Money Stuff

Hedge-Fund Growth and Tax Arbitrage

Also activist shorts, Aramco and indexing, Fintech 101, volatility, unicorns and bond market liquidity.

Skin in the game.

Everyone knows the stereotypical way that hedge funds work: You start a little hedge fund, raise a little money, and go invest it in your best ideas. Those ideas do well and you have good returns. You then market your fund based on those returns, and raise a lot more money. Now you have a big hedge fund, and you invest it in your best ideas, but also your second- and third-best ideas, because there is no room in the best ideas for all the money. Then you have mediocre returns. This is fine for you, because you are getting paid management fees on all the money in your hedge fund, and getting paid 2 percent on billions of dollars is a perfectly fine way to make a living. It is less good for your investors, though: They wanted the good returns you used to get on the small amount of money, not the mediocre returns you now get on their big pile of money.

But of course you are also an investor. So there is a trade-off here: As a hedge-fund manager, you want to grow as much as possible, even by sacrificing performance, because that's how you get fees. As an investor in your own fund, though, you don't want to grow beyond your best ideas, the ones that actually make money. One might imagine a sort of inflection point, where managers who are mostly managers want to focus on growth, and managers who are also large investors in their own funds want to focus on returns.

Here is a delightful paper by Arpit Gupta of NYU Stern and Kunal Sachdeva of Columbia Business School confirming that intuition:

We find that funds with greater investment by insiders outperform funds with less "skin in the game" on a factor-adjusted basis; exhibit greater return persistence; and feature lower fund flow-performance sensitivities. These results suggest that managers earn outsize rents by operating trading strategies further from their capacity constraints when managing their own money.

The mechanism is exactly what you'd expect:

We find that funds with little inside capital operate according to standard Berk and Green (2004) logic: good returns are followed by large fund inflows, so there is little predictability in excess returns. However, we find that funds with greater inside investment do not follow this pattern. For this subset of funds, high returns do not lead to excess inflows; instead excess returns are persistent. The joint behavior between fund flows, performance, and inside investment suggests that capacity constraints are an important driver of hedge fund performance; and that managers of hedge funds choose to deploy less capital (and so gain greater alpha) when their own personal capital is involved.

They use a cutoff of 20 percent insider ownership, which seems to be about the average. Funds with less than 20 percent insider ownership tend to grow after having high excess returns, and then have worse returns; funds with more than 20 percent insider ownership tend to stay the same size, and continue to outperform. "Our findings have implications for optimal portfolio allocations of institutional investors," they say, but do they? The most important lesson is probably that you should invest with a hedge-fund manager who doesn't want your money, but that is hard to do.

Dividend arbitrage.

I just can't get that worked up about dividend arbitrage, which seems like a straightforward and not particularly exciting tax trade. You take shares with taxable dividends, park them with a non-taxable holder on the dividend day, avoid the tax and split the profits. Meh. It's just a bit crude; as an aesthetic matter I like my tax trades to be subtler and more complicated. And as a policy matter most people seem to dislike dividend arbitrage: Any tax trade that crude probably has no economic substance and should be shut down. So now it has been shut down in a lot of places, but for a long time it could be done legally in Germany, and banks did a lot of dividend-arbitrage trades there and saved billions of euros in taxes.

But lots of other people always seem to be getting worked up about German dividend arbitrage, and in that vein I give you "The Great Tax Robbery," a deep dive from Die Zeit about "how bankers, consultants, and lawyers have been plundering the German state for decades" using dividend arbitrage trades. (There is also a series of data visualizations.) It is full of the sort of color you expect to see in big stories about financial scandals, though even this color feels somehow a bit wan. Apparently a lot of dividend arbitrage trades -- called "cum-ex" trades, because someone has the shares cum dividends and someone else has them ex-dividends -- were concocted at the Cinnamon Club, a fancy Indian restaurant in London: 

The British trade register contains the address of a man who was "director" of the Cinnamon Club until 2015 and has attracted the attention of German state prosecutors: Paul Mora, a banker who is 1.90 meters tall and weighs 120 kilograms. He was charged with putting into practice what Mr. Berger conceived, introducing young traders to the cum-ex loge and carrying out the stock transactions. Traders called him the "man in short pants" because he likes to walk through London in Bermuda shorts and Hawaiian shirts. Other cum-ex traders also had nicknames. There’s the "gentleman," the "crazy guy" and the "autistic," who really is autistic and has named his yacht "Cum-Ex." They’re all part of a tiny circle of traders who moved billions.

Those nicknames ... they are fine? "What should we call the guy who wears shorts?" "The Man in Short Pants." "Great. What about the crazy guy?" "Let's call him the Crazy Guy." "Great, glad we've figured this all out, I'm off for a cruise on my yacht, Large Boat Purchased With The Proceeds of Tax Arbitrage." With an imagination like that, you too could structure dividend arbitrage trades.

Andrew Left. 

