Venezuelan Bonds and Niche ETFs

(Bloomberg View) -- Venezuela.

The controversy over Goldman Sachs Asset Management's purchase of Venezuelan government bonds (really Petroleos de Venezuela SA bonds) from Venezuela's government (really from a small broker acting on behalf of Venezuela's central bank) has gone on longer than Goldman probably expected, given that Goldman apparently didn't think about it at all:

Internally, the purchase didn’t receive heightened scrutiny. The two co-heads of the unit, GSAM, were informed only after the trade had been completed, the people said. The trade didn’t reach Goldman’s firmwide standards committee, which often vets deals that carry potential blowback, they added.

An ensuing uproar over that trade, which critics say extends a financial lifeline to Venezuela’s embattled government, caught top executives at Goldman off guard.

Goldman Sachs Group Inc.'s "compliance and legal staff are reviewing the purchase" to see "how the process can be improved," but you can see how they missed this. It's controversial for Goldman to buy controversial stuff; but GSAM isn't quite Goldman. It manages money on behalf of customers; it bought the bonds with their money, not shareholder money. Its decisions aren't, in some sense, made on behalf of Goldman Sachs; they're made on behalf of GSAM's customers. Of course those decisions are made by Goldman employees in Goldman offices, not by the customers, but still, there is some deniability there. (Disclosure: I used to work at Goldman.) There is deniability for the customers too: Sure they own and benefit from the Venezuelan bonds, but they didn't decide to buy them; Goldman did. Somehow Venezuelan bonds are owned without anyone fully taking the responsibility of owning them.

Elsewhere in deniability, Ricardo Hausmann wrote last month about the moral taint of buying Venezuela's "Hunger Bonds." His argument is not quite that people shouldn't buy Venezuelan bonds. That would be too radical: Emerging-market bond funds almost have to invest in Venezuelan bonds. "The returns of the JP Morgan Emerging Market Bond Index (EMBI+) are heavily influenced by what happens in Venezuela," because Venezuela's bonds make up a lot of the yield and the price volatility of the index. Emerging-markets managers can't just walk away from Venezuela; they "currently spend a disproportionate share of their time 'getting the Venezuelan call right,' because their bonuses are based on their over-performance relative to the index – of which Venezuela is the main driver." And investors can't just walk away from emerging-markets bond funds:

Clearly, this would punish other countries that are innocent bystanders in the Venezuelan mess. There must be a better way.

There is. The solution is to demand that JPMorgan immediately exclude Venezuela from the emerging market bond indexes it calculates, thereby freeing fund managers from the need to compare their performance with hunger bonds. Over time, JPMorgan should introduce a Decent Emerging Markets index, which would save you from moral anguish by ensuring that only countries adhering to minimal standards of respect for their citizens are included.

The assumption here is that investment managers, and individual investors, cannot be expected to make moral decisions about investing for themselves, not when an index lurks in the background. (Others disagree; here is a story about Venezuelan investors who wrestle with the moral issues of owning Venezuelan government bonds.) Morality, on this theory, is a matter for index providers to judge. Investors -- index funds, yes, but also active funds that benchmark to an index -- are bound to follow the index, so if anyone is going to make a moral decision about what bonds to avoid, it is the index provider.

I am not sure the index providers would agree! JPMorgan is not in the business of saving you from moral anguish. An index is just a list. Venezuela is an emerging market. It has bonds. Its bonds are emerging-markets bonds. If you are writing a list of emerging-markets bonds, you could quite sensibly put Venezuelan bonds on that list. What is the problem?

But one thing that we talk about a lot around here is the human construction of investment indexes. The central idea of indexing, of passive investing, is that you own the entire universe of assets rather than making choices about what to buy. But in practice it's never that simple. Most actual indexes aren't really "the entire universe of assets"; they're a particular subset of that universe, U.S. large-cap stocks or emerging-market bonds or whatever. And even within that subset, the membership criteria have to be defined by a human, with some room for judgment calls. And increasingly judgments by index constructors are overtaking judgments by investors in importance: If investors give up their agency to index providers -- if the index providers are the only people actually making decisions about governance or profitability or morality -- then the index providers had better make good decisions. 

The future of passive.

The central idea of indexing, of passive investing, is that you own the entire universe of assets rather than making choices about what to buy, and also it's cheap. I mean: You just buy all the stocks on the list, and then you stop. There's no need to hire brilliant analysts and portfolio managers and pay them millions of dollars to pick stocks. There are some pretty significant economies of scale: One person can pick all the stocks for a $40 billion index fund as easily as for a $40 million index fund, and doesn't need to be paid 1,000 times as much. So it is not that surprising that BlackRock Inc., Vanguard Group and State Street Corp. combine for 83 percent of the U.S. market for exchange-traded funds. ETFs are mostly passive vehicles, passive investors want low fees, and scale is how you get low fees.

