Fitbit, Quants and Uber
Last Friday, Robert Murray, a 24-year-old mechanical engineer from Chesapeake, Virginia, was arrested and charged with manipulating the stock of Fitbit Inc. Murray is not my first reader to be arrested for a financial crime. But as far as I know his is the first federal criminal complaint to mention specifically that he reads me:
Indeed, on or about November 8, 2016, the user of the ABM Account accessed a Bloomberg article entitled, "Avon Stockholders Can't Take a Joke." That article describes a May 14, 2015 Avon tender offer filed with EDGAR as a "transparent hoax."
That was me! ("The user of the ABM Account" was, allegedly, Murray.) He apparently enjoyed the Avon hoax story so much that he allegedly wrote his own sequel the very next day, filing a fake tender offer in the name of "ABM Capital LTD" to buy all of Fitbit at $12.50 per share. As a casual reader, however, he was unfamiliar with my warnings about not buying short-dated out-of-the-money call options when you have inside information about a takeover. (Or, in this case, a fake takeover.) So, according to the Securities and Exchange Commission:
On November 9, 2016, at approximately 11:16 a.m. Eastern Time, Murray purchased out-of-the-money call options for a total of 14,900 shares of Fitbit stock with strike prices of $8.50 and $9.00 per share. Murray spent $887 to purchase the options, which expired just two days later, on November 11, 2016. At the time, Fitbit stock was trading at approximately $8.46.
He filed the fake tender offer 23 minutes later. (But it "was immediately rejected by EDGAR because it contained an incorrect identification number for Fitbit," so he had to file a corrected one five minutes after that.) The stock promptly went up a little bit as people thought "ooh a tender" and then quickly thought "nah a fake tender." Murray waited a whole day to sell, but still managed to make some money:
On November 10, 2016, between approximately 11:10 a.m. and 11:13 a.m., Murray sold all of his Fitbit options, realizing a profit of approximately $3,118—a 351% gain in less than 24 hours.
If the price of Fitbit stock had climbed to the purported tender offer price in the false filing of $12.50 per share and Murray had been able to sell the options based on that price, his illicit profits would have been approximately $53,200.
You can feel the SEC stretching there. The stock often doesn't go all the way up to the tender price even in a real tender offer! The headline on the prosecutors' press release calls it a "$100 Million Market Manipulation Scheme," which is a bit more impressive than a "$3,118 market manipulation scheme," which is what Murray allegedly walked away with.
The lesson here is ... what is the lesson here? "This arrest proves that no matter how much thought goes into a devious scheme, you can never outsmart law enforcement," says a U.S. Postal Inspector, which seems a bit stronger than is justified by the evidence. Never, really? The thought that Murray allegedly put into his devious scheme seems to have consisted mainly of reading articles about previous schemes and deciding to hide his IP address. I submit to you that if your entire preparation for committing a crime consists of reading Money Stuff, maybe you shouldn't commit the crime. We have fun around here but, as I constantly remind you -- though I forgot to mention it in the article Murray read -- it is neither legal advice nor illegal advice. If I knew how to be a criminal mastermind, why would I be writing a newsletter? But I guess if you do get arrested for reading about something in Money Stuff and trying to re-create it, I'll mention you here. I hope that isn't tempting.
My favorite part of writing about finance is that almost nothing that happens is inherently dramatic. People sit at desks typing on computers and talking on phones. Sometimes they type big numbers on the computer, or say rude things into the phone, but essentially all of the drama is intellectual. With rare exceptions, swashbuckling hedge-fund managers don't actually swing over the gunwales to board hostile ships. What they do is try to understand the structures of human institutions -- economies, legal systems, corporations -- and use those structures to their advantage. The excitement comes from understanding the world; the suspense comes from not knowing whether their understanding is correct, at least until it is proved with money.
