Robot Traders and Super Hedge Funds
Automating Steve Cohen.
Here is a fun story about Point72 Asset Management, Steven A. Cohen's almost-hedge-fund, and its efforts to transform from a classic hedge fund run by warring cliques of smart humans with ulcers into a quantitative hedge fund run by calm quiet rational computers. I feel like I read stories like that a lot: Point72, which is huge and famous and oddly institutionalized considering that it is technically a family office, seems to be at the forefront of the trend of human-driven hedge funds reinventing themselves as computer-driven ones (or at least talking about it). But what is new to me in this story is the description of Point72's plan for "parsing troves of data from its portfolio managers and testing models that mimic their trades":
Using analyst recommendations as an input, the effort involves examining the DNA of trades: the size of positions; the level of risk and leverage; and whether an investment was hedged, said one of the people. It also entails looking at the timing of trades, assessing pricing and liquidity in the market, and the duration over which managers build positions.
The model will identify patterns and relationships based on those analytics and seek to replicate bets, the people said.
Can you teach a computer to befriend a doctor and get illegal early access to drug trial results, har har har?
A dumb simplistic description of how machine learning works is that a computer shows a person a picture of a thing, and the person clicks "this thing is a dog" or "this thing is not a dog," and after the person has done that a few hundred times the computer will have figured out how to recognize pictures of dogs. Good job, computer.
A classic dumb simplistic description of machine learning in investing is something like: A computer looks at a state of the market last Monday, and then it looks at whether soybean prices went up on Tuesday, and after it has done that a few million times it will have figured out how to recognize opportunities to buy soybeans.
But I guess you could do it the other way? The computer shows human analysts pictures of states of the market, and the analysts click "this is a trade" or "this is not a trade," and after the analysts have done that a few hundred times the computer will have figured out how to recognize trades. That is: It will recognize good historical trades not from the fact that they made money, but from the fact that Steve Cohen liked them. That is a subtle but important difference. (Presumably all trades that Steve Cohen liked made money, but not all trades that made money pleased Steve Cohen.) Perhaps that way the computer will not only learn when prices go up, but will also acquire some of the gut instinct or market magic or je ne sais quoi of actual fundamental equity investors. Of course the real trick is to get computers who are better than the humans, not to replicate them exactly.
Then there's this boring complaint:
“The risk of automation is that the programs could go haywire,” said Jason Kennedy, founder of London recruitment firm Kennedy Associates, which places portfolio managers and analysts at hedge funds. “When you have one computer playing against another, you could end up with something resembling the flash crash.”
Sure, whatever. But that complaint mostly applies if the computers are all looking for the same signals. If you have one computer playing at being Steve Cohen, and another computer playing at being Warren Buffett, then perhaps that risk is reduced?
Over the past twenty years, a growing number of empirical studies have provided evidence that governance arrangements protecting incumbents from removal promote managerial entrenchment, reducing firm value. As a result of these studies, “good” corporate governance is widely understood today as being about stronger shareholder rights.
But their findings are more nuanced:
In contrast to that approach’s assumption that any form of incumbent protection harms shareholders, we show that only protective arrangements that can be unilaterally adopted by directors—poison pills, golden parachutes, and supermajority requirements to amend the bylaws—are associated with decreased firm value and hence fit the entrenchment theory of incumbent protection. Conversely, protective arrangements that require shareholder approval—staggered boards, supermajority requirements to amend the charter and supermajority requirements to approve mergers—are associated with increased firm value.
Loosely: If managers and directors can entrench themselves, that's bad governance. If shareholders vote to entrench managers, that's fine. It may be aesthetically bad governance -- governance experts may dislike it -- but it creates positive value. Why?
We suggest that the constructive governance function of these bilateral arrangements is as devices that commit shareholders to preserve a board’s ability to pursue long-term strategies that maximize firm value. Absent such devices, shareholders have no basis on which to decide not to challenge the board or seek board removal, or dump their shares after a disappointing short-term outcome. This is because shareholders are unable to tell whether such an outcome is due to mismanagement or to the pursuit of a project whose value will not be realized until later, which leads to what we refer to as the shareholders’ “limited commitment problem.” In response to this problem, directors and managers may rationally favor short-term stock price gains over long-term cash flows.
