| Programming note: Money Stuff will be off tomorrow and Friday, back next week. Active management A basic stylized fact of financial markets is that active investment managers, as a group, do not outperform a monkey throwing darts at the stock tables. This is an embarrassing stylized fact, but you cannot, if you are an active manager, feel too bad about it. The monkey is cheating. He is free-riding on your work. The reason his investments are good is that he is buying stocks of companies that have already been vetted by active investors, and at prices that represent the active investors' consensus about their value. The monkey is not doing any deep fundamental analysis of the cash flows and business prospects of the companies whose stocks he buys, because you have already done it for him, and you have told him what those stocks are worth. He just has to throw darts. If his dart lands on a good company, he will invest in a good company at a fair price. If his dart lands on a bad company, the price of the stock will reflect the risks and badness of the company, and will still, in expectation, give him a fair return. If you and your active-management competitors have done a good job, the monkey can't lose. Of course, if you've done a really good job, you can't lose either. But you also can't win: All the stocks will be fairly priced, and your business—of buying stocks at prices below their intrinsic value—will be impossible. You and the monkey and everyone else will just get the overall market return; your fundamental research can't add any more value than the monkey's darts. This is called the Grossman-Stiglitz paradox. (The paradox is that, if this is really true, then you won't do the good work of making the prices right, which means they will be wrong, which means that the markets won't be efficient, which means that you can in fact outperform the monkey, which means that you will do the good work of making the prices right, which means that you won't outperform the monkey, etc.) The monkey will work cheaper than you will: You probably want some analysts and a Bloomberg Terminal and a research budget and a big salary, while the monkey needs only some bananas and a box of darts. In fact in our modern age it is easy to dispense with the darts, and the monkey: An index fund can just buy all the stocks, or some large representative sample of them, without doing any fundamental analysis or anything else, just relying on the good hard work of the fundamental active managers to make sure that the prices are right. The index fund will be cheap. The active managers will be expensive. Their gross-of-fee returns, in expectation, will be the same. The people who pay the active managers' fees will effectively subsidize the people who only pay for index funds: Everyone will benefit from the work of making prices right, but only the active investors will pay for it. Here's a paper from Robert Stambaugh of Wharton, titled "Skill and Fees in Active Management": Greater skill of active investment managers can mean less fee revenue in a general equilibrium. Although more-skilled managers earn more revenue than less-skilled managers, greater skill for active managers overall can imply less revenue for their industry. Greater skill allows managers to identify mispriced securities more accurately and thereby make better portfolio choices. Greater skill also means, however, that active management corrects prices better and thus reduces managers' return opportunities. The latter effect can outweigh managers' better portfolio choices in equilibrium. Investors then rationally allocate less to active funds and more to index funds if active management is more skilled. Then there is some math, but the basic idea is extremely intuitive. The better the active managers are as a group, the fewer mispricing opportunities there will be, and so the harder it will be for them to outperform indexes. The harder it is, the better the active managers will have to be: The bad ones will quit, and the good ones will invest in alternative data and machine-learning strategies and whatever else they can find to get better at their jobs. This will make it even harder to outperform indexes, etc. Investors will observe all this, and as the active managers make the indexes more efficient—as they make the monkeys' jobs easier—the investors will allocate more to the indexes. This all feels extremely straightforward and almost obvious, but it is worth thinking about how this fundamental math translates into the subjective experience of active managers. That experience might look like: - You're good at finding mispriced stocks and are richly rewarded for it.
- Through your good work and the work of your peers, prices get more efficient and it gets harder to find mispriced stocks.
- At the same time you are gaining in experience and cleverness and technology and scale and so forth, so you get better at it, and continue to be richly rewarded.
- But you grumble a bit because you have to work harder for the same results.
- Eventually the curves cross: The benefits to you of increasing experience and scale and so forth taper off, while the market keeps getting more efficient, and you get left behind.
- You get mad at the market for not yielding its secrets to you anymore.
