Money Stuff: Brokers Have Some Good Ideas

The Wall Street Journal last week had a profile of Marshall Wace, which has perhaps the most delightfully contrarian investment model in finance: listening to the sell side. If you run a big hedge fund (Marshall Wace manages $70 billion), salespeople and analysts at every investment bank will constantly ping you with trade ideas. You can have various models of those trade ideas [1] ; two leading ones are:

1. The bank wants to be on the other side of the trade: It is stuck with a big position in XYZ stock and wants to get rid of it, so its salespeople are calling you to say “hey XYZ is looking like a great buy, do you want any?” 
2. The salesperson genuinely believes that the trade is a good idea, and she hopes and expects that it will work out well for you (so that you are impressed and trade more with her bank.) But if the salesperson reliably had good trade ideas, she would have your job, and she doesn’t. 

So the consensus is that if you set up a hedge fund whose investment model was “we’ll just get phone calls from banks and do what they tell us to,” that would not work very well. But Marshall Wace … doesn’t do that exactly, but it kind of does that, and it does work very well. From the Journal:

The firm, like most hedge funds, regularly received phone calls from Wall Street brokers, pitching Marshall Wace on stock ideas in hopes of gaining its trading business. [Ian] Wace thought it was worth formally tracking and analyzing the ideas to see if they were fruitful. [Paul] Marshall was skeptical.

Most people “on the buy-side like me were very arrogant about the sell-side,” Marshall said, referring to the financial world’s divide between investors and brokers. “Ian didn’t have that view at all.”

Wace tasked a summer intern, Anthony Clake, in the early 2000s to find a way to measure the ideas. The resulting spreadsheet evolved into what is known as TOPS, for Trade Optimized Portfolio System.

Today, more than 1,000 outside contributors, including the likes of Goldman Sachs and JPMorgan Chase, submit trading ideas—alongside detailed explanations for them—into model portfolios, the performances of which are continuously tracked and individually displayed to participants. Some rival hedge funds, mostly smaller firms, also submit ideas, some of them too impractical to trade on their own. Top performing firms are rewarded quarterly with commissions, whether Marshall Wace trades on the ideas or not.

What is the right model for it working? Some possibilities:

1. Some salespeople and sell-side research analysts sometimes have good investing ideas, but they also have bad ideas and spend time selling stuff that their banks are trying to get rid of. If you naively do whatever they tell you, that won’t work out well. But if you create an incentive structure for them to send you only their good ideas — “the firm can pay out hundreds of millions of dollars in a good year in total,” and “regular feedback detailing performance keeps participants hooked” — then maybe they will.
2. The stock market is not a pure abstract search for truth; “a good trade idea” is not perfectly synonymous with “a stock whose price is below its long-term fundamental value.” If a bunch of brokers are telling you to buy a stock, they’re probably also telling a bunch of other people to buy the stock, which means it might go up. Especially if they’re telling you first because you are a big hedge fund and have built a good incentive structure.
3. If you are systematic enough about tracking and analyzing brokers’ recommendations, you can extract more sophisticated signals than “this broker usually recommends stocks that go up.” “This broker usually recommends stocks that go down” is a perfectly useful signal, for instance. [2]

The third explanation might be the most promising. The Journal says:

TOPS isn’t just analyzing the ideas that come in, however. It also tracks behavioral biases of participants themselves. It can examine, for instance, what time of day participants submit their best ideas, or whether they dump their winners too soon. Regular feedback detailing performance keeps participants hooked. Low performers can be cut from the program. 

“It would be quite wrong to think of it as a simple translation of Joe Schmo’s idea into a portfolio,” said Marshall. “Joe Schmo may have an idea, and that might be a small part of a signal of whether or not that stock is interesting.” 

I like to imagine that there is some stock salesperson out there who would be an excellent hedge fund manager between the hours of 10 a.m. and noon, but after lunch she gets terrible ideas so her overall track record is mediocre. She lacks the rigorous self-awareness to see this, but Marshall Wace knows her better than she knows herself, so it makes a fortune trading on her pre-lunch ideas while she toils in obscurity on the sell side.

I used to sell equity derivatives at a big investment bank, but equity derivatives are expensive. After a few years on the job, I figured out a cheap homemade alternative to equity derivatives. [3] It is called “buying less stock,” and it works like this:

1. You own 100 shares of XYZ stock.
2. You would like to do some sort of derivative trade on XYZ.
3. This derivative almost always takes the form “I would like to limit my downside on XYZ stock, and I am willing to give up some upside in exchange,” though there are limitless flavors of exactly how you do that. [4]
4. You know what you can do to limit your downside while giving up some upside?
5. Just buy less stock!
6. If you own 50 shares of XYZ, and XYZ goes down by $1, you will only lose $50 (instead of $100). On the other hand, if XYZ goes up by $1, you’ll only make $50 (instead of $100). You have limited your downside, at the expense of giving up some upside.

