Money Stuff: The Government Wants ESG Out of Pensions

Programming note: Money Stuff will be off tomorrow, back on Monday. DOL v. ESG My maximalist theory of environmental, social and governance (ESG) investing goes like this. There is a government of the U.S., consisting of a president and Congress and and so forth, chosen through more-or-less democratic processes, and it makes big collective decisions for society. There is another government, in the world, consisting of a handful of gigantic institutional asset managers—BlackRock, Vanguard, Fidelity, etc.—who own (on behalf of their customers) most of the stocks of most of the public companies, and can, in some loose sense, tell those companies how to behave. They are not chosen democratically, exactly, but they are representative; millions of people give their money to those institutions and trust them to make decisions for them. Traditionally asset managers didn't really tell companies what to do, or if they did, they mostly told them to do business-y things like buy back stock or increase profits or whatever. But now the biggest asset managers are so big and so diversified that they do not get much bang for their buck from analyzing companies and telling them to improve their businesses, and they are too important to just do nothing. So the asset managers tell companies to do things that they think are good for society as a whole, in part because doing things that are good for society tends to improve the long-run economic returns to owning all the stocks (as the big asset managers do), and in part because the asset managers are run by humans who live in society and want society to be good. And so the asset managers find themselves in the business of making big collective decisions about how society should be run, not just business decisions but also decisions about the environment and workers' rights and racial inequality and other controversial political topics. There is a lot of overlap between what the regular government does and what the government-by-asset-managers does. Not total overlap, of course—the U.S. government has an army, BlackRock does not, etc.—but in broad areas of business and business-adjacent conduct, the U.S. government, and state governments, and BlackRock all have overlapping legislative power. Should companies be allowed to dig up coal to provide power, when coal causes a lot of pollution? That is a complicated question involving individual freedom, externalities, efficiency, economic growth, jobs, etc., and different governments could come to different answers. The U.S. government, under Donald Trump, comes to the answer "yes coal is great, more coal please."[1] BlackRock Inc., under Larry Fink, recently came to the answer "no coal is bad, no more coal please."[2] Coal companies are allowed by federal law but banned by BlackRock. Being banned by BlackRock is not as bad as being banned by federal law; if you dig up coal anyway, BlackRock can't put you in prison. But in a world in which capital is mostly allocated by a handful of giant institutional asset managers, those managers' quasi-regulatory decisions have a lot of weight, and companies will generally try to follow them. BlackRock makes big decisions on broad social and environmental issues, and then companies are somewhat compelled to do what BlackRock decides. This is all kind of new, and weird, and exaggerated; what I wrote above is not so much true as it is in the process of becoming true. The role of institutional asset managers in making big collective decisions is still under-theorized. The asset managers would not describe any of it like this, all of this would make them uncomfortable, and they claim only a modest role for themselves: "We just help our clients make their own investment decisions, we don't tell companies what to do, and we certainly don't write environmental legislation." While the U.S. government's regulatory process is formalized and full of checks and balances, the institutional investors' process is ad hoc and proprietary. We have talked before about John Coates's description of this situation as the "Problem of Twelve," referring to his estimate that "the majority of the 1,000 largest U.S. companies will be controlled by a dozen or fewer people over the next ten to twenty years." Coates has suggested that maybe the big asset managers need to have more formal procedures—analogous to U.S. administrative law—to make their governance decisions more transparent and legitimate. If BlackRock is a government, it should act like it. But another problem is that, you know, there already is a government, and it gets jealous. When Donald Trump says that there should be more coal mining, and BlackRock says that there should be less, that can feel like an intrusion on the U.S. government's turf. Why does BlackRock get to decide that? And since the U.S. government really definitely is a government—it can put you in prison, etc.—it can try to regulate the institutional investors to take away their governance powers.[3]   The U.S. Department of Labor sets the rules for retirement accounts in the U.S., both corporate defined-benefit pension funds and also defined-contribution 401(k) plans. On Tuesday it announced that it will ban ESG investments from retirement accounts. I mean, that is an overly dramatic simplification of the proposed rule; pension funds will still be allowed to consider ESG factors in their investments, and 401(k) plans will still be allowed to offer ESG funds on their menu of options. But the overall thrust of the DOL's proposed rule is that retirement-fund fiduciaries have to consider only economic factors in offering retirement accounts. They can consider ESG factors "only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories"; they can offer ESG funds in 401(k) plans only if they use "objective risk-return criteria, such as benchmarks, expense ratios, fund size, long-term investment returns, volatility measures, investment manager tenure, and mix of asset types … in selecting and monitoring all investment alternatives for the plan, including any ESG investment alternatives." You can refuse to buy polluters if you think, and can document, that their factories will blow up and they'll be fined a lot of money, because losing a lot of money is bad under, uh, "generally accepted investment theories"; you can't refuse to buy polluters because you think that pollution is bad for the world. You can offer ESG funds if their performance meets the same standards as your other funds; you can't sacrifice performance for social good.