And in fact you can find many examples of exactly this, long-time successful active managers getting cranky because their techniques don't work anymore. We talked in January about one such article: "Financial markets have significantly evolved over the past decade, driven by new technologies, and the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerised models." … There has been recently a flurry of finger-pointing by humbled one-time masters of the universe, who argue that the swelling influence of computer-powered "quantitative", or quant, investors and high-frequency traders is wreaking havoc on markets and rendering obsolete old-fashioned analysis and common sense. ... "These 'algos' have taken all the rhythm out of the market, and have become extremely confusing to me," Stanley Druckenmiller, a famed investor and hedge fund manager, recently told an industry TV station. I think that pretty much all of those words mean "the markets have gotten more efficient so it's harder for me to make money by finding obvious mispricings," but none of them say that; they all sound like complaints about bad crazy algos rather than good efficiency. The sad fact of life for active managers is that they devote their careers to making markets more efficient, but if they succeed too well then they put themselves out of work. Deutsche Bank The cliché about investment banking, and other intellectual-capital-based service-y businesses, is that the assets walk out the door each night: The value of the business is in the accumulated knowledge and skill of its people, and they can always leave. This makes these complicated businesses to sell: If a buyer is paying for a team of brilliant traders, and the traders all quit when the deal is announced, then the buyer has overpaid. Still you can apply some basic valuation techniques. If the assets walk out the door each night then the business is worth $X. If the assets walk out the door for a boozy lunch at noon each day, then it is worth … less. We talked yesterday about a story describing all the empty desks and day-drinking and open job hunting at Deutsche Bank AG's U.S. operations, after a year of mounting uncertainty and gloom. If Deutsche Bank is planning to shut those businesses, or to shrink them by laying people off, then this all makes pretty straightforward sense: The employees have gotten a jump on the layoffs, and are effectively paying themselves some informal severance by collecting a salary without doing much work. But if Deutsche Bank is planning to shrink by selling those businesses, to a competitor that is interested in staying in them long-term, then it's pretty awkward. Some other bank will buy the business, and send in a new manager to meet his employees, and he'll find them all at the bar. "Oh man you want me to trade swaps? I haven't done that in like a year." Similarly here is a story about how Deutsche Bank is shopping its prime brokerage operation to other banks, and, oof: Deutsche Bank's prime brokerage business has long had a high-profile client roster with hundreds of billions of dollars in assets at its peak. Top clients include algorithmic-trading giants Renaissance Technologies LLC and Two Sigma Investments LP, according to people familiar with the business. Deutsche Bank was a top-six prime brokerage player globally as recently as 2017, according to industry research firm Coalition. But last year its ranking fell into a lower tier, placing it in the top nine. … The pool of assets handled by Deutsche Bank's prime-brokerage unit has shrunk significantly as executives waffled over strategy and the bank cut risk-taking, said people with knowledge of the operations. Many hedge-fund clients fled in 2016 when the bank's health came into question. Much like the employees, the clients notice when a business stops being a priority. Some of the employees get other jobs; others just check out and go to the bar. But the clients don't really have that option; their most straightforward response is to find a new prime broker. The lesson is that if you have a prominent business that you decide is non-core and that you want to get out of, you sell it first, and then tell everyone that it was non-core and you wanted to get out of it. If you instead go around for years foreshadowing that you're going to get out of the business, the clients will walk away before you have a chance to sell them. Andrea Orcel The thing about poor Andrea Orcel's departure from UBS Group AG to become chief executive officer of Banco Santander is that it was a failed deal. Like, Orcel and Santander reached an agreement on Orcel's new role and pay, and then he did his part in the deal by quitting UBS, and then Santander walked away and left Orcel in an awkward lurch. If you were a company in an analogous situation—if