Is Paying for Performance Bad?
Active managers win!
There is one pretty good objection to active investment management, which goes something like this: Your active manager probably won't outperform a passive manager before fees, and will therefore underperform after fees, so you might as well index and save on the fees. Obviously this argument is only as good as its empirical underpinnings: If you consistently give your money to active managers who do outperform, even after fees, then you can ignore it.
But there is also a pretty bad -- and yet popular -- objection to active management that applies even to active managers who reliably outperform. It goes like this: Sure your active manager outperforms passive management, even net of fees, but she charges fees, and that's not fair. So here is this:
Pension schemes that used active fund managers over the past quarter of a century were rewarded . . . but only by 16p a year for every £100 they invested.
Active fund managers took home three-quarters of the value they created for pension scheme clients, according to analysis carried out for FTfm by CEM Benchmarking, which evaluates investment performance and costs. “A lot of value that is being created has been returned to the asset management industry rather than to the pension funds and their members,” said John Simmonds, principal at CEM.
"Active managers beat the market by 60 basis points, of which 44bp was consumed in costs," found the study, and obviously you'd prefer to get 60 basis points of outperformance rather than 16, but on the other hand, I ... think ... you'd prefer to get 16 rather than zero? Maybe not? Perhaps you have a moral, or aesthetic, objection. Or a political one: If switching to passive management will cost pensioners millions of dollars, but will cost "Wall Street" even more dollars, isn't it worth it? I don't know:
“Of course, managers should not be seeking to take 75 per cent of the value they add,” said Stuart Dunbar, director responsible for relationships with financial institutions at Baillie Gifford, the UK active investment specialist. He said the managers’ take should be about a quarter to a third of the value they create.
That is quite an "of course"! If you told me that the active managers took, say, 105 percent of the value they added, or 300 percent, then (1) I would not be all that surprised and (2) yes I suppose I would agree that it is inappropriate. But I am not sure that you can conclude a priori that any number lower than 100 is too high. When you buy a car, you pay the car dealer almost the entire value of the car. And yet.
One mental model you might have is: Shouldn't the active managers' share of the pie be reduced by competition? If Fund X outperforms by 60 basis points but takes 44 for itself, shouldn't Fund Y swoop in and offer to outperform by 60 basis points but take only 30 for itself? Just asking the question makes it obvious that the answer is no. Sure, right, if lots of active managers could predictably outperform, then they might compete with each other on price. But as long as reliable outperformance is rare, investors should rationally prefer to pay a lot for outperformance rather than to pay less for underperformance.
My mental model is actually the reverse: Money is incredibly plentiful, while active-management skill is rare. Investors should be competing to give their money to active managers who reliably add value, rather than those managers competing for pension funds' giant piles of money. The rarer skill is and the more plentiful money is, the more the skillful active managers should be able to appropriate the benefit of their skill.
The rule of law.
I have made a certain amount of fun of Mick Mulvaney's appointment as the acting head of the Consumer Financial Protection Bureau, a job that he is doing part-time after previously calling the bureau a "sick, sad" joke, but here is a client note from Davis Polk & Wardwell LLP calling Mulvaney's memo to the CFPB last week "one of the most remarkable documents to be published by an agency head in many years," and they are not exactly wrong? Here is Mulvaney:
I think it is fair to say that the previous governing philosophy here was to aggressively "push the envelope" in pursuit of the "mission;" that we were the "good guys" and the "new sheriff in town," out to fight the "bad guys."
Simply put: that is what is going to be different. In fact, that entire governing philosophy of pushing the envelope frightens me a little. I would hope it would bother you as well.
Well, it bothers me! We have talked before about regulation by enforcement, in which agencies (or prosecutors) decide that some previously widely accepted practice really should have been illegal, and instead of declaring it illegal from now on, go back and prosecute the people who were doing it before. Regulation by enforcement is appealing to regulators because of its efficiency: You don't have to go through the brainstorming exercise of thinking up new rules about what should be forbidden, or the administrative work of writing and passing those rules. You just see stuff that looks bad, sue the people doing it, and get them to settle for a large fine because, to be fair, it does look bad and they don't want to spend years litigating it. There is a rough justice here: If something looks bad enough to get the regulator angry, and it looks bad enough to embarrass the people doing it into settling, then it probably should have been illegal, and declaring it illegal after the fact makes some sense.
But Mulvaney objects:
On regulation, it seems that the people we regulate should have the right to know what the rules are before being charged with breaking them. This means more formal rulemaking on which financial institutions can rely, and less regulation by enforcement.
The rulemaking is harder for the agency, and makes it more likely that financial institutions who do bad stuff can get away without being punished. (Because the bad stuff, though bad, was not illegal.) Still it seems to me like the right way to regulate: Tell people that something is illegal, and then punish them if they do it anyway, rather than the reverse. Financial markets work better when they are governed by clear written rules rather than by the gut instincts of regulators and prosecutors, even if that does give rise to a certain amount of gamesmanship.
