Active Management and Insider Trading
Here is a story about whether Capital Group can win its "epochal battle against the rise of passive investing":
That is why the company has ripped up a decades-old policy of operating in relative anonymity and is advancing new research that aims to destroy the “myth” that active management is doomed. “I feel we’re yelling from the top of a mountain, and no one is listening,” Mr Armour says. “Passive is here to stay, and it’s an important option. But we are better than passive.”
There are two aspects to this story. One is a mushy story of, essentially, advertising: marketing pitches, fickle investor preferences, Trump-driven volatility, recharacterizing distribution fees as brokerage commissions, yelling from mountains, etc. Will Capital's advertising work? I don't know.
But the other aspect is simpler and less mushy. A central fact of markets is that "after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar." There are some caveats, but this is basically a matter of arithmetic, and doesn't rely on any assumptions about market efficiency.
But that is not in itself a reason to choose passive management. You could just invest in an above-average active fund, and still do better than passive funds after costs. The problem is not just that the average active fund will underperform the average passive fund, but also that it's very hard to tell in advance which active funds will outperform: Most top funds one year aren't top funds the next. So how can you pick one that will be? The trick for an active manager who wants to be successful in this age of skeptical and scientific investing is to have a compelling answer to that question: not blather about its tradition of stewardship or its commitment to investors, but rather to lay out a set of objectively observable criteria for how to pick an active fund, show that those criteria repeatably predict outperformance, and show that it meets those criteria. And Capital ... kind of does that?
Capital’s analysis of historic fund performance — research that has been corroborated by Morningstar, an industry data provider — has shown that two factors are strong indicators of long-term, market-beating returns: fund managers having plenty of their own money in a fund; and low fees. Capital scores well on both measures.
These criteria strike me as surprisingly underpowered -- are there really a lot of mutual fund managers who don't put their own money in their funds? -- but they apparently work.
A popular approach for active managers these days is to try to speak the language of passive management. (An alternative approach -- to distinguish yourself from passive management and "closet indexing" by focusing only on a few high-conviction trades -- is also popular, though Capital rejects it.) Often the way to do this is sort of cheap and superficial: You hand-pick a list of stocks, call it an index, and call yourself an index fund. (Or, even better, an exchange-traded fund.) You're still picking the stocks based on gut instinct, and you're still charging active-ish fees, but the words "index" and "ETF" soothe investors who know that they're supposed to invest in passive funds. Capital's approach -- to charge low fees, for one thing, but also to meet the main statistical arguments for passive investing head-on -- seems a bit more honest.
Leon Cooperman is fighting civil insider trading charges, and I'm sort of impressed that his lawyers are really pinning their hopes on this theory:
Cooperman was under no obligation to refrain from trading following his calls with the executive because any purported promise he made came after he had already received the information.
“You may have broken your promise not to trade, but you haven’t misappropriated," Daniel Kramer, a lawyer for Cooperman, said during the hearing. “Not every broken promise is fraud.”
Cooperman, remember, had a bunch of conversations with an executive at Atlas Pipeline Partners L.P., and then traded Atlas stock, bonds and options. Cooperman has claimed publicly that he talks to corporate managers all the time, that he always asks them not to give him any material nonpublic information, that he did so in this case, and that the executive promised not to -- and didn't -- give him any material nonpublic information. The Securities and Exchange Commission claims that the executive gave Cooperman material nonpublic information in several conversations, and then at some point in one of the later conversations, long after giving Cooperman the information, said "oh hey you're not going to trade on this are you?" (And he said no.)
Without seeing any of the evidence in the case, I find Cooperman's story much more plausible. Hedge fund managers really do call up corporate executives and say "don't lock me up" before talking. Corporate executives don't usually say "oh hey by the way you're locked up" after talking. And when they do lock up investors by giving them material nonpublic information, they tend to confirm that in writing. If it comes down to a he-said/he-said dispute about who promised whom what, Cooperman really ought to win. And there is precedent for the SEC losing a trial like that, in its case against Mark Cuban.
But Cooperman's lawyers, understandably, don't want to have that trial: They argue that even if the SEC's story is right, that's still not illegal insider trading, because Cooperman didn't promise not to trade until after he already had the information (but before he traded). It sounds pretty goofy, but you can sort of see where it comes from. I often say that insider trading law is not really about fairness, but about theft. Atlas owned its corporate information, and it would be insider trading for Cooperman to steal that information for his own ends -- but it would be perfectly fine (for Cooperman) if Atlas gave that information to him freely. If you really think about insider trading that way, then Cooperman's theory has an appeal. If you reach into my wallet and take out $20 while I'm not looking, then that's theft. But if I give you $20, and then later I say to you "you're going to give the $20 back, right?" and you say "sure," and you don't, then you haven't exactly stolen the money. (Picky lawyers might even say that your promise to give it back had no consideration and isn't binding.)