If you believe that finance is becoming increasingly quantitative, then this will only increase. Quantitative investing is more intellectually interesting than a guy in suspenders calling his buddies for stock tips. It requires math, for one thing, but it also seems to require philosophy; you need a more deeply grounded view of how the world works to do systematic quantitative investing than you do to buy a stock on a takeover rumor. But the guy in suspenders is at least wearing suspenders. He's working the phones, flattering his friends and abusing his enemies, creating a bit of human drama to go with his stock-picking. The quant funds do less of that. The computers abstract out most of the human drama and just quietly go about picking stocks. Their understanding of human behavior is statistical, not personal; they don't befriend corporate executives on the golf course to pump them for information, but they do notice that executives with low golf handicaps tend to produce lower stock returns.
Here's a Wall Street Journal article, the first in a series, about the rise of quantitative investing. One aspect of it that I particularly recommend to you is the photos, which were taken at an April networking event for quants in London. They are beautifully, perfectly, paradigmatically dull; a bunch of (mostly) men in collared shirts sitting on leather couches watching a slide presentation. There is a picture of a man looking at another man's business card. They look like they are pantomiming "do some business things." The future is so interesting, but nothing that is interesting about it can be observed by looking at the people doing it, these men and their couches.
Anyway right yeah quant is big now:
Point72 lost money in most of its traditional trading strategies last year, say people familiar with the results. The firm’s quant investors made about $500 million.
Matthew Granade, Point72’s chief market-intelligence officer, recently encouraged London School of Economics students to learn basic programming languages, like R and Python, to become more competitive when they graduate. Investors are shifting their preference from “artisan to engineer,” he said.
This seems like good advice, though remember there are trends in investing and programming languages and everything else. The only timeless wisdom is that if you want to work in finance, you should learn ancient Greek.
Elsewhere: "Hedge fund magnate Paul Tudor Jones has invested in a brace of artificial-intelligence powered 'quantitative' hedge funds," CargoMetrics and Numerai.
A lot of businesses act as middlemen between buyers and sellers. There are two basic ways to do this:
- Find buyers and sellers, connect them, and charge a fee.
- Find buyers and sellers, keep them apart, buy low from the sellers, sell high to the buyers, and keep the difference.
The advantage of the first model is that it is transparent: You figure out how much your services are worth, you tell people what you're going to charge for them, and then if they want the services they pay the price. People like transparency, and paying what they think is fair. The advantage of the second model is that it isn't transparent: The people paying you to be a middleman don't exactly know how much they're paying for your services. This is useful because people tend to distrust middlemen and not want to pay for their services; it is also useful because the difference between what the seller wants and what the buyer will pay is sometimes comically large and you can make a lot of money.
Here's a story about Uber:
On Friday, Uber acknowledged to drivers the discrepancy between their compensation and what riders pay. The new fare system is called “route-based pricing,” and it charges customers based on what it predicts they’re willing to pay. It’s a break from the past, when Uber calculated fares using a combination of mileage, time and multipliers based on geographic demand.
Daniel Graf, Uber’s head of product, said the company applies machine-learning techniques to estimate how much groups of customers are willing to shell out for a ride. Uber calculates riders’ propensity for paying a higher price for a particular route at a certain time of day. For instance, someone traveling from a wealthy neighborhood to another tony spot might be asked to pay more than another person heading to a poorer part of town, even if demand, traffic and distance are the same.
Uber has a model for figuring out how much it needs to pay drivers, and another model for figuring out how much it can get away with charging riders, and then it pockets the difference. (Its earlier model was to set the same price for drivers and passengers, and then charge a commission.) In a sense this is obviously the right thing to do! There is no necessary link between the driver model and the passenger model, no certainty that drivers will want more to drive in areas where passengers will pay more. (Maybe the reverse: If a fancy neighborhood is full of rich people, you can charge customers a lot to travel there; if it also has nice roads and lots of passengers, you can pay drivers less to drive there.) If there are willing drivers at the price it is willing to pay them, and willing passengers at the price it is willing to charge them, then the difference is in some economic sense the value that Uber is providing, so why shouldn't it charge that?