[4] BlackRock has announced that ESG funds will become the default option in some of their fund menus; the DOL has announced that ESG funds can't be the default option in a 401(k).[5] The explicit reason that the DOL is doing this is to protect retirement savers from losing money: "Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan," said Secretary of Labor Eugene Scalia. "Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers." But it is pretty tempting to read it instead as a political statement about the separation of powers: No, says the government, we are in the business of furthering social goals and policy objectives. The people making environmental, social and governance decisions should be the government, says the government; the asset managers and pension funds had better stick to making money. Vol trading If you are a hedge fund, what you mostly want is high returns with low volatility. The simplest, best-known way to get that is to sell disaster insurance. Sell puts, sell tail risk, bet against disaster, whatever, some version of that. People pay you a little money now, and you agree to pay them a lot of money if things go horribly wrong. Mostly the disaster never comes, and you collect a steady premium. If you do this for a few years, you probably will have a good track record of achieving high returns with low volatility—a high Sharpe ratio—and people will give you a lot of money to invest. You will charge them high fees and buy nice houses. Eventually the disaster will come and your fund will be wiped out, but the trick is to have that happen after you have bought your nice houses. Two things about that description. One is that it is an extremely well-known problem. The popular phrase is "picking up pennies in front of a steamroller." Sophisticated investors are very well aware that selling disaster insurance and hoping nothing goes wrong will, in normal times, create a track record of good stable returns, and that it is not actually a good strategy in the long run. Sophisticated investors will ask about this. When a hedge fund pitches them its track record of steady high returns, they will ask questions like "well are you just selling puts or what?" The other thing about this description is that it is sort of abstract. There are lots of versions of this; some involve literally writing insurance contracts or selling put options on stocks, but there are more complicated approaches, and also much simpler ones. Any strategy that provides a steady return when things are normal, and blows up when they aren't, can have this basic profile; just lending companies money is not entirely dissimilar from writing insurance against disaster. Lots of normal things that normal investors do can be loosely characterized as "kind of like selling puts." At Institutional Investor, Leanna Orr profiles Malachite Capital Management as an archetypal story of put-selling. The particular pleasures of this story are in the catty things that volatility traders say about each other anonymously: Fatalities include Malachite, Ronin Capital ("the plumbing just kinda fell apart," per one vol pro), Parplus Partners, and Allianz's ill-named Structured Alpha hedge funds. ("Now that's a whole rabbit hole. They drifted from their mandate — not a good example of a disciplined vanilla put-selling program.") … The severely wounded include Alberta's public fund AIMCo, which killed its aggressive vol unit after losing C$525 ($387) per woman, man, and child in the province. Another is $100 million hedge fund Plinth Capital, founded in the Malachite model by "a reasonably nice sales guy from Barclays" with backing from a Texas institution. Yeah no that one's a fatality. In a better world, "reasonably nice sales guy from Barclays" would replace "equities in Dallas" as the most cutting insult in the financial business. Though this, about Malachite, is also tough: The pair had a knack for inspiring envy. As two "VP-level sales guys" on Goldman's derivatives desk, peers say, they got a "pretty incredible" $25 million seed investment from a former client of theirs, Global Endowment Management, and started Malachite in 2013. (Disclosure, I was once a VP-level sales guy peddling equity derivatives at Goldman, though in investment banking rather than sales and trading.) And then there's this, about the Alberta public pension fund: "It's the Tiffany Trump of Canadian pension funds," says one local industry player. "In everything I've ever done in pensions, AIMCo has never been there. They are just nowhere to be found in the pension community. CPPIB, Caisse de Depot, PSP, BCIMC" — public funds for Canada, Quebec, the military and Royal Canadian Mounted Police, and British Columbia, respectively — "are kind of incestuous in that they all trade staff. Nobody joins AIMCo from CPPIB." It is all like this, anonymous vol-trader venting, I love it so much. Anyway the fun thing with Malachite is that it was in a pretty extreme form of the disaster-insurance business: Malachite would take a premium in exchange for effectively agreeing to pay a bank $X times the square of stock-market volatility, but only if volatility more than doubled.