you signed up for and announced a hugely risky bet-the-company deal, and then your counterparty in the deal just said "wait never mind this is embarrassing, deal's off" and dared you to sue—you'd be really mad. You'd be mad at your counterparty, sure, and at yourself, but you'd also be really mad at the advisers who guided you into this pickle. "Why did you let us trust these snakes, aren't you supposed to be a good negotiator," you would ask your banker. And: "Why didn't you demand a more ironclad commitment from our counterparty before we made this big risky announcement?" So I guess one question is, if you are a company considering a huge risky bet-the-company transaction, would you hire Orcel as an adviser? Orcel is considering starting a boutique investment bank, one of a range of options that may force him to give up tens of millions in deferred pay from his former employer, UBS Group AG, according to people with knowledge of his conversations. He isn't close to a decision, the people said, but has held informal talks with boutique investment banks and large rivals to UBS on both sides of the Atlantic, as well as Silicon Valley technology firms. I mean, sure, right? He's been really badly and visibly burned once; surely he'll be extra careful about not letting it happen again. There is a popular line of thinking in finance that it is better to hire a trader who has lost a billion dollars than one who hasn't: Losing a billion dollars (1) absolutely demonstrates that you are willing (and have been trusted by others) to take big risks, and (2) at least leaves open the possibility that you've learned from your mistakes and will be more careful next time. Just trucking along and reliably making money is somehow less informative. Maybe hiring a banker with a notable botched deal in his personal life is the same idea. Meanwhile: "Andrea Orcel is set to launch a €100m lawsuit against Santander after the Spanish bank withdrew its offer to make him chief executive earlier this year." Tickers I am always a sucker for this sort of analysis: Longer tickers, cool tickers, and even tickers that spell words trounce the stock returns of short and single-letter issues. Our "cool" category of ticker symbols were up an average of 17.5% annually over the last five years, versus just 3.7% for companies with single-letter tickers. "Longer" and "single-letter" are pretty straightforward categories, but "cool tickers in this study are, admittedly, solely defined by Barron's." Their leading example of a cool ticker is Slack Technologies Inc.'s "WORK," which might not be your idea of cool? Meanwhile Canopy Growth Corp.'s "WEED" ticker is excluded for technical reasons, and perhaps because Barron's thinks WORK is cooler than WEED. Anyway the point is that tickers that Barron's finds cool outperform tickers it doesn't. A good exercise would be to build a machine-learning investing algorithm that (1) figures out what is cool and then (2) buys stocks with cool tickers. Then not only will you get rich but also you'll have a computer that knows what's cool, which must have other applications. Of course this is all spurious or semi-spurious or at least confounded with other factors: Value investing strategies have lagged behind growth strategies for a decade. The Russell 1000 Growth Index (RLG) has outperformed the Russell 1000 Value Index (RLV) by more than a cumulative 300% since 2007 as investors have flocked to faster growing companies in the current, long-running bull market. It makes some sense, therefore, that new issues, with tickers that are four characters long, or that spell words, are outperforming shorter tickers. "Cool," right now, is cool, but there may come a time when retro and old-school are cool again. I think there's a decent case to be made—purely on aesthetics, mind you, and not as any sort of financial analysis—that the coolest ticker is actually U.S. Steel Corp.'s "X," and maybe one day the market will agree. Jets Do you think that videoconferencing software will ever get to the point that hedge funds won't be able to predict mergers based on the movements of corporate jets? I feel like it is the oldest trick in the book; plane-tracking was a feature on Dealbreaker a decade ago; everyone knows about it. And it's still going strong: If you have a meeting with Warren Buffett in Omaha and you want to keep it a secret, consider driving. The airports are being watched. In April, a stock research firm told clients that a Gulfstream V owned by Houston-based Occidental Petroleum Corp. had been spotted at an Omaha airport. The immediate speculation was that Occidental executives were negotiating with Buffett's Berkshire Hathaway Inc. to get financial help in their $38 billion offer for rival Anadarko Petroleum Corp. Two days later, Buffett