When I was an equity derivatives salesperson, I would have expressed this as something like: “You want to do a costless collar with a 50 delta, but we make like 1% edge on that trade, and you could just sell 50 deltas of stock and be in approximately the same place but without the 1% fee.” Would I have expressed it that way to a client? Ideally no — my job was to sell the derivative and make the 1% edge — but also sometimes yes! (I was not a great equity derivatives salesperson.)

Similarly, as a former equity derivatives salesperson, I have delighted in various sorts of “hedged” or “buffered” exchange-traded funds, whose basic schtick is along the lines of “we give you exposure to the stock market, but we protect you from the downside, but you give up some upside.” That’s a good schtick, and I have discussed it lovingly a few times. But, as a cynical former equity derivatives salesperson, I have also thought “well just buy less stock then.” 

Here’s a Wall Street Journal story about those funds, citing some AQR Capital Management research (previously discussed by Bloomberg’s Denitsa Tsekova). From the Journal:

Hedges are costly, and options’ regular expiration requires fund managers to pay up repeatedly, chipping away at returns, AQR found. Meanwhile, the protection is often weaker than simply reducing your stockholdings. 

AQR’s Cliff Asness and Daniel Villalon said that investors looking to take less risk in markets would be better off simply keeping more of their portfolios in cash.

For example, they said 78% of these funds tied to options fared worse during this year’s steep market decline than a portfolio of stocks and cash, according to an analysis through April. 

And from AQR:

There are simpler ways to get returns that are lower than equities with less risk. For example, instead of putting $100 in the market, an investor could invest only $70 and put the other $30 in Treasury Bills. Presumably, if this simpler approach were more effective than options-based strategies (either via 1. higher returns, 2. less risk, or 3. higher returns with less risk), an investor would prefer it. …

We … compare each fund’s returns to that of a strategy that simply matches its average equity exposure via a passive index and invests the rest in T-bills. … More than two thirds of all [equity hedged] funds deliver lower returns with more risk than a simple combination of passive equities and T-Bills.

It’s okay, though, because like six people are typing emails to me right now that say “no, you don’t understand, if you put $100 in a buffered fund you can’t lose more than $10 (or whatever), but if you just buy $70 worth of stock you can lose $70.” [5]  Nobody actually wants to hear the advice “just buy less stock” because it is boring. Options strategies are fun; they come with a story, and that’s worth something.

One theory of credit ratings goes like this:

1. Issuers (companies and governments that want to borrow money, banks that want to issue asset-backed securities, etc.) want to get high credit ratings, so that they will be able to borrow a lot of money.
2. Lenders want to make safe loans, and they trust credit ratings agencies to accurately rate issuers.
3. The issuers pay the ratings agencies for their ratings, and can shop around for the best rating.
4. Therefore, ratings agencies have a conflict of interest: Their paying client (the issuer) wants a high rating, so they give the issuer a high rating, at the expense of the actual consumers of the rating (the lenders), who are deceived.

This theory became particularly popular after the 2008 financial crisis (when a lot of stuff with AAA ratings turned out to be bad), and led to various regulatory changes to manage this conflict of interest. 

But it seems to me that the more correct theory is:

1. Issuers want high credit ratings, sure.
2. Lenders do their own credit analysis to decide what loans to make and don’t particularly rely on ratings agencies.
3. But lenders do need credit ratings because of their own investment mandates or regulatory requirements: An investment-grade bond fund can only invest in bonds rated BBB- or better; an insurance company will get better regulatory capital treatment when it buys highly-rated bonds than when it buys junk bonds.
4. The lenders much prefer high ratings: If you can make a loan that (1) you think is pretty good, (2) pays 14% interest and (3) gets an investment-grade rating so you don’t need much capital against it, that’s great. If it gets a junk rating, that’s less great: You still want to own the loan, but pesky regulators won’t let you. 
5. Therefore, ratings agencies do have a conflict of interest, but it’s pushed back one level. The paying client (the issuer) and the direct consumers (the lenders: investment funds, banks, insurance companies etc.) are all on the same page and want a high rating. The people keeping an eye on the lenders — their regulators and ultimate customers — care about ratings accuracy, but there is not much direct incentive to care about them.

Here’s a Bloomberg story about Egan-Jones Ratings Co., which was founded on the principle of avoiding the first set of conflicts of interest:

Sean Egan, 67, and his company first came to widespread attention on Wall Street in the 2000s, with timely warnings about Enron Corp. Egan was hailed as something of a hero — a David taking on industry Goliaths. It took him nearly a decade to crack the old ratings triad and persuade the US Securities and Exchange Commission to acknowledge Egan-Jones as an official ratings provider.

Over the years, Egan has criticized the failures of the industry’s famous Big Three: S&P Global, Moody’s and Fitch, all of whom have been around more than a century. His critiques include how they make money. The majority of credit-ratings firms get paid by people who sell investments. Egan-Jones is the opposite: It typically gets paid by the people who buy them, an arrangement the firm says reduces the potential for conflicts of interest.