[6] Its business was selling insurance against extreme moves in stock-market volatility, about as literal a form of disaster-insurance selling as you can get. This generated a high Sharpe ratio, high (apparent) risk-adjusted returns, since they kept getting paid the premiums and the market kept not crashing. It also … it is obvious stuff, people know about this stuff: In trader-speak, these kinds of deals are called "selling the small puts," and are often described as picking up pennies in front of a bulldozer. Malachite's founders tried to challenge that mentality. According to someone familiar with their thinking, even post-demise, the pair saw their strategy as "much more like picking up $100 bills in front of a Tyco truck."  As a matter of personal outcomes, sure, that seems right; they picked up a lot of $100 bills and probably get to keep their nice houses even after their trades blew up, their investors were zeroed, and the banks who bought the tail insurance from them won't get paid on it. Selling disaster insurance is a risky strategy, but selling the strategy of selling disaster insurance cuts off some of the tails. If this is so well known, though, why did it work? Why would anyone invest in this strategy, if it is the archetypal Thing That Blows Up? There are two answers, a good one and a bad one. The good one is that selling disaster insurance can be a reasonable strategy, there's a price for everything, etc.; if your insurance is richly priced and you have reason to think a disaster is unlikely, then it can be in your (and your clients') interest to sell it. Ex post that turned out to be wrong, here, but lots of people didn't predict the coronavirus crisis, no hard feelings. The bad one is that, sure, everyone knows that selling disaster insurance is a bad way to get high and apparently stable returns, but look at those high stable returns! It is one thing to know, intellectually, that this often works out badly; it is another thing to pass on a trade, or a fund, that is making a lot of money. Orr's story is full of FOMO: Weinig and Aiken — a confident pair of former Goldman Sachs guys, which may be redundant — said yes to exotic trades with Wall Street banks, while their competitors studied the what-ifs and frequently balked at what they found. Malachite led the pack in insuring banks against infinite losses during an extreme stock-market crash, all in exchange for tidy premiums. … "It really was a dilemma as a fund manager: What do you do? All of these guys were outside the room doing their calculations, and then all of a sudden one or two funds just rush in," he says. "They're in there running up points, outperforming everybody, and they're going to raise the assets from investors. People had to decide whether to go in after them or not. If you do, you'll eventually get blown up and lose everything and then some. But if you hang back, you're not fully in the game, and for an indefinitely long period of time."  And: "What happened with Malachite and the others was no accident," says the prominent trader. "People on the buy side knew it. People on the sell side knew it. The allocators should have known it." One other thing: "People on the sell side knew it"? Malachite was in the business of insuring big banks against their tale risks. The tail risks happened. Malachite's insurance … mostly won't pay out: With $600 million in chips and the magic of leverage, Weinig and Aiken had bets worth upward of $1.5 billion in other people's money on the table early this year. … So when Malachite blew up in March, it left a hole in the ground twice as large as the fund itself.  They wrote $1.5 billion of insurance with $600 million of capital; the other $900 million is the banks' problem. Malachite sold tail-risk protection to the banks, but effectively bought back extreme-tail-risk protection by just not having enough money. The banks found a sucker to sell them tail-risk insurance, but then when the risks came true the insurance didn't pay out. Who's the sucker, really? Copay assistance We talk from time to time about bribery in the pharmaceutical industry, which just seems to have developed it to a higher and more sophisticated standard than you see elsewhere. Take copay assistance. The basic idea is that if you charge $10 for a drug, you'll sell a lot of it; if you charge $10,000 for it, you'll sell less, but you'll make more money on each sale. This is true in every business, and businesses try to set a price that optimizes revenue, etc. But in drugs it is different, because most of the price of most drugs is paid by insurance companies. If you can get an insurance company to approve a drug as medically necessary, they are going to have a hard time rationing it by price; if you charge a million dollars they might not approve it, but if you charge $10,000 and they approve it, they won't buy fewer units because of the price tag. But what they will do, for price rationing, is require a copay: The insurer pays for most of the drug, but the patient pays for some of it. With a 20% copay, a $10 drug costs the patient $2, and the patient might take it even when it isn't necessary; a $10,000 drug costs the patient $2,000, and the patient may skip it. There is an opportunity here for the drug company. What you do is, you charge $10,000 for the drug, and then you pay the copay. The insurer pays you $8,000, the patient pays you $2,000, and you pay the patient back the $2,000. You are up $8,000, but the patient has paid zero dollars and has no disincentive to take the drug. You have the advantages of a high price (more money per sale) and the advantages of a low price (lots of sales). On the one hand this is obviously cheating and insurers try to prevent it. On the other hand it is sort of … nice? Like if you are a drug company and you say "our drug is expensive but we make sure that no one who needs it is prevented from taking it for financial reasons," that sounds like a good public-spirited thing to say. So it is hard to just ban this, exactly. The compromise, for patients covered by Medicare, goes like this: Federal law prohibits drugmakers from providing financial assistance to help Medicare patients pay copays and deductibles. Drug companies may contribute to third-party charitable foundations that offer copay assistance to Medicare patients, but companies aren't supposed to earmark such