I don't think that insider trading law quite works that way, but however it works is pretty weird. I mean, here's how the SEC thinks it works:
Bridget Fitzpatrick, a lawyer for the SEC, urged Sanchez to let the case proceed to trial. Cooperman, she said, was pursuing an “astounding theory” and attempting to create a “new loophole” in securities laws by claiming he had no duty to refrain from trading after his calls with the insider. Cooperman could have told the insider he intended to trade but chose not to, Fitzpatrick said.
Got that? The SEC's theory is that if an executive gives material nonpublic information to a shareholder, and then asks the shareholder not to trade on it, and the shareholder says "nah I'd rather trade," that's fine. That's the SEC's theory.
Elsewhere in insider trading, "There Are No Perry Mason Moments in Insider Trading Cases." And lawyers for Billy Walters can ask a key witness in the insider trading case against him if news articles based on leaks from the FBI influenced his decision to cooperate with the government.
For the last couple of weeks it's been pretty easy to find articles to the effect of "N equity research analysts cover Snap Inc., and none of them have buy ratings," with N slowly ticking up and the number of buy ratings stubbornly stuck at zero. Not any more! "James Cakmak at Monness, Crespi, Hardt & Co. appears to the be first Wall Street analyst to slap a 'buy' rating on the company that owns the disappearing-message app, Snapchat." N is now 12. I see six sells, five holds and that one lonely buy.
It's widely assumed that that will change when the analysts at some of the 26 banks who did Snap's initial public offering publish their own reports in the next few weeks. (Rules restrict them from publishing for a while after the IPO.) And when that happens, if a lot of them have buy recommendations, there will be a round of cynical groaning about analyst conflicts of interest. It's quite a coincidence, people will say, that the general consensus among disinterested outside analysts is that Snap is a sell, while the analysts whose banks got big checks from Snap think it's a buy.
But one thing that I like to think about research analysts is that they have conflicts, sure, but their key conflicts aren't conflicts of interest. I assume that most research analysts genuinely want to do right by their investor clients, rather than just abusing them to win investment banking business. But doing right by their investor clients isn't quite the same thing as only publishing research reports whose headline buy/sell/hold recommendations match your deepest convictions. We've talked a lot about the fact that giving a mediocre company a buy rating can be good for your investing clients, because it can help you help them get access to the company's management, which they might very plausibly value more than an accurate buy/sell/hold recommendation.
But there's an even simpler dumber conflict: Giving a mediocre company a buy rating can be good for your investing clients, if they own the stock. If no one owns Snap -- if, say, it's a private company coming to market for the first time -- and your clients come to you to ask if they should buy it, you should tell them what you think. But Snap has already had an enormously hyped IPO. If you are publishing a research report weeks later, you know that a bunch of your investor clients bought Snap in the IPO. You know others were pitched the stock in the IPO, and didn't buy, and presumably won't now. Putting a buy rating on the stock will help the former group (the stock will go up!), without much hurting the latter group (what do they care?). Might you be tempted to be bullish, not to win investment banking business (the check for the IPO already cleared!) but just to help the investor clients you're supposed to help?
This is kind of weird:
Using a novel, proprietary database of micro-level trading activities by asset managers, we show strong evidence of asset managers engaging in strategic trading to cloak their most valuable trades. This takes the form, for instance, of a manager who sells her entire position of Microsoft on March 30, and then repurchases to re-establish the same position on April 1. This manager will be holding economically the same position throughout, yet without having to publicly signal this position. These cloaked trades earn an abnormal return of 370 basis points in the following month, or more than 36 percent per year. We further show that the same managers do not engage in such information-rich cloaked trading around other month ends (non-reporting months), nor in institutional accounts (that are not subject to the reporting requirements) at the exact same quarter-end dates.
That's from this paper by Lauren Cohen, Dong Lou and Christopher Malloy. They find a lot of cloaked trades: In a data set based on just 67 mutual funds, they find an average of 64 cloaked trades (defined as when a mutual fund sells a stock in the five days before a quarter end, and buys at least half of that stock back in the five days after the quarter end, or vice versa) per quarter, with an average size of $8.4 million.