But which is, you know, maybe susceptible to the second set of conflicts:

Egan-Jones bills itself as the biggest ratings company in private credit, one of the hottest businesses in finance today. Time and again, people familiar with the firm say, it has declared private credit investments to be relatively sound — maybe not gilt-edged AAA, but good-enough BBB.

Those ratings have helped Wall Street usher vast sums of complex debt onto the books of life insurance companies that manage retirement savings for millions of policyholders. Desperate to source higher-yielding investments after a decade of near-zero interest rates, insurers have embraced the upbeat ratings. In fact, many seek them out to avoid more onerous capital charges and, in the process, boost profits, according to people in the industry.

Right if you go to insurance companies and say “we have a business model where you pay us to rate the securities you buy and we’re very tough,” why would they want that? Here’s a deal:

Or consider 777 Partners, the US investment firm whose bid to buy English Premier League soccer team Everton collapsed due to financing problems and scrutiny over the Miami-based firm’s management. Egan-Jones rated various 777 investments, including a $15 million loan for OmniLatam, a fintech company based in Bogota. In spite of carrying an interest rate of 14% — a level typically seen on borrowers with ratings deep into junk territory — the loan received an investment-grade BBB- by Egan-Jones, according to a copy of the report obtained by Bloomberg News. The financing was written off after 777 collapsed last year, a person with knowledge of the matter said.

The point of buying a loan with a 14% interest rate and a BBB- rating is not that you think it’s safe: The interest rate tells you it’s not! The point is that you can tell your regulators and customers that it’s investment-grade. 

One thing that sometimes happens is that an activist hedge fund will quietly accumulate a stake in a public company, and then it will announce its position and push for changes at the company. Often the company’s stock will go up when the activist announces its position, since the activist often (1) has a good track record and/or (2) targets a company that could use a bit of a managerial shake-up. Often, too, the company’s board of directors will come out against the activist when it announces its position: The board presumably likes the current strategy and will feel blindsided and aggrieved to be targeted by the activist.

Boards really do get stressed about this, so there is a whole activism-defense industry of people whose job is to prepare boards of directors for activist attacks: There are best practices to insulate your company against activists, good ways to respond if an activist shows up, etc. Activism defense also tries to do early warning: Even before the activist publicly discloses its stake, or calls the board up privately to push for changes, there might be signs (rumors, trading volumes, etc.) that an activist might be buying the stock, and the board might be alerted to those signs so it can be ready to fight the activist threat as soon as it materializes.

If you are a director on the board of a company with a lurking activist, what should you do about it? There are various imaginable corporate-finance and public-relations moves you can make, but there is also a simple personal finance move, which is: Buy more stock? Not legal or investing advice, but here’s “Betting on my enemy: Insider trading ahead of hedge fund 13D filings,” by Truong Duong, Shaoting Pi and Travis Sapp in the Journal of Corporate Finance:

Corporate insiders often become aware of hedge fund attention prior to a 13D filing. We find abnormal buying activity by insiders in the months leading up to hedge fund 13D filings. Whereas 13D announcement abnormal returns are 7.72 %, profits to insiders who buy average 12.09 %. Insider buying is not linked to common firm characteristics that predict activist targeting. Our findings indicate that insiders are benefiting from private knowledge that their firm has become the focus of hedge fund activism, and sometimes this knowledge comes directly from the activist. However, insiders largely refrain from trading when there is formal communication with the activist. Profits to insiders who buy when there are no talks prior to the 13D filing are 14.49 %, triple the amount for insiders who have had early talks with the hedge fund. Insider trading is linked to indicators of poor corporate culture, but not related to outcomes of activism campaigns.

On the one hand, if the insiders are buying stock to bet on the activist, that somewhat undermines their defense against that activist. But I suppose it’s a good hedge. If an activist is buying your stock, one possible outcome is that the activist will run a proxy fight and you will be kicked off the board. That would be bad for you, but in that case, the stock that you bought will probably be up, which will be some consolation.

In like two years, every American will be presented at birth with 100 Trumpcoins, and it will be illegal to sell them. For now, though, this weekend’s New York Times Magazine featured this ethics question for Kwame Anthony Appiah:

My wife and I just had a baby girl. A college friend of ours sent us $175 in Bitcoin as a baby gift. He’s a crypto bro and is super-into it, while I, on the other hand, am extremely skeptical. My friend said that I can’t sell it until her bat mitzvah (when “it will be at least $1,000,” in his words). I believe that there is a decent likelihood that it is worth $0 in 12 years. Since I am the steward of my baby’s money (until she turns 18), do I have a fiduciary responsibility to sell the Bitcoin now since I think it will be worth nothing, or do I have a responsibility to honor my friend’s wishes and keep the money in Bitcoin until she turns 12?

Appiah told him to keep the Bitcoin, with the logic that either (1) it will go up or (2) it will go down and “you can gloat about how right you were all along.” Seems fine. On the other hand, unless the friend is Bill Ackman, it’s a little weird to give a baby gift with that sort of investment restriction.

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