donations for their own drugs. The charities still seem like a good bet for the drug companies, collectively, but even so there is cheating. That quote is from this story: The U.S. Justice Department sued Regeneron Pharmaceuticals Inc., accusing the drugmaker of paying kickbacks to a charitable foundation to boost sales of its high-selling eye-disease treatment Eylea. In a lawsuit filed in federal court in Boston Wednesday, the U.S. attorney's office for the District of Massachusetts said Regeneron provided money to a foundation, which in turn used the funding to help people with Medicare health insurance pay out-of-pocket costs for Eylea prescriptions. Eylea costs more than $10,000 a year, and copays for Medicare patients can top $2,000 a year, according to the Justice Department lawsuit. ... "Regeneron's payments to CDF were not charity; rather, the company intended those payments to subsidize Eylea's high price for Medicare patients and to ensure that physicians would not have to worry about collecting co-pays on Eylea from their Medicare patients," the lawsuit said. Tax laziness arbitrage What even: Taxpayers who are owed a refund may also get a second check this year if they took advantage of the July 15 extended filing deadline, according to the Internal Revenue Service. Individuals eligible for a refund who didn't receive one by April 15 will get paid interest, accruing from the original April filing deadline to the date that the refund is issued, the IRS said in a statement Wednesday. The interest rate is 5% through June 30 and 3% after that. The interest payment may come separately from the refund. The announcement is an added bonus for taxpayers who waited to file after the IRS said it would extend the filing deadline by three months to give people more time to submit their tax paperwork amid the coronavirus pandemic. Generally, the IRS has 45 days to issue refunds before it has to pay interest, but because of the delayed filing deadline, it now has to pay interest on refunds sooner. The IRS encouraged taxpayers to file by April 15, despite the later deadline, to get their refunds sooner and so that the agency could have up-to-date bank account and address information for stimulus payments. Despite that recommendation, millions of taxpayers have yet to file and some could end up benefitting financially for waiting. Five percent is a lot better than I get on my savings account. The IRS told people to file early if possible, and then rewarded the people who filed late. The government is not always good at incentives. I mention it here because, as I have written before, "I am always fascinated by business circumstances in which laziness is the optimal move." Usually they are more complicated than this one. Things happen Wirecard Files for Insolvency After $2.1 Billion Went Missing. Wirecard Banks on Hook for $1.8 Billion in Loans. Quants Sound Warning as Everyone Chases Same Alternative Data. ECB seeks to defuse row with German court over bond-buying programme. While Hertz Stock Surged, CDS Auction Valued Bonds at 26 Cents. How Coronavirus Upended a Trillion-Dollar Corporate Borrowing Binge and Kicked Off a Wave of Bankruptcies. SoftBank CEO Masayoshi Son Quits Alibaba Board. 'Crush This Lady': Inside eBay's Bizarre Campaign Against a Blog Critic. US woman sparks transatlantic tea war with brutal online brew. Dog old. 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! [1] State governments might come to different answers, and there is tension between the federal and state governments in various sorts of environmental regulation. [2] Approximately. BlackRock said it would cut coal out of a lot of its funds, though you could question how much that actually means.  [3] Does this work in reverse? If these are really two competing forms of government fighting for turf, do asset managers actually fight for the turf? Do asset managers regulate governments to take away *their* governance powers? Well, in the U.S., there are sometimes corporate boycotts of states to try to make them change government policies; those tend not to be led by asset managers, but it is a form of corporate regulation of state governance power. Asset managers (and index providers, etc.) will sometimes shun *foreign* governments, for policy reasons, which can look like asset managers regulating countries' governance power. [4] It is a commonplace to argue that ESG funds should generally *outperform* non-ESG funds, because pollution is expensive, bad governance costs money, etc., and the DOL recognizes that. But there is also a compelling argument that, if the goal of socially responsible investing is to make the cost of capital higher for companies that do bad things, then the return on bad companies should be higher, so socially responsible investments will underperform.  [5] ESG funds are allowed in the 401(k) menu if "the environmental, social, corporate governance, or similarly oriented alternative is not added as, or as a component of, a qualified default investment alternative (QDIA as described in 29 CFR 2550.404c-5) that participants are automatically defaulted into as opposed to a fund added to the menu from which they are free to choose." [6] The specific strategy is a capped-uncapped variance swap, in which the bank would write Malachite a capped variance swap (it would pay Malachite the square of volatility times some notional amount, subject to a cap) and Malachite would write back an uncapped swap (it would pay the bank the square of volatility times the same notional amount, but with no cap). The bank would pay Malachite a premium to do this. If volatility went up or down a modest amount, the swaps would offset and Malachite would keep the premium; if volatility went up a lot, though, Malachite would have an exponentially growing problem. Here is more on the trade from Gontran de Quillacq. You received this message because you are subscribed to Bloomberg's Money Stuff newsletter. Unsubscribe | Bloomberg.com | Contact Us Bloomberg L.P. 731 Lexington, New York, NY, 10022