Here is a fun profile of Andrew Left, the activist short seller behind Citron Research, that sometimes seems to confuse "the world of finance" with "Twitter":

At 10 a.m., having placed his bet against the stock the night before, Left put out his first tweet, which he misspelled and deleted four times. Such is his mystique in the world of finance, however, that one of his followers assumed that the misspellings and deletions were part of a premeditated scheme to exploit Twitter’s visibility algorithms.

But that's fine, an important theme of modern life is the convergence of reality and Twitter. Left, for instance, uses his skill at Twitter to make real money; he shorts stocks, then tweets mean things about them, then they go down, even if his tweets have some errors:

In 15 minutes, $6 billion of market capitalization vanished. (Five months later, the stock price is still down 13 percent.) Left considered the circus around him. “See,” he said, “some guys know this stuff better than me. But I know how to put it in [expletive] tweets.”

I mean, that can get you elected president these days. 

The thesis of the profile is that Left is sort of operating as a journalist, though, as he says, "The difference between this and journalism is you can make millions of dollars." In the olden days, short sellers just shorted stock and stayed quiet. Then they started shorting stock and working with journalists to expose frauds at their targets. Now, "short-sellers of Left’s generation are following this example but cutting out the middleman," shorting stock and taking to Twitter to expose frauds in their own names. But "cutting out the middleman" isn't quite right either; Left is also taking over that role:

The man on the other end of the line was a hedge-fund manager, this one a very close associate of Left’s, at the center of his circle of sources. His relationship with Left was completely informal. His role was to trade ideas back and forth, sometimes shorting the companies they discussed. In exchange for sharing his insight and institutional muscle, Left’s source avoided the legal liability that came from going public with a position.

Why call a reporter to pitch a story that is helpful to your short thesis, when you can call Andrew Left? He has a lot more to gain from that pitch.

Aramco and indexing.

When I am trying to be contrarian, I sometimes like to say that it's weird that Uber Technologies Inc. isn't in the Standard & Poor's 500 index. Obviously this is absurd: The S&P is only open to companies that are listed on U.S. public stock exchanges, and Uber is not public. (Also the S&P requires GAAP profitability, but that is a minor quibble compared to the public listing thing.) But it is a very large-cap U.S. company, and many of its shares are owned by large U.S. mutual funds, and they trade in the secondary market. If you are an institutional asset manager and your mandate is to invest in large U.S. companies, then Uber could quite plausibly be on your list of potential investments. And if you are an institutional asset manager with a passive mandate to invest in all the large U.S. companies, then it might seem a little arbitrary to exclude Uber. It is a large U.S. company that you can invest in; why exclude it just because it's not in the S&P, or listed on an exchange, or whatever? I mean there are plenty of reasons not to invest in Uber, but by hypothesis you are not looking for reasons. You are just investing in "the market." But even so, you need to give some thought to exactly what "the market" is.

I am mostly just kidding about all of that, but meanwhile in London:

Saudi Aramco will not join the FTSE 100 stock index if it lists its shares in the UK, averting confrontation with City institutions and strengthening London’s status as frontrunner for a slice of the Saudi state oil group’s initial public offering.

"Concern has grown that a UK listing would mean the state oil company becoming a member of the FTSE 100 index, making an arm of the Saudi state an automatic holding for millions of pension funds," but that concern seems to have been averted. But imagine if Saudi Arabian Oil Co. does go public in the U.K. at some of the numbers that have been batted around, like a $2 trillion valuation and a 5 percent ($100 billion) free float. The combined market capitalization of the FTSE 100 is about 2 trillion pounds. If you are an investor who wants passive exposure to large-cap U.K.-listed companies -- if you just want to own "the market" -- it has to feel a little weird to exclude a U.K.-listed company that is as big as the rest of the market combined. 

Oh of course there are good reasons to keep Aramco out of the FTSE! (Such as the FTSE requirement that index companies have at least 25 percent free float.) But those reasons are choices; they are distinct from the classic passive-investor desire to avoid complexity and underperformance by just owning the whole market.

Blockchain blockchain blockchain.

The kids these days, they go to the business schools, and they say "blockchain!", and the business schools say "blockchain?", and the kids say "blockchain!", and the business schools say "block ... chain?", and this happens:

But the burgeoning industry is so diverse that academics said it is difficult to construct a syllabus for financial technology 101. There are no textbooks and few professors have fintech expertise.

"For fintech, some people mean bitcoin and cryptocurrencies; some people mean the technology JPMorgan uses for trading," said Angela Lee, Columbia Business School's chief innovation officer. "Everyone thinks it's sexy, and a lot of people use it colloquially without knowing what it is."

"Fintech" doesn't really seem like a coherent body of knowledge any more than, like, "Cool Finance Stuff" would be, but I guess you have to follow the trends. I think if I were a business school professor I would teach a course called Fintech 101, and people would show up on the first day and I'd be like "it's called Microsoft Excel, ever hear of it?" Actually no I am kidding, if I were a business school professor I would teach a course called "Cool Finance Stuff." There'd probably still be a blockchain unit, I'm sorry.