Intuitively, the point of the cloaking seems to be that if you are a mutual fund, and you decide on March 15 to buy Microsoft stock, and on March 29 you haven't yet bought the full size you want, and you report the position on a Form 13F at the end of the quarter, everyone will see that you're buying Microsoft stock, and will run out and buy it too, pushing up the price for you. ("With frequent (e.g., continuous) portfolio disclosure, a fund that conducts costly research effectively has to fully disclose its information; all other investors, who do not pay the cost, can free-ride on the fund's research and perform just as well.") So instead you dump the stock, report no ownership, and buy it back in April to silently get to your full size.
Importantly, these cloaked trades continue to accrue returns over the next quarter, and the returns never reverse. This implies that the information that managers intend to cloak through their trading is fundamentally important information that gradually does get incorporated into firm value. We also show that managers continue to significantly build and grow their positions over the quarter after cloaking the trade, and the result is a significantly larger position than pre-cloaking (i.e., end-of-quarter reporting). Thus, the incentive to cloak is compatible with plans to build larger positions and is a critical piece of the cloaked trading thesis.
I guess? It seems a little inefficient to build up a Microsoft position in March only to sell it at the end of the month and buy it back again in April. Also: The 13F deadline is 45 days after the quarter end. So if you start buying on March 15, you don't have 15 days to build your position before you have to disclose it; you have 60. Seems like that would give you plenty of time to build the position?
I love this interview with Arturo Di Modica, the guy who sculpted the "Charging Bull" statute in Bowling Green Park. For one thing, you probably knew the back story of the "Charging Bull," but I did not, and it's pretty wild:
Di Modica cast the bull as a gift to the city following the 1987 stock-market crash, believing the 7,100-pound symbol of virility would be an antidote to New York’s flaccid, Low-T economy. He spent $350,000 of his own money and then dropped the bull right in front of the New York Stock Exchange (without permission) in December 1989.
But Di Modica does not like the "Fearless Girl" sculpture that is now facing down his bull:
“That is not a symbol! That’s an advertising trick,” the 76-year-old Sicilian immigrant said, clutching his heart.
Well he is not entirely wrong. "Fearless Girl" was commissioned by State Street Global Advisors as part of an advertising campaign and gender-diversity initiative. There is something pleasing about the fact that the Charging Bull, a global symbol of rapacious financial capitalism, is a piece of guerrilla art installed without payment or permission -- while the Fearless Girl, an egalitarian symbol meant to challenge the bull's soulless greed, is a piece of corporate advertising commissioned by an asset-management company.
People are worried about covered interest parity.
John Cochrane is puzzled by failures in covered interest parity:
Still, why not start a money market fund to give greater returns by going the long end of the arbitrage? Alas there are regulatory barriers here too, as even a riskless arbitrage fund can no longer promise a riskless return.
These are the remaining questions. The episode in the end paints, to me, not so much the standard picture of limits to arbitrage. It paints a picture of an industry cartelized by regulation, keeping out new entrants.
People are worried about unicorns.
Business is booming at the unicorn glue factory, according to this TechCrunch interview with Marty Pichinson of Sherwood Partners, which liquidates assets for failed startups:
MP: We’re seeing two to four companies wind-down a week, which we’ve never seen before. I think more [investors] are taking the Sequoia Capital approach, meaning if something isn’t working, they’re moving on.
TC: Haven’t they always?
MP: It’s happening faster right now. Microsoft and Intel and Facebook and Google and Apple — they own all the territory and they aren’t going away, so it’s more difficult to be the same type of company as another, but with a slightly different twist. For these companies, it’s great if someone else wants to develop a new feature or tool; they’re just going to fix that in the next version [of their own offerings].
Elsewhere, I don't know if Thinx is a unicorn, but now there is a sexual harassment complaint against its founder Miki Agrawal. And: "Here's Proof Your Startup Needs HR." And: "This Louis Vuitton Sneaker Is Silicon Valley’s Latest Status Symbol."
People are worried about bond market liquidity.
Here you go:
Blackstone, the world’s biggest alternative asset manager, just closed a $3 billion distressed-debt hedge fund that allowed periodic withdrawals. It gave clients the option to transfer their money to Blackstone funds that lock up capital for longer periods.
The longer-lockup funds have performed a lot better. "Many investors have sacrificed returns for liquidity," writes my Bloomberg Gadfly colleague Lisa Abramowicz, "perhaps more than they realize."
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