swaps swagger for small and smart. Aetna and Humana Defend Merger, as Antitrust Trial Begins. Awaiting the Second Circuit’s Decision in Marblegate. SEC Awards $3.5 Million To Whistleblower. Google Looks for 'Conservative Outreach' Manager After Trump Election Win. Trump’s ‘Retribution’ Tax Stirs Questions, GOP Resistance. Trump’s Threat to the Constitution. "A sore subject in the Ford household: Jack has some light-up dinosaur shoes, and sometimes he tries to wear them to school, and when Ford catches him doing this, he has to step in." "When I first joined the Illuminati, I thought I’d work here forever." "I had meetings this morning, so I got robbed of my power and spirit." Economics rap. Cheese ballsSextacles.

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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