Money Stuff

Indexing, Boredom and Butter

Also orphan CDS, prime brokerage leakage, crisis flashbacks and a unicorn index.

Indexing, quants, etc.

Here is an intriguing opinion article from Paul Woolley and Dimitri Vayanos arguing that "Action must be taken to stop quants exploiting weakness." The thesis is that quantitative funds rely on either value (buying underpriced stocks) or momentum (buying overpriced stocks and then selling them at even higher prices), and that in either case they need some sucker on the other side of the trade. And "logic suggests that benchmarkers are the 'patsies' that fulfil this role": Index funds and quasi-indexers are obliged "to chase bubbles, overpaying for high-risk stocks they do not like and selling low-risk ones they do like." The quant funds profit from exploiting these predictable behaviors by indexers:

When pension trustees hire quant managers or private investors buy mutual funds specialising in momentum, they are fuelling strategies that feed off the opportunities created by the benchmarked funds that they may also employ.

Investors are hiring managers to engage in damaging battles with each other, in which the managers with their hefty fees are the guaranteed winners. 

I like to consider myself a bit of a connoisseur of the arguments against index funds, but I had never seen quite this argument before. One argument against indexing that you sometimes see is that it makes life too difficult for value investors: As money pours into index funds, it constantly props up overvalued stocks and keeps prices divorced from fundamentals. You sometimes see the opposite argument -- that more indexing means less competition to spot value, making life easier for value investors -- but it is usually phrased as a good thing. But Woolley and Vayanos's argument is that indexing makes life too easy for value investors: Indexers buy stocks dumbly without regard for value, which makes it easy for value investors to profit, which leads to "an unsavoury cocktail of asset mispricing, bubbles and crashes, secular over-pricing and the inversion of risk and return."

Of course, so what? "The whole is a chronically unstable system and the very opposite of the picture of efficiency painted by standard finance theory," they write, but actually it sounds very much like the picture of efficiency painted by standard finance theory. It seems fairly standard to say that some people are wrong about stocks, and so prices become wrong, and so other people who are right about stocks step in to buy the underpriced stocks and sell the overpriced ones until prices become right again. "Chronically unstable" sounds like another way of saying "self-stabilizing."

Elsewhere in blaming index funds, my Bloomberg View colleague Noah Smith has jumped into the "should index funds be illegal" debate. And elsewhere in blaming quant funds, oil traders "say program trading is distorting the market, often causing shallow price drops to accelerate." Also: "Quant Funds That Chase Trends Are This Year's Biggest Losers." I guess they are chasing the trend of losing money, har har har.

It's boring.

Here is a funny story about priorities. This is apparently bad: 

One bond trader says he’s been slipping out early to watch his kids play sports. A fund manager says his office just staged a golf retreat. A trading supervisor at another bank confides he’s swiping through a lot of profiles on Tinder, the dating app.

I mean, sure, Tinder is a nihilistic horror, and so is golf, and maybe that guy's kids are bad at sports, but all in all that sounds nice. But of course bond traders are pursuing their hobbies and social and family lives because they don't have enough work to do, and not enough work translates into not enough revenue, and not enough revenue is bad. "Analysts estimate the five largest firms will say their combined revenue from trading dropped 11 percent from a year earlier to $18.4 billion -- the smallest haul for a second quarter since 2012." 

But you know what would help a little? "Traders need a major overhaul of U.S. regulations, a significant shift in fiscal or monetary policy, or some other surprise to trigger sustained investor action." The actual nature of the surprise doesn't matter that much: Banks are in the moving business, not the storage business, and so anything that shakes things up and moves prices is helpful for revenue. 

But even an escalation -- or resolution -- of tensions with North Korea, or a terrorist attack, would probably only spur a “a very short and temporary impact,” Compass Point Research & Trading bank analyst Charles Peabody said.

You can ... sort of ... see why ... people don't like Wall Street, right? The framing here is basically "boy I hope there is a terrorist attack so I can spend less time with my children."


Ahahahaha Pablo Salame, the co-head of trading at Goldman Sachs Group Inc., is mad about losing market share, so now there are hats:

Too often top clients are confronted with a tangle of fees from disparate desks that don’t work together, or they’re snubbed entirely attempting transactions deemed too small by a misguided trader, Salame, 51, told the gathering, one of the people said.

He said he was tired of losing. In an impassioned speech, Salame likened the problem to a regular at a restaurant who asks for butter on his steak, only to be rebuffed by penny-pinching chefs in the kitchen.

“Just add butter!” Salame implored his team.

The three-word slogan quickly became both a rallying cry and an internal joke, and blue baseball caps emblazoned with the phrase in white lettering were passed around.