Obviously this message would be more compelling if it came from a legally appointed and Senate-confirmed independent director of the CFPB, instead of an Acting Director who is simultaneously a White House official. (And in a White House run by a president who "does not understand why he cannot simply give orders to 'my guys' at what he sometimes calls the 'Trump Justice Department.'") The commitment to the rule of law here seems angstroms deep. I think financial enforcement could use a deeper commitment to the rule of law, but a commitment to the rule of law only in financial enforcement is troubling too. (Do only white-collar offenders get the benefits of due process?) Still a good memo is a good memo, and financial regulation by rules really is preferable to financial regulation by enforcement.
How should research analysts be compensated? A naive approach would pay them more for putting Buy ratings on stocks that go up (and Sell ratings on stocks that go down), but of course an analyst's job isn't really to pick stocks that will go up or down. An analyst's job is to drum up business for the bank, to create and cement client relationships, to inspire warm feelings among the customer base. Those intangibles are harder to measure, but you can try. For instance, analyst rankings -- in which a publication takes a poll of buy-side customers and uses their votes to rank sell-side analysts -- can be a decent measure of warm feelings. Those warm feelings will not necessarily be based on correct Buy and Sell ratings, sure, but why would you expect them to be?
Here's a story about how analysts in China use tactics like "free iPhones, revealing miniskirts and Chinese new year 'red envelope' cash" to attract votes in these rankings, and I guess that is bad, though it is not bad in precisely the way that it sounds bad. It's not bad because they are gaming the rankings; the rankings measure customers' warm feelings for the analysts, not objective performance, and if the warm feelings are created by bribes that doesn't necessarily make them less real. (It is bad because a sell-side analyst bribing a buy-side manager presumably cheats that manager's investors; they want her warm feelings, and her use of research, to be based on performance rather than bribes.) Meanwhile this is more or less fine:
More harmless forms of persuasion are still thriving, however. The lead macro-economy analyst at Guotai Junan Securities, the country’s third-largest brokerage by revenue, composed a poem in Tang dynasty style entitled “Guotai macro’s goose call of everlasting spring”. At Sinolink Securities, a utilities analyst recorded an original song titled, “The song of a simple secondary-market dog”.
Give the customers what they want! What they want is good content. Correct Buy and Sell calls are good content, sure, but they are not the only kind of good content. Amusing research can be as valuable as correct research.
Everything I read about the Saudi Arabian Oil Co. initial public offering reminds me of why I was a bad investment banker. A good investment banker wants to work on the biggest deals for the most important clients. But the biggest deals are a pain, and the most important clients are often the most demanding and least appreciative ones. I mean, come on:
Aramco in recent weeks also contacted several new banks and invited them to Saudi Arabia to make pitches for potential roles on the IPO team, people familiar with the process said. It told them to draft presentations on a venue-agnostic basis.
Aramco’s IPO team has most of the paperwork ready for a listing in New York, London, Hong Kong or locally, people familiar with the matter said. Bankers on the deal say they have never seen another company work in this manner, as normally a venue decision is made first, because of the time it takes to draft even a single, less-complicated prospectus.
Imagine drafting the mammoth hypothetical prospectuses for the largest-ever IPO on every imaginable exchange, only to find out -- as still might happen -- that Aramco is just going to list on Saudi Arabia's own exchange and will just throw out all your uncompensated work. "That's great, perfect choice, I am glad we were able to give you the flexibility," is the only proper reaction from a real investment banker, but it would not be my reaction.
Late last year, Blackstone Group's GSO Capital Partners executed a very clever trade with Hovnanian Enterprises Inc. in which GSO agreed to refinance Hovnanian's debt in exchange for a commitment by Hovnanian to default on a small chunk of bonds to trigger a big credit-default swap payout for GSO. Earlier this month, Solus Alternative Asset Management LP, which had written CDS on Hovnanian and which stands to lose money if GSO's plan works, brought a somewhat less clever lawsuit against GSO and Hovnanian, alleging, in essence, come on, that is not fair. I was skeptical, and on Thursday so was the judge hearing the case. Here is Mary Childs at Barron's:
As the plaintiffs were trying to explain just how GSO and Hovnanian were deceptive, Judge Swain summed up the situation succinctly: "GSO wants money in the CDS market. And Hovnanian wants .... money."
"I'm very much looking forward to you telling me who was deceived here," she said.
Swain also questioned Solus's assertion that there were illicit purposes: GSO got a "strategic benefit" and Hovnanian got a "lifeline" so that it could continue building homes and contributing to society. What’s the problem?
Solus's real objection, and it is not a terrible one, is that if you allow games like this then that will not be great for the long-term health of the CDS market. But that is not really a concern of the judge's, or of Hovnanian's. To be fair, it ought to be a concern of GSO's. "It would be amusing if the death blow" to the CDS market, writes Childs, "was dealt by one of its most creative and enthusiastic users."
Oh the crypto, the crypto, the crypto.