announced a $10 billion investment in Occidental. Where there's a jet, there's a data trail, and several "alternative data" firms are keeping tabs on private aircraft for hedge funds and other investors. The data on the Occidental plane came from Quandl Inc., which was acquired by Nasdaq Inc. in December. (Bloomberg LP, which publishes Bloomberg Businessweek, provides clients with reports from another company called JetTrack.) Buffett's reaction, of course, was to pitch Berkshire's NetJets business—"I should point out to anybody out there who wants to do business with us, that if they take a NetJets plane, nobody will be able to track them"—because he is good at his job. If I ran a videoconferencing software company I might do the same. Obviously it will be a long time before people will negotiate mergers without ever meeting in person, but at least this is one reason to consider it. People are worried about bond market liquidity Oh yeah there it is: "Liquidity risk has been socialized," said Mike Terwilliger, a portfolio manager who runs the Resource Credit Income Fund, an interval fund that restricts quarterly withdrawals to 5% of total assets. "It sits on the portfolio of every single mom and pop investor, and they have no idea about that risk." Okay so first of all, is it good or bad if liquidity risk has been socialized? Like the idea of liquidity risk here is basically that there are bonds, and right now you can buy or sell the bonds reasonably quickly at some price that is reasonably close to the price yesterday, but maybe one day you will not be able to sell them easily, or you will only be able to sell them at a much lower price. And this risk is always with us and the question is, who happens to bear it? And the answer is "the people who own the bonds." And the other question is, who are good people to bear the risk? And the answer is "some reasonably diverse group of holders who are unlikely to all need to sell bonds at the same time." There are some really good traditional versions of that answer: Pension funds and insurance companies are traditional big holders of bonds, because they tend to buy and hold bonds for the long term and have fairly predictable needs for money, so they're unlikely to all have to dump bonds at once. There are some fairly bad answers: If banks all hold lots of bonds, with their high leverage and relatively short-term funding and vulnerability to contagion, none of them will have much margin for error, and they really might all have to sell at once. What about "every single mom and pop investor"? I feel like they're pretty good, as these things go! Mom and pop tend not to have a lot of overnight funding; if they have to wait a day or two to sell bonds it is unlikely to lead to a bankruptcy. And "every single mom and pop" is a relatively uncorrelated group: A vast pool of millions of individuals will have different investment horizons and different cash needs. If there's a huge economic downturn they might all decide to sell their bonds once, but if there's a huge economic downturn then you should really expect bond prices to go down. There is not, I think, a high likelihood of a localized financial contagion in the mom-and-pop sector, in which moms and pops are all forced to dump bonds at fire-sale prices while everyone else is fine. Also though I just want to say again that (1) every single day I read articles worrying about bond market liquidity and (2) all of those articles feature someone complaining that investors "have no idea about that risk." I recognize, at some level, that many moms and pops really don't know about bond market liquidity. But it still boggles my mind: What economic fact could possibly be better publicized than the worry about bond market liquidity? Things happen Trump Picks Two Fed Nominees Likely to Support Easier Policy. Lagarde tapped to head ECB as EU reaches deal on top jobs. The Mystery Millionaire Who Haunted London's Insider-Trading Trial. Bank funding costs and capital structure. Shipping Blockchain Initiative Gathers Steam. The British Banking Dynasty That's Even Older Than the Rothschilds. How H2O doubled down on Lars Windhorst in his hour of need. Inside the conflict at Walmart that's threatening its high-stakes race with Amazon. Rogue Trader Skirts U.S. Sanctions to Buy Maduro Regime's Oil. JPMorgan Commits Hedge Fund to AI in Technology Arms Race. Société Générale chairman admits it was too slow to fire traders. Gold's Rally to Six-Year High Spurs People to Sell Their Old Tiffanys and Rolexes. Rent-stabilization hotel-ownership strategy. The Truth About the Thicc Starfish. Mum furious after spending £100 trying to get teddy from 'rigged' claw machine. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! | 
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