This, to me, is the core interesting question in debates about corporate governance. Say an activist shareholder wants a company to do a stock buyback, while the company's chief executive officer wants to instead invest more in the company's, I don't know, edible drone initiative. The activist will say: The CEO is just entrenching himself, wasting shareholder money on low-return vanity projects just so he can justify a higher salary for himself. The CEO will say: The activist is just focused on the short term, pushing us to abandon high-return long-term projects just for a momentary pop in the stock price. This is a real tension! Sometimes managers want to hang on to shareholder money for dumb self-aggrandizement reasons; other times they want to hang on to it for long-term value creation. How do you decide which is which?
I am not sure there is an easy answer, but Cremers et al. suggest a plausible one, which is: Shareholders can decide. That is, they can decide in advance to trust managers, or not, and their decision provides some information. If they vote to allow a staggered board, it's because they trust the managers and don't want them to be easily displaced by a proxy fight. If they don't vote for a staggered board, but the board unilaterally puts in place a poison pill to fend off an activist shareholder, then that might suggest that the board is not acting in the long-term interests of the shareholders.
The extreme case is a company -- like Snap Inc. -- whose public shareholders don't get to vote. Of course, they chose that fate when they bought the stock. It is an extreme commitment device: If you are investing in Snap, you have to trust that its founders will "pursue long-term strategies that maximize firm value," because you never get to change your mind.
Super hedge fund!
Elsewhere in governance, there are some well-known issues with hedge fund activism as a corporate governance tool. Activists may not have the same aims and incentives as long-term institutional shareholders. And activists buy a chunk of a public company, agitate for changes, push up the value of the company -- and then have to share that value with the other freeloading public shareholders. Here is a blog post (and related article) by law professor Sharon Hannes, titled "Super Hedge Fund," that proposes a bizarre solution to those problems:
The super hedge fund would not really be a fund but, rather, a contractual arrangement among a broad group of institutional investors and a task force of financial experts. The task force would pool together the potency of the institutional shareholders in a sophisticated manner and then unleash its sting on target corporations.
Imagine that an organization gathers teams of experts to form independent task forces for each market sector or a well-defined group of corporations.
The institutions would jointly pay the experts' salaries, which "would enable each task force to search, within its mandate, for potential targets that may benefit from shareholders activism." When they find a target, they'll call capital from their institutional members -- "only from those institutional investors with shares in the target, pro rata to their holdings" -- and use it to do activism. It's a little like the existing informal concept of the "request for activist," where big institutional investors bring in activist hedge funds to shake up management at their portfolio companies, but much more formalized. In effect the institutions would jointly own the activist, fund its work, and share in the rewards.
We talk a lot around here about the theory that highly diversified mutual funds -- "quasi-indexers," in the lingo -- are or should be illegal under antitrust law. A lot of my readers find this theory absurd. Index funds are not, as the theory's proponents claim, "trusts in sheep's clothing," evil cartels that coordinate economic activity for their own enrichment at the expense of workers and consumers. Index funds aren't anything: They're the neutral background of finance, a transparent mechanism for the operation of the invisible hand of the market.
Obviously if you are worried about quasi-indexers as an antitrust problem, you should be really worried about broad coalitions of quasi-indexers coordinating a "super hedge fund" to monitor "each market sector" and demand changes at any company that displeases the investor coalition. But you shouldn't worry about it, because it will never happen, in part because U.S. laws (antitrust laws, sure, but also "group" rules under the securities laws) would prevent it.
The conclusion to draw from Hannes's article is not that "super hedge funds" are imminent, or a good idea. The deeper point is that this line of thinking -- that institutional shareholders all have common interests in the running of their portfolio companies, and should team up to enforce those interests -- is seductive, and not just to academics. ("The world’s largest asset managers have held secret summit meetings to hammer out proposals for improving public company governance to encourage longer-term investment," etc.) The "super hedge fund," as proposed, will never happen, but in a sense it already exists. And if there is a unitary class of diversified shareholder capitalists that collectively enforces its interests, and if those interests are sometimes in conflict with those of managers -- why couldn't they also sometimes be in conflict with the interests of workers and consumers?
A basic problem in mergers and acquisitions is: If, at some point during the many months between the signing of a merger agreement and the closing of the merger, the target turns out to be a terrible company, does the acquirer still have to buy it? The basic answer is "yes," but the formal answer is "no": Merger agreements have "material adverse effect" clauses providing that if the target turns out to be super terrible, the buyer doesn't have to close. But the standards for declaring an MAE are so high that buyers are rarely able to get out of deals, and then only after much risk, litigation and uncertainty.