Disclosure: I used to work at Goldman, and I enjoyed the picture that Bloomberg tweeted with this story, of a steak covered with a gigantic pat of herb butter. It is a nice metaphor for what I remember as being the Goldman approach:

Customer: I would like some butter on my steak please.
Trader: Well.
Senior executive: Just put butter on the steak, come on.
Trader: We have added a slab of artisanal hand-churned compound truffle butter to your steak.
Customer: Uh. Thanks.
Trader: There will be a $12 supplement.

Goldman will make you a fancy thing, but you will pay for it.

Orphan CDS!

Ah yes:

Bankers and investors said that the group of credit-focused hedge funds have sold a large amount of contracts and received a premium for insuring outstanding debt issued by Matalan. This leaves the funds at risk of having to pay buyers of the contracts out, should the retailer fail.

However, the hedge funds that have sold CDS have offered to fully support a new bond issue from Matalan, so long as the company issues the debt out of a new entity. This process “orphans” existing CDS contracts written against the old entity, making them essentially worthless as they no longer reference any debt.

There have been enough stories like this, by now, that if you buy credit default swaps you should expect a little gamesmanship. But there is a natural limit on the gamesmanship here. If you are a hedge fund that has sold CDS on Matalan Plc, then you are at risk of having to pay out if Matalan defaults, and so it makes sense for you to offer this refinancing-and-orphaning plan that will render the CDS contracts worthless. But! If you do it by actually lending Matalan money, then you still have a risk of losing your money if Matalan defaults. You have transformed your synthetic Matalan exposure (CDS) into actual Matalan exposure (loans). It's not exactly a windfall profit for you; it's more just turning your financial exposure to Matalan into actual money for Matalan. And because there's no windfall, you can't necessarily offer especially attractive terms: "Two of the people familiar with the trade said Matalan’s senior management were unlikely to accept the hedge funds’ gambit."

On the other hand, if it does work, nobody has much cause to complain: People who bought old Matalan bonds and hedged with CDS will get their old bonds paid off, which is what they wanted. People who didn't buy old Matalan bonds, and who bought CDS just for a naked bet against the credit, will lose out, but you can't really say that they're losing out unfairly. If you're betting that a company will default, one risk that you take is that its current lenders won't let it default, and will extend new financing to keep it alive. That's what's being proposed here, except that instead of Matalan's current actual lenders offering new financing, it's the current CDS writers.

Information leakage.

I don't know, what do you make of this:

We document a channel of information flow from prime brokers to their hedge fund clients. We examine whether hedge funds make informed trades on the stocks of firms to which their prime broker’s affiliated bank initiates a syndicated loan. We find that these connected hedge funds make abnormally large trades in quarters prior to loan announcement, compared to their own trades in other stocks or to the trades in the borrowing firm’ stock by unconnected hedge funds. More importantly, we find that the connected hedge funds’ trades outperform other trades by 2.1%–4.0% on an annualized basis. Lastly, the outperformance is stronger for hedge funds that can generate more revenue for their prime broker.

That's from a paper by Nitish Kumar, Kevin Mullally, Sugata Ray and Yuehua Tang, and I guess there is a bit of a genre recently of papers documenting information leakage from brokers to clients. (We've talked twice before about a paper by Marco Di Maggio, Francesco Franzoni, Amir Kermani and Carlo Sommavilla finding that brokers leak information about client trades to other clients.) The syndicated lending/prime brokerage link is a weird one, though. Those activities are far enough removed from each other that it's just sort of hard to imagine the prime-brokerage person sitting down with the syndicated-loan person over lunch and being like "so got any loans coming up that I should tell my hedge-fund clients about?" I don't know. But there is "abnormal trading activity" by hedge funds in their prime brokers' loan clients, and that trading is profitable.

Elsewhere in academic papers, I enjoyed this title/subtitle combination: "How Soon Is Now? Evidence of Present Bias from Convex Time Budget Experiments." 

Crisis flashback.

Ten years ago yesterday, Standard & Poor's put some mortgage bonds on watch for downgrade, and then the financial crisis happened. I mean, eventually. But "from that day onward, even the most cautiously optimistic economist or sanguine Federal Reserve governor should have known that the housing mess and the subprime debacle wasn’t going to be contained," says this Bloomberg article, "the first in a series of stories looking back at the events of the global financial crisis 10 years ago." Doesn't it feel like just yesterday? My own memories of the financial crisis are inextricably bound up with the fact that I started work at an investment bank the previous week: My first day at Goldman Sachs Group Inc. was July 2, 2007, and eight days later S&P downgraded those bonds in what I guess is as good a starting gun for the financial crisis as anything else. I like to think that I am somehow responsible. Anyway, I look forward to the next 14 months of crisis decennial commemoration, which will culminate in September 2018, the 10-year anniversary of that time I went on vacation for a week.

Blockchain blockchain blockchain.

