Expensive Research and Cheap Hedge Funds

(Bloomberg View) -- Expensive research.

The basic way that sell-side research works is, investors place trades with a bank, and they pay commissions, and in exchange they get access to research analysts. If they place a few trades (say, in a retail account), they get a little access: They can read written research reports, and that's it. If they place a lot of trades (say, they're a giant asset-management firm), they get a lot of access: Analysts take them to visit company managers, and whenever the investors call, the analysts pick up immediately. This is pretty straightforward -- the more you pay, the more you get -- but it is rendered a bit opaque by the fact that no one pays directly for the research. Everyone just understands that some portion of the trading commissions are paying for research.

Except that in Europe, starting next year, that will be illegal under the Mifid II rules. And so banks and fund managers are in awkward negotiations about how much the funds will pay for what they previously got for free, or "free."

Banks have put forward quotes of as much as $10m a year to provide fund companies with complete access to their research, according to several asset managers and consultants that are involved in the negotiations.

Fund managers who want additional services, such as face to face meetings with analysts or invitations to events with companies, are being asked to pay more on top of the annual subscription fee to access banks’ research platforms.

Some banks have asked for "$10,000 for a single phone call with their most senior analysts."

One obvious difficulty is in matching the scale of the fees, the services and the clients. In the old days this sort of took care of itself. Big funds paid lots of commissions and called analysts a lot, and the analysts jumped to answer their calls. Small funds paid fewer commissions and went more frequently to voicemail. Because no one was explicitly paying for research, the banks could just decide for themselves what tier of service each fund got. The senior analysts could pick up the best clients and ignore the smaller ones. 

But, now, what? You have like Platinum All-Access Service that gives you 24-hour cellphone access to the senior analyst, and Bronze Research Basic that gives you three five-minute web chats with the junior analyst, and the fund companies have to decide how ambitious they want to be, rather than just sorting themselves by commissions. Who wants to sign up as a fourth-tier client? And investment banks are not generally great at explicitly sorting clients into tiers. Every investment banker knows that big clients should get more attention than small ones, but no one wants to tell a small client "I'm sorry, your package doesn't cover this service." The standard model is that everyone gets the same white-glove service, but some people just quietly get less of it.

There are alternatives. The banks can charge everyone the same fees, but then big firms would underpay and small ones would overpay. "For smaller managers this is a big problem," says a boutique fund manager. "They just don’t have the scale to put a cheque of that size through." Or the banks can just sort everyone the old way:

The prices being put to asset managers are varied and very flexible at this stage, and often depend on the size of the fund company and the amount of trades they place with the bank, according to Mr Quinlan.

Hmm. The idea of the rules was that funds are supposed to pay for research, which you'd think would mean charging based on research usage. Charging based on trading usage just sounds like commissions.

Elsewhere in research, "the Chinese-owned brokerage firm CLSA Americas unexpectedly shut down its stock research unit and related functions on Monday, sending some employees and analysts scrambling to pack their things." And Wells Fargo Securities put out a research note titled "The Girl with the Draggin' W-2," which is surely worth at least $10,000. 

Cheap hedge funds.

Well, 1.75 and 20 isn't that cheap -- the average hedge fund charges a 1.49 percent management fee and a 17.5 percent performance fee -- but Paul Tudor Jones's Tudor Investment Corp. has cut its fees twice in the last year, so I guess you should look forward to their Memorial Day clearance sale. More importantly, cheapness is now a thing:

“Times have changed,” said Trip Keuhne, a Tudor investor at Double Eagle Capital Management in Westlake, Texas. In the past, hedge funds pointed to high fees as a bragging right—which “used to make them more in demand,” Mr. Kuehne said. “Now you have to come down on your fees to stay competitive and help your investors who have been with you for a long time.”

Here I want to laugh at the people who thought that paying more for a hedge fund was better. (Warren Buffett, further down in this newsletter, will laugh at them.) But really it's perfectly logical. Investing in hedge funds requires a willing suspension of disbelief in the efficient markets hypothesis. So it is comforting to have a kind of meta-efficient-markets evidence for it: The fact that everyone pays high fees for one particular fund must mean that that fund really does reliably outperform the market. (Otherwise, why would they pay the fees?) Investing in hedge funds is about trying to do better than the average investor, so why would you want to invest in the average hedge fund? And doesn't paying average-hedge-fund fees suggest that you have average-hedge-fund expectations? And if that's the case, why not index?

Cheap lawyers.

Here is a story about how JPMorgan Chase & Co. is becoming a tech company, and of course the first thing they did was kill all the lawyers:

At JPMorgan Chase & Co., a learning machine is parsing financial deals that once kept legal teams busy for thousands of hours.