But there's still another 17 percent for smaller ETF providers to fight over, and this Bloomberg Markets article details their approaches. Here is my favorite, from Deutsche Asset Management, which uses the traditional financial-industry marketing approach of clothing metaphors:

“It’s like talking to your tailor rather than someone who wants to sell you a suit,” says Reinhard Bellet, the company’s head of passive asset management and Bassett’s boss in Frankfurt. “You cannot just issue a product and say, ‘Good luck!’ You have to be there, and you have to be a partner of the client, and I think that’s the future of passive: providing service.”

See, it's bespoke! I mean arguably providing service is the past of active management; arguably investors have concluded that actually they were overpaying for service and what they really want is to be handed a cheap broad market index and be left alone. But obviously that is not true of all ETFs, or all ETF investors: Many investors want narrowly focused ETFs with lots of trading opportunities -- active management by other means -- and providers are happy to give it to them.

Elsewhere in niche ETFs, I wrote on Friday about Dani Burger's "cat" index, and the need (or lack thereof) for a human-legible economic intuition underlying a factor. About a dozen people reminded me of Robert Mercer's line in Sebastian Mallaby's "More Money Than God":

“Some signals that make no intuitive sense do indeed work.” Indeed, it is the nonintuitive signals that often prove the most lucrative for Renaissance. “The signals that we have been trading without interruption for fifteen years make no sense,” Mercer explains. “Otherwise someone else would have found them.”

Perhaps there is still hope for the cat factor.

Blockchain blockchain blockchain.

Central banks seem to love thinking and writing about bitcoins and blockchains, which I guess makes sense. If you are a central bank, your basic job is to keep an electronic list of who has dollars or pounds or whatever, so you might be particularly interested in new ways of keeping electronic lists of who has money. There is not usually a lot of breaking news in Keeping Lists of Money Quarterly, so it's understandable that the blockchain stuff has caught the eye of a lot of central bankers.

But the blockchain is not an obvious fit for central banks. The point of a blockchain is to decentralize the keeping of ledgers of assets. Central banks have "central" right in the name. I once said: "the central bank issues the money; it could just keep a list of how much money everyone has, and that could be the official list, and that would be that. You don't need a blockchain." 

But here is Simon Scorer at the Bank of England's Bank Underground blog with what I think is the most sensible thing about blockchains I've read from a central bank. In particular, Scorer thinks that the main benefit of using a blockchain "is the high level of operational resilience it might offer by avoiding a single point of failure":

This resilience comes at a cost: you only get the full resilience benefits if you’re willing to allow multiple parties (i.e. transaction validators) to manage transactional data; which raises significant privacy challenges.

The main solutions are "to not include sensitive data on the shared ledger," which "may limit the extent of any resiliency benefits" (if the shared ledger doesn't include actual transaction details, it's not really usefully shared), or to include the data but fully encrypt it, which "presents a significant challenge in asking a group of participants to agree on the validity of transactions, without allowing them to see the full details." 

Elsewhere in blockchains: Possible bitcoin unicorn!

Coinbase Inc., is in talks with potential investors on a new round of funding at a valuation of more than $1 billion, according to people familiar with the matter.

It is unclear which investors are committing to the round, which was described as targeting around $100 million or more. That would represent the largest funding round on record for venture-backed bitcoin companies.

And: "The number of job adverts on LinkedIn for blockchain-related positions has more than trebled in the past year." 

Elsewhere in central banking.

Here is "(Why) Do Central Banks Care About Their Profits?" by Igor Goncharov and Vasso Ioannidou of Lancaster University and Martin Schmalz of the University of Michigan:

We document that central banks are significantly more likely to report slightly positive profits than slightly negative profits. The discontinuity in the profit distribution is (i) more pronounced amid greater political or public pressure, the public’s receptiveness to more extreme political views, and agency frictions arising from governor career concerns, but absent when no such factors are present, and (ii) correlated with more lenient monetary policy inputs and greater inflation.

"The discontinuity is unlikely to be a mechanical byproduct of the central banking business model," they write, "and more likely the result of imperfect de facto independence of the central bank." The more worried the bank is about its independence, the more pressure there is on it to say "well, at least we are profitable." Elsewhere: "Have the Swiss National Bank’s currency interventions actually been good for Switzerland?" 

John Paulson.

Of all the problems to have, the problem of client withdrawals leaving your hedge fund with just $2 billion in client money to go with $8 billion of your personal money is the least bad problem. Oh I know, I know, people think it's a problem for John Paulson, who at his peak "oversaw $38 billion -- half of which belonged to outside investors." 

“As outside assets continue to erode, the running question for Paulson becomes more forceful: Why doesn’t he just convert to a family office?” said David Tawil, the founder of Maglan Capital LP, a New York based hedge fund that specializes in event-driven strategies. “But to get the firm back on the rails, I don’t think is impossible.”