And yet, you know, it just seems unfriendly. The classic markup-based middleman has a business where the buyers and sellers don't meet: If you buy a bond, or a used car, from a dealer, you never meet the person who sold him that bond or car. (If you did you'd just buy the bond, or car, from the seller, and skip the dealer entirely.) Uber can't really avoid bringing the drivers and passengers together. The drivers have to drive the passengers, that is the point. If it is charging the passengers one price and paying the drivers another, eventually they will figure it out. Also, Felix Salmon notes: "I do think that it does bring Uber one step closer to being the drivers’ employer, since the drivers are effectively being paid a flat wage for generating a variable revenue stream."
You sometimes get the sense that people expect modern technology to cause the decline of the hidden-markup model of middleman activity, and the rise of the transparent-fee model. (Or a variant which goes: Find buyers and sellers, connect them, don't charge a fee, but sell ads on your website.) Technology can just build all-to-all platforms in which buyers and sellers can come together directly, without any centralized middleman who controls information flow and can charge large non-transparent markups. But in fact technology seems to cause middlemen to proliferate, and to profit from tiny advantages in information about where to find buyers and sellers. All-to-all electronic trading of stocks is dominated by high-frequency electronic market-makers. We have discussed Amazon/eBay arbitrage, in which middlemen buy from sellers on Amazon, sell to buyers on eBay, and keep the profits that come from the buyers and sellers not realizing that the other platforms have better prices. Uber started out charging commissions, but it seems to have realized that its value comes from its control of information, and that the way to make money with information is by charging markups.
Human stock-pickers are in low repute these days: The quants are on the rise, and even more importantly, indexing has taken over the world. Why trust the gut instinct of some individual human to pick the best stocks when you can just buy the entire index? So of course here is a profile of the human stock-picker who picks the stocks in the index: "David M. Blitzer leads the committee that determines the makeup of the S&P 500, which aims to include stocks that collectively reflect the U.S. economy." He wears a bow tie. Oh of course of course of course he's not just relying on his gut instinct; he's not just one man making arbitrary decisions. There's a rigorous repeatable process involved:
The silver-haired, bespectacled Mr. Blitzer says decisions aren’t arbitrary.
“It’s not a bunch of people sitting in a room throwing darts at the wall or flipping coins,” said Mr. Blitzer. “When it’s a big surprise and one of your colleagues writes, ‘I don’t know where they got that from,’ it doesn’t do any good for us,” he said. The committee has published its methodology, which includes considering factors like liquidity, a company’s profitability and market capitalization, he adds.
But, you know, your average active equity manager would say much the same thing. Active equity management isn't dead yet, but surely no one is advertising an active fund by saying "oh right we are a bunch of people sitting in a room throwing darts actually." You need methodology, rigor, a committee, if you are going to compete in this index-driven world. And the guy making the index has those too.
Elsewhere in index funds, Rüdiger Fahlenbrach and Cornelius Schmidt find that passive owners make life easier for managers:
Using a sample of U.S. stocks from 1993–2010, we find evidence suggesting that corporate executives use the (index-reconstitution-driven) exogenous change in the shareholder base to influence corporate governance to advance their personal interests. We find that the power of CEOs increases in firms with more passive owners. The likelihood to become chairman or president increases significantly. While the fraction of independent board members does not change, we find that in firms with more passive investors, independent board turnover decreases so that directors serve longer terms.
We find strong evidence that the cumulative announcement returns to mergers and acquisitions decrease after exogenous increases in passive ownership and that the reduction of shareholder value is economically meaningful in dollar terms. In additional tests, we show that the same firms make worse M&A decisions after they experience an exogenous increase in passive ownership.
There is an intuitive story here: Index funds are more forgiving owners than active funds, because after all they can't sell the stock. So corporate executives take a few more liberties, giving themselves more power and making dumb acquisitions to expand their empires. This fits with at least one version of the theory that index funds undermine competition: Index funds don't tell the managers of the companies they own not to compete with each other, but they don't tell them to compete either, and the managers just get lazy.
It fits more awkwardly with another empirical finding, which is that higher index ownership increases shareholder activism, and makes activists more likely to be successful. But I suppose there's an intuitive story there too: Higher index ownership makes management complacent, which attracts activists to the stock. And the index funds are happy to support the activists, because they know that their approach makes managers complacent. They just can't do anything about it, except wait for the activists and then vote with them.
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