As an allocation of risks, you can see why this happens. The target normally suffers far more from a failed deal than the acquirer does, so the target wants certainty more than the acquirer wants optionality. Still it seems like the wrong answer: After all, the target surely has more information about whether it is secretly terrible than the buyer does. The right answer is probably for the target to take the risk that it is secretly terrible, which will force it to disclose any secret terribleness to the buyer before the deal is signed.
Anyway here is Ronald Barusch on Abbott Laboratories' deal to buy Alere Inc., which is "no longer the company" Abbott thought it was. Barusch suggests that MAE clauses need to become a little more buyer-friendly to deal with this problem.
Todd David Alpert: not a Money Stuff reader.
Todd David Alpert was a security guard for a board member of H.J. Heinz Co. in 2013 when federal regulators say he received an email from his employer spelling out terms of an impending takeover of the food company.
Starting the following day, the Securities and Exchange Commission alleged that Alpert called his broker and bought Heinz shares and options. After the announcement that an investment group including Warren Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc. was buying Heinz, Alpert sold his position for a profit of $44,000.
This violates at least the first two laws of insider trading: Don't insider trade, and if you do insider trade, don't do it by buying short-dated out-of-the-money call options. I said the same thing yesterday about Nima Hedayati, and then foolishly went on to promulgate a Third Law of Insider Trading, "If you do insider trade, don't do it in your mother's account." I forgot that I already had a Third Law of Insider Trading, the straightforward "If you must insider trade, and you must do it by buying short-dated out-of-the-money call options in a merger target, at least don't text or e-mail about it." So the mother thing is really the Fourth Law. Once I get up to ten I will publish a pamphlet, but I am not sure that there are ten laws of insider trading. The first two are all that you really need to know; the first one would suffice in a pinch.
Anyway Todd Alpert! It does not quite rise to the level of a Fifth Law, but there is something a little off about being the board member of a public company and having an employee of an outside personal security company read your confidential emails? The SEC's complaint describes Alpert's role:
As a dispatcher for the Board Member and his family, Alpert worked in a security booth located on the Board Member's New York property and was involved in various aspects of the personal, day-to-day lives of the Board Member and the Board Member's family.
Among other things, Alpert's responsibilities included answering phone calls, receiving requests from the Board Member and his family, delegating tasks to other staff, and reviewing email messages sent to a designated email account (the "Security Email Account")
The board member "would forward emails to the Security Email Account so that the emails and any attachments could be printed by the dispatchers." I guess if you are the sort of person who has to employ a dispatcher to manage your personal security force, you are not the sort of person who prints your own emails. But then you gotta trust the dispatcher.
Elsewhere in insider trading, somehow I missed this case?
Schulman allegedly got drunk before sharing inside information about a planned M&A deal with a pal. Specifically, he told his friend and investment adviser Tibor Klein that his client King Pharmaceuticals was going to merge with Pfizer, using this hint: “It would be nice to be King for a day.”
That seems like worthy material for a Fifth Law, but what would it be? Don't insider trade drunk? Only insider trade drunk?
Happy bonus pool!
Good work everyone:
Wall Street’s bonus pool rose 2 percent to $23.9 billion in 2016, the first increase in three years, according to estimates by New York State Comptroller Thomas DiNapoli.
The bonus pool climbed as the industry added 3,800 jobs in New York City to reach 177,000, DiNapoli said Wednesday in a statement. The average bonus was up 1 percent to $138,210, and pretax profits from the broker-dealer operations of New York Stock Exchange member firms jumped 21 percent to $17.3 billion, the highest level in four years.
I joke a lot about financial-services companies being socialist collectives run for the benefit of their workers, but a 21 percent increase in profit and a 2 percent increase in bonuses suggests that the shareholders are getting the upper hand.
People are worried about unicorns.
Here is Robert Cyran on the prospects for unicorns after Snap Inc.'s successful-ish initial public offering:
Several are taking the public-market plunge. MuleSoft, a producer of software that allows companies to connect different applications, is the best of the lot. Underwriters estimate it is worth $2 billion.
I feel like there is a bit of a lowering of standards -- cryptozoological standards, not financial ones -- when a mule gets to be a unicorn. Meanwhile Snap's stock keeps going down and analysts keep hating it.
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