Selling Software That Sells Funds

(Bloomberg Opinion) -- Are banks tech companies?

The last time we talked about BlackRock Inc.’s Aladdin risk-management system—which I somehow did not know stands for “Asset, Liability, Debt and Derivative Investment Network”; good acronyming!—\was when Morgan Stanley was bragging about its use of Aladdin to advise brokerage clients on their risk. I wrote then that many of the traditional roles of banks in financial markets—to provide capital, to take market risk, to coordinate information, to advise on what securities to buy—have become less important, as regulations change and as technology becomes more powerful. Instead the technology itself is more important, and the banks—and other big financial firms like BlackRock—are increasingly software providers, giving clients the benefit of their wisdom and information not in the form of personal advice and stock-picking, but in the form of software.

Here’s Bloomberg’s Annie Massa on BlackRock’s broader effort to get wealth managers to use Aladdin:

“There is a huge opportunity for Aladdin to be the language of portfolio construction,” said BlackRock Chief Operating Officer Rob Goldstein during his presentation. “We’ve only just scratched the surface here.”

Aladdin is the lynchpin of BlackRock’s fast-growing technology business. Chief Executive Officer Larry Fink has said he hopes technology will power 30 percent of the firm’s revenue by 2022, though he said last year that would be a “giant reach.”

Okay let’s pretend that BlackRock is a technology company whose business is building cool portfolio-construction tools for clients. Here’s a question for you: How does it make money doing that? Obviously lots of technology companies make money the simple way, by selling their software to customers and charging them for the software, customer support, etc., and that seems to be BlackRock’s main model for profiting from Aladdin. (“Revenue for these services may be based on several criteria including value of positions, number of users or accomplishment of specific deliverables,” it notes in its 10-K, and “Aladdin assignments are typically long-term contracts that provide recurring revenue.”) 

But lots of other technology companies—Facebook, Google—make their money by delivering free software and then selling ads against it. The idea is that if your software is good enough, your users will use it constantly, and their attention will be more valuable than their money. And Aladdin seems to operate on that model too:

Winning over brokers and investment advisers will give the firm a huge platform from which to sell mutual funds and ETFs -- and expand its already vast, some say alarming, influence in finance. …

If Aladdin spots gaps or undue risk in portfolios, BlackRock can be in a good position to promote -- and sell -- its products, especially low-fee ETFs and index funds that clients on Main Street crave.

You set up Aladdin, it looks at your portfolio, it tells you what BlackRock funds you need to buy, and you buy them. It’s got your attention, and it uses that attention to sell you stuff. And the better Aladdin is for customers—the more you trust it to analyze your portfolio and tell you what to do—the more effective it will be as a sales tool.

It’s an obvious, pleasing, yet somehow strange revenue opportunity for financial companies. Last month there was a story about Goldman Sachs Group Inc. rolling out an activism-defense app:

It used to take Goldman Sachs Group Inc. bankers days to analyze a company’s vulnerability to activist investors. Now, the firm is launching an app that lets clients do it themselves in seconds.

Goldman Sachs has spent two years quietly developing “Jupiter,” a program that sifts historical data on a company’s shareholders, then combines that with other information to rate its vulnerability to activists. The firm will offer the app in coming weeks to clients that could become targets of corporate raiders.

I have not been beta-testing Jupiter or anything (does it stand for Just Use a Pill If There’s Ever a Raider?), but the way I imagine it works is that you open the app; it downloads information about your stock price, governance situation and shareholder base; it ignores that information; and it says “Yep you are vulnerable to an activist, better have a Goldman Sachs banker come in and talk with your board about your takeover defenses, and maybe while she's there she could pitch you on a few acquisitions you might want to do?” Like, what could be the point of that app if not to give Goldman Sachs a point of entry to talk to the company and pitch for business? It is a hybrid model of banks as technology companies: They are tech companies, and their tech products are supported by advertising, but the advertising is for themselves.


I sort of love Just Capital, the nonprofit organization created by Paul Tudor Jones II and Deepak Chopra (!), and championed by Andrew Ross Sorkin and Alessandra Stanley at the New York Times, whose aim is to rank public companies on their “justness” (!), and which is now teaming up with Goldman Sachs Group Inc. (!) to create an exchange-traded fund (!) of the justness-est Russell 1000 companies. Back in the good old days, before “Dennis Rodman arrives in Singapore for the Trump-Kim summit in a T-shirt promoting a cannabis cryptocurrency” was a real thing that happened, that was the sort of incongruous assortment of words that I could really enjoy. Also I have said it like 100 times now and the word “justness” still just makes me laugh.