People are worried that people aren't worried enough.

Here are some people worrying about why volatility is so low and what will happen to it. The consensus in conversations like this always seems to be that low volatility now means that there will be high volatility later. "Whenever something is the new norm, I know it is about to change," says Chris Concannon of CBOE Holdings Inc. That is generally a safe thing to think about markets: This time is never different; human folly recurs endlessly. But it is often more interesting to think about why today's low volatility really might be a new normal, an evolution in financial markets rather than just a low point in a cycle. Here is Nicholas Colas of Convergex:

“Think of the self-driving car market,” he suggested. “A person can drive a car pretty well with fairly low error rates and a human-dominated market can do the same. As you infuse artificial intelligence and information into a bigger algorithm to drive market and asset prices, volatility should collapse over the next two, three, four, 10, or 20 years in the same way self-driving cars have fewer crashes than those driven by humans.”

Maybe that is wrong and naive, but in some sense shouldn't it be right? We tend to expect progress in most technological and scientific domains: Over time, people are supposed to learn stuff and improve their performance. Cars really do get safer over time. Shouldn't markets get more efficient?

People are worried about unicorns.

The main unicorn worry these days always seems to be about Uber Technologies Inc. Today it's about how Uber, a giant mature multinational company, still seems to operate on the rather casual standards of the rest of the Enchanted Forest:

Key unfilled positions include chief operating officer, chief financial officer, chief marketing officer and general counsel — an astonishing list for a company that has more than $7bn in annual revenues and which was valued at $68bn by investors last year.

When Snap Inc. issued nonvoting stock in its initial public offering so that its charismatic founders could retain control even while raising money from the public, I assumed that would set a precedent for other big unicorns to limit shareholder control, a precedent that would only be reversed when something went wrong: Eventually some unicorn with a charismatic founder will go public with terrible shareholder rights, and get in trouble, and the shareholders will have no recourse, and they will learn a lesson and refuse to let future unicorns get away with nonvoting stock. But I guess there are other things that might cause investors to push back. If Uber went public tomorrow, would you buy nonvoting stock that would let Travis Kalanick keep unilateral control forever?

People are worried about bond market liquidity.

My Bloomberg Gadfly colleague Lisa Abramowicz, who has been worrying about bond market liquidity for years, wonders what took the Trump administration so long:

It's almost antiquated that newly minted regulators are ramping up their bond-market liquidity worries now.

Traders already spent years fretting about a logjam in debt markets, back in 2013, 2014 and 2015. But many people have tired of thinking about it, especially because trading volumes have generally been increasing and Wall Street firms are profiting.

"When a man is tired of thinking about bond market liquidity, he is tired of life," Johnson almost said, but this seems right:

Regardless of how substantial bond-market liquidity threats are to financial stability, this study is years too late. At this point, banks and investors have generally adapted to the current environment. To the extent traders are still concerned, they hold more cash, use derivatives, turn to electronic-trading systems or plan to hold assets for longer. To the extent banks lament the fat profits of yore, they've jettisoned traders accustomed to multimillion-dollar bonuses and changed the way they do business to match buyers and sellers.

The Volcker Rule, for instance, is probably not a switch that can be turned on and off at will: Once you fire all your proprietary risk-takers, it's not so easy to start taking proprietary risk again just because the regulators let you. And the old-fashioned model in which banks step in to take on a lot of risk whenever the rest of the market panics, which was not all that true to begin with, will be hard to revive no matter how favorable the regulatory environment is. Equity markets moved pretty far away from that model long before the Volcker Rule.

Elsewhere, here is Darrell Duffie of Stanford University arguing "that one particular regulation, the leverage-ratio rule, has inefficiently distorted dealer incentives for market making and that its financial-stability benefits could be achieved more effectively with risk-weighted capital requirements." And Goldman Sachs Group Inc. is launching an exchange-traded fund for investment-grade bonds.

Things happen.

JPMorgan Loses Another Potential Dimon Heir as Zames Walks. Emergency funds failed to save Banco Popular from death spiral. House Passes Bill Rolling Back Wall Street Rules. Yahoo Stockholders Approve Sale of Yahoo’s Operating Business to Verizon. ISDA asked to consider alleged Venezuela Russian loan default. Toshiba Unaware Its Nuclear Unit Was Preparing for Bankruptcy, Timeline Shows. Hedge Fund Looks to Shake Up BHP Billiton’s Board. Deutsche Bank Won’t Disclose Trump Dealings Citing Privacy. Trump Picks Scaramucci to Be Ambassador to OECD, Sources Say. Fintech Company Raises $300 Million to Help Businesses Stop Using Checks. Small is lucrative for Wachtell, corporate America's legal defense force. "I’m not going to stop working hard until I get to this point where I can travel around the world, until I can jump into a pool with all these different currencies like Scrooge McDuck." Police dog fired for being too nice.

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    Matt Levine at mlevine51@bloomberg.net

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