But the central fact is that he is still running $8 billion of his own money, which means that he has $8 billion of his own money, which means that his problem is better than anything that has ever happened to almost anyone else on Earth. 

Management methods.

One possibly out-of-consensus belief that I have is that there are not a lot of classic supervillain scenes at modern public companies. A popular view of the financial crisis, for instance, is that there was a meeting in an executive dining room at Goldman Sachs where the head trader said "let's trick our clients into buying bad mortgages so we can profit from the coming crisis," and then the CEO said "yes and then we can take everyone's houses," and then the general counsel said "also I just want to add that this is a crime and I love it," and then they cackled and tossed around wads of cash, and that if prosecutors could just find the videotape of that meeting then we could finally achieve justice and put the crisis behind us. I do not think that happened. I think that most of the time, when a company does a bad thing, it is the result of a series of smaller local decisions that were understandable in their own terms, that most people don't knowingly choose to do bad stuff, and that when they do, they are shamefaced about it and don't go around gloating with each other. People who work at big corporations -- even banks! -- are, in my experience, people, and explicit self-aware evil seems to be unusual among people everywhere.

But Charles Duhigg notes that Mylan NV's EpiPen, which was hugely controversial last year for how expensive it is, remains just as expensive. And he reports that, starting in 2014, Mylan executives "began warning Mylan’s top leaders that the price increases seemed like unethical profiteering at the expense of sick children and adults." And that one of those top leaders was chairman Robert Coury, and that this happened:

Mr. Coury replied that he was untroubled. He raised both his middle fingers and explained, using colorful language, that anyone criticizing Mylan, including its employees, ought to go copulate with themselves. Critics in Congress and on Wall Street, he said, should do the same. And regulators at the Food and Drug Administration? They, too, deserved a round of anatomically challenging self-fulfillment.

Ah. Yes. What? For some reason I imagine him keeping the middle fingers up throughout what sounds like a fairly long tirade. You know how boards of directors sometimes go into executive session? Maybe Mylan's sometimes goes into Double Extended Middle Finger Session, in which everyone just vents about their critics. Mylan says that "any allegations of disregard for consumers who need these lifesaving drugs, government officials, regulators or any other of our valued stakeholders are patently false."

Elsewhere, Ronald Barusch argues that "Investors concerned about governance and shareholder control should think twice about investing in companies organized under Dutch law," like Mylan:

In the case of Mylan, a group of pension funds launched a campaign earlier this week to unseat six members of Mylan’s board over executive pay issues. But it isn’t likely to have much of an impact. As the company’s proxy statement explains, under Dutch law and the company’s charter, shareholders don’t have a right to replace directors at annual meetings. Directors are appointed “from a binding nomination proposed by the Mylan Board.” In other words, shareholders have no right to a say in who gets nominated. They can vote no on the board’s nominees, but it takes a whopping 2/3 of the shares voting at the meeting to defeat a nominee. Even if shareholders could muster up enough votes, the board just makes more “binding nominations” for election.

Presumably the binding nominations are made in a Double Extended Middle Finger Session of the nominating committee.

People are worried about unicorns.

Here is a story about Palmer Luckey, who founded and sold virtual-reality unicorn Oculus VR to Facebook Inc., "was pressured to leave Facebook months after news spread that he had secretly donated to an organization dedicated to spreading anti-Hillary Clinton internet memes," and is now working on a new startup, to be funded by Peter Thiel, that will make a virtual border wall. Also he likes cosplay and collects decommissioned missile silos. "A person who knows him described Mr. Luckey as a casual 'prepper,' someone who prepares for societal collapse," and really who among us is not at least casually preparing for societal collapse? 

Things happen.

Bank at Center of U.S. Inquiry Projects Russian ‘Soft Power.’ Saudi-Led Alliance Cuts Ties With Qatar. Lawyers warn Saudi Aramco of New York IPO litigation risks. Dissecting Marissa Mayer’s $900,000-a-Week Yahoo Paycheck. Kushners Hunting Hard for a Loan to Pay Back Chinese Investors. Chinese Companies Move Deeper Into Shadow Banking. As Seats Go Unfilled on Federal Panels, Businesses Face Uncertainty. One of Trump’s potential Fed picks is a huge fan of negative interest rates. Banco Popular to Meet ECB as It Weighs Options for Liquidity. Star Rapper Akon Mulls IPO of Chinese-Funded African Solar Unit. Justice Department Drops Antitrust Case Against AmEx, But 11 States Press On. How Goldman changed its ways to boost women at the top. Cheddar to Fusion. The Most Interesting Man in the World "had a lovely dalliance with one of Groucho Marx’s wives" and is friends with Barack Obama. Man who mowed lawn with tornado behind him says he 'was keeping an eye on it.' Harvard Rescinds Acceptances for At Least Ten Students for Obscene Memes.

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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.

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