Goldman Sachs: If you care about justness, you should invest in our new financial product.

You: You mean, if I care about justice?

Goldman Sachs: I never said that, you said that.

Anyway Sorkin has a column about the new ETF, and how it “would have outperformed the Russell 1000 by 3.47 percent over the past two years” in a backtest. You might consider Cliff Asness’s argument that for socially responsible investing to work, it must have lower expected returns than socially irresponsible investing, but that is a bit of a downer so maybe ignore it for now.

What I like about Just Capital, besides its terminology, is its methodology. Socially responsible investing—particularly, socially responsible index investing—is hard because it is difficult to know what to care about, and how much. If you run an investment portfolio whose objective is to maximize returns, then you know what you are looking for (stocks that will go up), and you know how to measure your performance (did the stocks go up). If you run an investment portfolio whose objective is to maximize returns and social welfare, then, first of all, how do you manage the tradeoff between those goals? But even harder: How do you manage the tradeoffs among social-responsibility goals? How do you pick what those goals are, and rank which are most important, and quantify how much of one is worth how much of another? If a company is generous with its workers and honorable with its customers, but pollutes a lot, is that better or worse than an environmentally pristine company that uses unpaid interns? 

The approach you see a lot in socially-responsible investing is to assume away the problem. “Whether social impact investing will turn out to be the most profitable way to invest has become one of the biggest questions within the investment world,” writes Sorkin, and of course if the answer is yes then you don’t have to worry about the tradeoff between profits and social responsibility. (Asness’s side of this debate—that it’s not a question at all, and that the point of social impact investing is to be less profitable—seems a lot more compelling to me.)

The subtler form of this argument is that these issues go to the long-term sustainability of a company, and that a company that is environmentally rapacious or mistreats its workers will underperform in the long run, even if it does well today. This argument suggests a way to rank and optimize social-responsibility criteria: Whatever is most important to the long-run success of the company should get more weight. (If mistreating workers will depress morale a little without causing a crisis, while polluting will ultimately lead to massive liability and bankruptcy, then you should care more about the pollution, etc.) But if you really believe all of this then you are sort of back where you started from. That’s a financial ranking. Stock prices, after all, are supposed to discount the expected future cash flows of a company, in perpetuity. If those expected cash flows will be lower in the far future because the company pollutes too much or whatever, then that should be reflected in the stock price. Your measure of success in socially-responsible investing is just, did the stock price go up and stay up for a long time. You are making active bets about what characteristics are most likely to maximize the stock price. You’ve gone back and subordinated everything to maximizing stock price, but in a more roundabout way.

Alternatively you could figure out what you care about and optimize for that, whether or not it maximizes the stock price in the long run. This is fine if you are a person, but harder if you are an asset manager or index provider who wants to market a product. “Why should I invest in a fund that buys stocks based on the social issues the fund manager cares about personally,” a customer could reasonably ask.

Just Capital takes another approach that I find pleasingly bizarre and random: It does an annual survey. From its methodology page:

The 2017 Survey Results defined seven major sets of issues that capture corporate justness, which in our ranking model we call Drivers. Each Driver comprises multiple specific criteria, which we call Components. These determine what we actually measure in the model, and there are 39 Components in total. Through extensive quantitative polling, we then derive weights for the Drivers and Components, which correspond to their relative importance in the public’s opinion. We make sure the opinions we gather are as representative as possible of all Americans.

To produce the company rankings, we then collect and evaluate data from a myriad of different sources on how each company actually performs across the various Components. 

I mean. I don’t know why any individual person would want to invest in a way that maximizes the weighted social preferences of a broad survey of Americans, and that changes each year as those preferences chnage. You should invest in a way that maximizes your preferences, not the average preference. On the other hand, I can understand why an asset manager offering a product would want to maximize the average preference. That's where the money is! (Really you should weight the preferences by net worth rather than trying to be “as representative as possible of all Americans,” but whatever.) Mostly though I just like it because it is an approach, a way of ranking and deciding between social criteria that—well, that isn’t objective, exactly, but that pushes the subjectivity back onto someone else.

Controlling CEOs.

I admit that I have not seen this before:

Check out this section of Comcast’s articles of incorporation:

“The Chairman shall be Mr. Brian L. Roberts if he is willing and available to serve. … The CEO shall be Mr. Brian L. Roberts if he is willing and available to serve. For so long as Mr. Brian L. Roberts shall be the CEO, he shall also be the President of the Corporation.”

Board members are usually subject to shareholder votes when they’re up for reelection, and CEOs typically renegotiate their employment contracts every few years. But absent the kind of scenarios you can imagine would justify invalidating Comcast’s corporate charter, he’s basically CEO for life, or at least as long as he wants to be.