I am starting to think that the right way to think about blockchain and cryptocurrencies and tokens might be the way you'd think about stocks, if stocks had just been invented. Here in 2017, it is uncontroversial to say that the invention of limited-liability joint stock companies utterly changed how humans organized their economic activities, and had huge impacts on economic productivity and on society as a whole. But it is also fair to say that the first few hundred years of stocks were mostly fraud and irrational speculation. Similarly with cryptocurrencies and initial coin offerings, it is possible both that proponents' grandiose claims about how they will transform finance and society will turn out to be true, and that most crypto stuff in our lifetimes will be nonsense.

Anyway: "Swiss city of Zug to offer blockchain-based digital identity to residents." And here is Fred Wilson on tokens as a financing model:

The crypto playbook is a disruptive one. It is not a new way to raise money. It is a new way to architect a business. The profit motive is flipped upside down. You extract profits with your currency, not your business model.

And here's a story about someone with a lot of ether:

An unknown cryptocurrency trader turned $55 million of paper wealth into $283 million in just over a month.

The only clue about this person or persons, beyond a virtual wallet with the identification code 0x00A651D43B6e209F5Ada45A35F92EFC0De3A5184, surfaced on a June 11 Instagram posting, in Bahasa, in which he or she (or they) (or somebody posing as them) boasted about the 413 percent profit accumulated earlier this year from ether, the digital money of the Ethereum blockchain.

And: "Smart contracts will need human juries." And: "Chief of bitcoin exchange Mt. Gox denies embezzlement as trial opens." And: "Will Bitcoin Tear Itself Apart?"

People are worried that people aren't worried enough.

I don't know exactly which recurring section "Death-of-Bond-Market Concern Means It's Time to Buy, Peters Says" fits into, but it sure seems like the sort of thing that goes around here somewhere. People are worried that people aren't worried enough? People are unworried because people are worried enough? People are worried about bond market liquidity, or unworried about bond market liquidity, or unworried because of worries about bond market liquidity? "We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be," Keynes said, and I suppose there is a similar game with the worrying.

People are worried about unicorns.

Oh hey it's a unicorn index:

SharesPost Research LLC, a wholly-owned subsidiary of SharesPost, Inc., a leading liquidity provider to the Private Technology Growth asset category, today launched the U.S. Private Growth Index (“the Index”) to measure the quarterly performance of leading private growth companies.

Here is the white paper. In back-testing, or back-indexing or whatever you call it, the index is up 74.8 percent from January 2015 through March 2017, much better than the S&P 500, which I guess retroactively justifies why so many public mutual funds have gotten into the unicorn investing game over the last few years.

In worse unicorn news, my Bloomberg Gadfly colleague Shira Ovide is worried about pipes clogged with unicorns, which require very specialized plumbing skills:

The math simply doesn't work to arrive at a happy ending. If last year's rate holds at $50 billion worth of startup acquisitions plus initial public offerings, it would take 14 years to clear the clog of unicorns from Silicon Valley's plumbing.

The bull case here is something like "nah, they can just stay private forever; private markets are the new public markets and early investors can get liquidity without an IPO by selling to mutual funds," but it is hard to entirely believe that. And in more bad unicorn news, "the Trump administration said it plans to rescind an Obama-era program that would allow foreign entrepreneurs who launch startup companies in the U.S. to live in the country." And: "Snap Shares Fall Below IPO Price for First Time."

Food Stuff.

"London restaurant Dirty Bones is lending diners 'Instagram kits' to better photograph their meals," it says here, and I know they are doing this to get a reaction from people like me, so I will just let it go, difficult though that is.

Things happen.

Trump to Nominate Randal Quarles as Fed Bank Regulator. U.S. Agency Moves to Allow Class-Action Lawsuits Against Financial Firms. Prime money market funds are back. Ford commercial paper is back. Elliott Set to Duel Berkshire for Energy Future’s Oncor. Warren Buffett’s Berkshire Moves Away From Stock Picking. "Alliance Bernstein LP’s sell-side unit has quoted smaller firms about $150,000 a year for two or more fund managers to access analyst reports and other basic services," though presumably the research about index funds and Marxism is shared to each according to their needs. 26-Year-Old’s Stock-Picking Game Acquired By News Network Cheddar. UK lawyers rush to register in Ireland to ease Brexit fears. Goldman Was Vilified in Venezuela for Something Big Oil Does Every Day. Traders Gobble Up Wheat Amid Great Plains Drought. Shkreli Investor Pleaded for Money Back But Got the ‘Run Around.’ Jared Kushner Tried and Failed to Get a Half-Billion-Dollar Bailout from Qatar. Happy Prime Day. The Rise and Fall of Working From Home. Communion Bread Must Contain Some Gluten, Vatican Says. Nearly a Third of Millennials Have Used Venmo to Pay for Drugs. Chinese umbrella-sharing startup loses most of its 300,000 umbrellas in three months. 

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