This is not legal advice:
Crypto Callz currently has about 5,729 members, and it's one of dozens of pump-and-dump groups that have set up shop on Telegram, one of the world’s most popular messaging apps. Their goal: to conjure speculative buying frenzies around new digital currencies and cash in on them. These groups are easy to find, mostly free to access, and largely unpoliced by Telegram, which has become the go-to gathering place for bitcoin and “altcoin” traders to exchange news, tips, and, increasingly, to orchestrate cryptocurrency scams.
“What we are doing is perfectly legal,” a Crypto Callz administrator who identified himself as Maxwell Anderson told BuzzFeed News. He noted that "being a part of well-managed professional crypto pump groups like Crypto Callz is just getting early info on a coin" and wasn’t worried about Telegram cracking down on such efforts.
I mean, it's certainly not legal advice from me! Who knows, maybe this pump-and-dump administrator means it as legal advice? He seems to:
“Sure, ‘pump-and-dumps’ are fraudulent in the securities industry,” said Anderson over Telegram. “But as of now, the only regulations and statement the [Securities and Exchange Commission] has implemented involving crypto has been with ICOs.”
That is not ... you know what, never mind. A good piece of life advice is, don't take legal advice from people who operate self-identified "pump groups," or for that matter from people who replace s's with z's. The lawz will cauze you problemz.
I tell you what, the last few days of crypto news have been pretty stupid, even by the standards of the previous few days of crypto news. The quotes above are from BuzzFeed's investigation of crypto pump-and-dump schemes on Telegram, which should not be confused with the Outline's investigation of crypto pump-and-dump schemes on Discord and Telegram, though they both are full of people who are very open about running pump-and-dump scams. From the Outline:
“Pumping is the process through which a large group of people agree to buy a certain coin at a particular time,” reads the welcome messages for The Alt Pump, a pump group based in the messaging app Discord that has more than 30,000 members. “With this group, you will have large amounts of people buying a coin at the same time. This will pump the price straight up. After this the dumping part comes in. After the price rises tremendously up because of the pumping, we start selling at a good profit. This is called dumping.”
Meanwhile Telegram itself is doing an initial coin offering, "seeking $1.2bn to build a virtual economy within its app," and "Kleiner Perkins Caufield & Byers, Benchmark and Sequoia Capital have each told the company they want to invest $20m." Presumably the virtual economy will involve a lot of pump-and-dump schemes?
Elsewhere, we all know that the function of a Bitcoin exchange is to lose all your Bitcoins to hacking or embezzlement, but Japanese crypto exchange Coincheck Inc. innovated on Friday by losing $500 million worth of ... NEM? XEM?
According to Coincheck’s account of the incident, an unidentified thief stole 523 million coins tied to the NEM blockchain project, which were trading at about 94 U.S. cents at the time of the hack. It wasn’t until around 11 a.m. on Friday morning -- about eight hours after the initial breach -- that Coincheck staff noticed an alert pointing to a sharp drop in their NEM coin reserves.
The thief was able to seize such a large sum in part because Coincheck lacked basic security protocols. It kept customer assets in what’s known as a hot wallet, which is connected to external networks. Exchanges generally try to keep a majority of customer deposits in cold wallets, which aren’t connected to the outside world and thus are less vulnerable to hacks.
Coincheck also lacked multi-signature, a security measure requiring multiple sign-offs before funds can be moved.
It is constantly amazing that cryptocurrency developed out of cryptography -- like, the science of making information more secure -- and yet cryptocurrency exchanges just cannot stop leaving their coins lying around unguarded. The most advanced encryption techniques the world has ever known, but the password is "password123."
- Tether, which issues a mysterious and controversial cryptocurrency that is pegged to the dollar, has "dissolved" its relationship with the auditor who was supposed to confirm that it actually has enough dollars to back its liabilities.
- Robinhood Financial LLC announced that it will offer crypto trading on its free trading app, and hundreds of thousands of people immediately signed up to "get early access."
- Nouriel Roubini thinks blockchain is bad.
- "Crypto Investors Risk ‘Total Loss,’ Deutsche Warns."
- "For them, making money from cryptocurrency served as a means of attaining financial independence."
- There's a story about an ICO called Prodeum that I cannot even bring myself to type, but trust me, it is very stupid.
"Trained as an anthropologist and medical doctor, Mr. Kim now says that the world of high finance is 'some of the coolest stuff I have ever looked at.'" UBS bankers ‘frustrated’ with growth on Wall St. Nomura Recharges U.S. Coverage With New Investment Bankers. London’s Bankers Haven’t Been This Gloomy Since 2008. U.S. CFTC to fine UBS, Deutsche Bank, HSBC for spoofing, manipulation. Davos Elite Eyes M&A Across Europe’s Struggling Banking Industry. Activists to Press Avon to Explore a Sale. "Everything seems absurd until we die and then it makes sense." Doughnut-eating contest winner arrested again after doughnut shop robbery. Donkey leads escaped animals on midnight parade through neighborhood.
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