That’s my Bloomberg Opinion colleague Tara Lachapelle writing about Comcast Corp., where Brian Roberts is in charge not just because he happens to be the chairman and chief executive officer (which, normally, is the sort of thing that the board of directors decides, and can change), and not just because he happens to own Comcast’s all of super-voting stock, giving him 33 percent of the voting power of the company (which could always change, if he sold it), but also because the charter says that he’s the CEO. If the other shareholders got together and voted in a new board of directors, and that board of directors voted him out as CEO, he could just sit back, cross his arms, and say “nah.” 

We have talked recently about some strange fights over the control of corporations. Can CBS Corp.’s board get rid of a controlling shareholder because it doesn’t like her? Can she get rid of them? Can Rockwell Medical Inc.’s board of directors fire its CEO? Can he ignore them, just because he happens to know the password to make securities filings? We have also talked a lot about founders of buzzy technology companies, and their controversial efforts to keep control of their companies. Can Mark Zuckerberg  keep his voting control of Facebook Inc. even if he sells his super-voting stock? Can Evan Spiegel and Bobby Murphy take Snap Inc. public by selling non-voting shares, so that they can retain control forever?

These controversies pop up because there is deep, genuine uncertainty about what a corporation is supposed to be. Is it an entity owned by the shareholders, managed by directors and managers who work at the shareholders’ pleasure and answer to them? Is it a project controlled by a founder-CEO, with public shareholders who come along for the ride but who have no special claim to control the company? Is it a complex network of contracts and relationships whose ultimate power is embodied in a board of directors? All of those views have their adherents, and each of them is more or less correct in different particular companies, but none are universally accepted, and nothing is ever spelled out, and the specifics are often contested in muddled ways.

But you could just write it down! You could just found a company and put in the charter “this company belongs to Mark Zuckerberg and if you want to give him money that’s your problem,” or whatever. Obviously spelling out the voting rights of different classes of stock, etc. etc. etc., can have much the same effect, but we are not talking about effects here. We are talking about clarity. If you say in the charter that it doesn’t matter what the shareholders think because the CEO is in charge, then that makes the situation clear in a way that no amount of triple-class stock can do.

Index adds.

Rob Arnott is criticizing index funds for adding stocks when they are added to the index:

Trading during the grace period inflates the prices of the new additions and drags down the stocks that are being removed, Mr. Arnott said. By the time the effective date rolls around, investors are stuck overpaying for the new stocks and getting lousy prices for the stocks they must sell.

The index performance suffers, but passive managers can say they are following their mandate to match the benchmark, Mr. Arnott said. ...

Mr. Arnott’s solution? Slower action. Instead of trading when everyone else does, index managers should wait a few months for prices to snap back to normal levels. Deletions outperform the market by more than 21% in the year after being cut while additions lag by 1.3%, his research showed.

This seems like a pretty simple thing to implement, no? Like, let index funds be index funds and track the index, but start your own lagged index fund that tracks whatever the index was a year ago. It should get outperformance by owning outperforming dropped stocks and not owning underperforming added stocks. It’s a form of “smart beta” I guess, but if I were marketing it I would call it “Slow Indexing.” If that doesn’t exist let’s just say that I’ve trademarked it and will license it to you for a reasonable fee.

People are worried about non-GAAP accounting.

Here are Alexandra Scaggs and Jamie Powell making fun of Aleris International for using accounting measures with silly names:

In the documentation announcing its debt restructuring, Aleris included figures called “further adjusted ebitda” and “structuring adjusted ebitda”. 

Scaggs and Powell’s headline is “‘Structuring adjusted ebitda’ now exists,” but surely the winner there is “further adjusted Ebitda.” Like:

  • “Adjusted Ebitda” means earnings before interest, taxes, depreciation, amortization, and whatever else you’re adjusting out.
  • “Structuring adjusted Ebitda” really ought to mean earnings before interest, taxes, depreciation, amortization, and structuring costs; in grammar—though not in practice—it ought to be narrower than “adjusted Ebitda.” 
  • But!
  • “Further adjusted Ebitda” means earnings before interest, taxes, depreciation, amortization, and whatever else you’re adjusting out, and then also the further things you’re adjusting out.

Like, you can just adjust all the things in “adjusted Ebitda” and not need to adjust any further. Have it go up to “adjusted,” and make “adjusted” louder, you know? If you’re too embarrassed to adjust for a thing in “adjusted Ebitda,” why aren’t you also too embarrassed to adjust for it in “further adjusted Ebitda”?

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