The program, called COIN, for Contract Intelligence, does the mind-numbing job of interpreting commercial-loan agreements that, until the project went online in June, consumed 360,000 hours of lawyers’ time annually. The software reviews documents in seconds, is less error-prone and never asks for vacation.

Most of what banks do is enter into standardized contracts that specify the timing and amount of conditional cash flows between the bank and its clients. The standard way to do that is you write a contract, and the client signs it, and then when the conditions occur a lawyer looks at the contract and decides what it says. The 21st-century way to do it is that you write a computer program, and the client clicks "OK," and then when the conditions occur the program does what it was supposed to do. The intermediation of human intelligence and interpretation, which was essential when these contracts were invented, is now obviously superfluous. Even the idea of COIN seems like a half-measure. Why have a program to read agreements? The agreements should themselves be programs.

Blockchain blockchain blockchain.

Speaking of smart contracts:

Microsoft, JPMorgan Chase and other corporate giants are joining forces to create a new kind of computing system based on the virtual currency network Ethereum.

As always, the idea is to take an open, unpermissioned blockchain system (Bitcoin, the Ethereum smart-contract network) and turn it into a closed ecosystem dominated by major banks:

The companies working on the Enterprise Ethereum Alliance want to create a private version of Ethereum that can be rolled out for specific purposes and open only to certified participants. Banks could create one blockchain for themselves and shipping companies could create another for their own purposes.

One objection to this would be: The original point of these blockchain innovations was to disintermediate the big banks and allow new competitors to spring up. Building a closed smart-contract blockchain run by banks defeats that purpose, and makes the blockchain just a boring upgrade to existing bank technology systems.

But there's another objection, which is that the maximalist blockchain dream isn't just about disintermediation. It's also about putting everything on one blockchain, using a single universal blockchain to track identity and money and commerce and whatever else you've got. Shipping companies would track their cargos on the same blockchain where they tracked payments, rather than relying on banks to do the payments on their own separate blockchain. Securities transactions would settle instantly because both the securities and the currencies would live in a single system. Creating different blockchains for different purposes is just like -- well, I mean, banks keep track of who has money now, and securities intermediaries keep track of who has securities, and shipping companies keep track of where their ships are. Doing all of that on separate blockchains, instead of separate databases, might be a technology upgrade (or a bunch of technology upgrades), but it is not a revolution.

Elsewhere here is a Bank for International Settlements paper on "Distributed ledger technology in payment, clearing and settlement: An analytical framework," which is thoughtful about the differences between open and closed blockchains:

In arrangements where access is completely open, the entities operating the nodes are not likely to know each other. Such arrangements may be difficult to govern and the entire set of rules governing interactions among nodes needs to be primarily “on-ledger” (encoded in the computer protocol). By contrast, restricted platforms allow control over participants’ access to the arrangement. Because access is controlled, the set of rules governing interactions can also be “off-ledger”.

One problem with Ethereum (the anarchic open Ethereum, not the Enterprise Ethereum Alliance) was that the rules were on-ledger, and when someone messed up the rules, a hacker could exploit them to take a bunch of money in ways that were, at least, contrary to most people's expectations. A bank-run blockchain project could at least get together to say "wait that wasn't how we meant it to work, let's change that."

Meanwhile here at Bloomberg Gadfly: Bityuan.

Happy Warren Buffett weekend!

Berkshire Hathaway Inc. released Warren Buffett's annual letter to shareholders on Saturday, and as usual everything you need to know about modern financial capitalism is contained in that letter. For instance:

People are worried about stock buybacks. Buffett is straightforward and reasonable here (buybacks are good at low prices and bad at high prices), but he acknowledges that "discussions about share repurchases often become heated":

As the subject of repurchases has come to a boil, some people have come close to calling them un-American – characterizing them as corporate misdeeds that divert funds needed for productive endeavors. That simply isn’t the case: Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital. (Call us if you have a candidate.)

People are worried about non-GAAP accounting. Buffett:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

This comes directly after a section in which Buffett explains why U.S. generally accepted accounting principles don't accurately reflect the reality of his business (because GAAP overstates amortization costs and understates depreciation -- and, more broadly, because GAAP requires him to write down unsuccessful investments but never allows him to write up successful ones). You can dislike non-GAAP accounting because it has bad incentives: Companies tend to want to present figures that make them look better than GAAP, not worse. But disliking non-GAAP accounting because it is "fantasy accounting," or whatever, falsely assumes that GAAP is "real."

When can companies talk to their owners? Here is Buffett on one-on-one investor meetings:

We do not follow the common practice of talking one-on-one with large institutional investors or analysts, treating them instead as we do all other shareholders. There is no one more important to us than the shareholder of limited means who trusts us with a substantial portion of his or her savings. As I run the company day-to-day – and as I write this letter – that is the shareholder whose image is in my mind.

That is an unusual position, and for good reason. Most managers want to keep their big shareholders happy, because their big shareholders are the ones with the most votes, and if the big shareholders are unhappy the managers might get fired. (This is obviously not much of a concern for Buffett.) Running the company on behalf of small shareholders who are unlikely to sell does not seem like cutting-edge corporate governance. On the other hand, avoiding one-on-one investor meetings does seem to avoid a lot of potential disclosure pitfalls. Running your company for the smallest retail shareholders seems odd these days, but disclosing for that shareholder is the safest approach.

Should index funds be illegal? Well, Buffett doesn't actually address that in his letter. But in a CNBC interview yesterday, Becky Quick asked him whether Berkshire's recent interest in owning shares in every major airline might look bad:

Quick: You know, Warren, it does occur to me, though, if you're building up such a significant stake in all the major players, is that anything that's, like, monopolistic behavior? Is there any concern to think that you would say something to the airlines to make them make sure that they're not competing on prices quite the same? What would keep somebody from worrying about that?

Buffett: Yeah, I've never met— I've never met the CEOs of any of the four airlines — I may have met one down in a Texas business Hall-of-Fame thing, shake his hand. I mean, Herb Kelleher was down there for sure. But-- no-- have no communication with 'em. And-- index funds own a significant percent of each one. And-- we'll see how it turns out.

Yeah see that is not precisely the concern. Presumably a lot of index-fund managers have never met the chief executive officers of any of their airline holdings. And yet there is a concern, in some circles, about mutual-fund cross-holding. The worry is that it is a sort of self-operating anticompetitive influence: The CEO of one airline, knowing that his shareholders are mostly index funds and Warren Buffett, will fulfill his fiduciary duties to those shareholders by keeping prices high and not competing too hard against other airlines, because he knows that his shareholders also own them. (He will, in this theory, be less concerned about the shareholder of limited means who owns shares only in his airline.) If the normal approach is for every shareholder to own every company in an industry, why would those companies want to undercut each other? It wouldn't do their shareholders any good.

Buffett, of course, is very pro-index-fund. From the letter:

Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion.

I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them.

He makes fun of those rich people for seeking to pay higher fees: "The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive." We talked about meta-efficient-markets above, but I also like to think of this as a more general feature of postmodern capitalism. Mass production makes some great stuff! If you buy your food or furniture from a giant multinational conglomerate, it will be precisely engineered to give you exactly the features that you want. If you buy it from the tattooed artisan in your Brooklyn neighborhood, it will be inconsistent, flawed, human. If you go see the latest Marvel movie, it will have big, satisfying explosions. If you go see an avant-garde play in a downtown black-box theater, it will have smaller explosions. But the smaller, more human experiences seem more authentic, and so -- now -- read as upper-class. Maybe it's the same with hedge funds?

Buffett is not worried about bond market liquidity.

People are worried about unicorns.

"Since last year’s peak in mid-December, startup deal-making has fallen 37 percent, according to the Bloomberg U.S. Startups Barometer, which tracks fundraising, initial public offerings and acquisitions," reaching its lowest point since April 2014. And: Even unicorn employees can't afford to live in the Enchanted Forest. But: Building a new Enchanted Forest (Enchanted Prairie?) in Kansas City didn't work either.

Things happen.

Sheelah Kolhatkar on Ackman vs. Herbalife. PricewaterhouseCoopers messed up the Oscars. Morgan Stanley Gave Some Wealth-Management Clients Wrong Tax Information. Deutsche Boerse-LSE Deal Caught in Brexit Political Crossfire. Marblegate and the Use of Exit Consents to Restructure (Venezuelan) Sovereign Debt. AIG Directors Weigh Consequences for CEO After Big Setback. Samsung Heir Lee Jae-yong to Be Indicted on Bribery Charges. Jacob “Kobi” Alexander Sentenced To 30 Months In Prison For Securities Fraud. Trump: Nobody Knew Health Care Could Be So Complicated. "The point is that you shouldn't take Trump seriously or literally. He just says whatever his audience wants to hear." Is capitalism dying? Florida man says his dog shot his girlfriend. Internet of Things Teddy Bear Leaked 2 Million Parent and Kids Message Recordings. Union gets larger inflatable rat to outsize building owner’s cat. Are We Knitting Too Many Tiny Sweaters for Animals?

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net.

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