Tuesday, September 10, 2013

The Great Temptation or Why Asset Mgmt Firms Will Fail The Marshmallow Test

Consider for a moment the temptation of managing a large mutual fund (and ETF) complex (or, if you are in the UK, a Unit Trust or similar regulated collective investment scheme) on which you earn relatively small but steady fees on large AUM, alongside a stable of hedge funds upon which you ostensibly earn larger management fees and incomprehensibly-ginormous-to-ordinary-human-being performance fees on more moderately-sized AUM. If you cannot guess where I am going with this, you are either:  (a) unusually scrupulous, or, (b) have never worked in cut-throat finance or trading. For the avoidance of doubt: rarely has Wall St. (& the City) failed to unsalubriously exploit the spoils yielded by the nexus of opportunity and incentive (e.g. HFT, JPM's manipulation of western power markets, tainted research, CDOs of sub-prime mortgages, insider trading, mis-selling PPI, banks' collective gaming of Libor, etc. etc. etc.). And that is just in finance.

Consider that on any given day, one learns of incredible feats of extraction in some industry or vertical (today WSJ highlighted the $2bn bonanza executives lavished upon themselves in the For-Profit education sector), and contrast that (according to the BBC) against the scruples and integrity of First World War British Captain Robert Campbell who, as a POW in Germany requested - and was granted leave - by Kaiser-Willie-Deux in order to visit his dying mother on the basis of "his word" and promise to return to the POW (which he in fact did). Jamie Dimon, David Einhorn or Phil Falcone would of course just call him a chump or an idiot. We truly live in different times in which numero uno is ultimo primo. Capt. Campbell knew however, that his actions or dishonor would in future directly impact other POW officers in potentially the same predicament. And so, in those different times, he returned to present himself as a captive at the POW camp, after which he set his best efforts upon tunneling his way back out.

As convergence in asset management gathers pace, with Hedge Fund managers offering "long-only" vehicles and services, and long-only shops and fund complexes pulling out all the proverbial stops to launch and gather assets for all things 2&20, investors are being asked in these different times 'to trust' - yes, to T-R-U-S-T (in boldfaced upper-cased font) - that their investment manager(s) will conjure integrity, pass the marshmallow test, and will not make cannon-fodder out of their non-performance-fee-paying, non-hedge-fund clients as managers pursue The Really Big Prize, the Fuck-You prize, the one that lets you Fly Private at will or purchase Professional NHL Hockey Teams, simply because you can. This, at a time when the currency of TRUST is, I believe, at all-time low.

Try as I might, I cannot see how this will end well - for integrity in general, or non-hedge fund investors in particular.

Granted, conflicts between adjacently-managed hedge funds and long-only funds are not a prerequisite for dishonesty or malfeasance. No shortage exists in other spheres outside finance. But if one believes, as I do, that humans beings will rarely fail to miss an opportunity to steal a cookie when: (a)  the jar is full (b)  the jar is conveniently-placed and (3) few - outside others who have a reasonable appreciation and appetite  for cookies - are in a position to monitor the cookies, then it follows that, with these conditions met, the temptation for investment managers will likely prove irresistably-great.  

I do not have a particularly evil or cunning mind, but I can, without great difficulty, imagine morally challenging situations  - chinese walls, or not - the kind where the incentives of almost everyone involved will be, in marshmallow parlance, to eat it now, rather than take one's chances later, irrespective of the elevated gains accruing to the patient. Imagine the fund complex, sweet on a stock, who've accumulated an elephantine position in the same. Their HF will likely have shared in the feast (and the benefits upon the marks of continued accumulation) transmuting the appropriate debits from their investors' accounts, into credits of their own. Now (we'll call them "BlueRock Mgmt" or "BlackBay Partners") Black&BlueRockBay have soured on the portfolio firm's prospects. Of course they can unwind together. But The Temptation for the HF to unwind in front of the larger positions - because it's smaller and more nimble, and it can, and because it likely has limited transparency - and because its AUM has a much higher beta to performance, to unwind, must be excruciating...both for the managers of the HF, and their managers.  How excruciating? Well that likely depends upon HF performance in more or less inverse proportions. Or if they are feeling less-bold, they can sell calls, or buy puts, or for the truly greedy, unwind AND go short well-before the MotherShip has fully left orbit. I'd even posit that, as a result of such increasing adjacencies, window-dressing activity around performance crystallization periods would increase lock-step in line with the opportunities to game the fee-structure disparities - entirely related to the increased ability to impact prices from the much larger scale of adjacent assets. That's the basic blue-print. Moreover, there are large asymmetries in the intensity of managers (and their management's) interests for banking short-term profit, rather than waiting for long vesting periods for their ownership interests, or building long-term value of their firm. Short-termism seems to trump patience in most circumstances outside the partnership structure

Scoffers might argue that in the long run, they will be discovered.  One might point out that economies of scale across the functional areas of an investment management firm - in research, compliance, back-office, trading, portfolio management, technology, and marketing - make such combinations not only sensible but deterministic. One might highlight the integrity of certain trusted individuals or firms. And they might well be right to do so. But such a view remains panglossian in failing to address the inherent conflicts between the two undertakings, the payoff asymmetries and more-than-ample opportunity that in many other similar conflicted situations would lead to large transfers of wealth from investors in long-only collective schemes to investors and, as importantly, managers and manager's managers of Hedge Funds. And should such a firm erect truly impermeable Chinese walls - separating research, portfolio management, trading, possibly even risk-management, so whithers the argument for the economies of scale outside of share a back-office and a (ummm... errrrr... trusted?!?) brand-name.      

By this point in my missive, interested parties will be protesting ferociously, and preparing their counter-points, if not for me, then for their potential investors, their existing investors, and their existing  investors' investors. Ignoring the absurdity of the average HF fee structures, ignoring the alpha vs. beta debate (because this is, of course, NOT a diatribe AGAINST HFs) but rather a spotlight on the burgeoning pregnancy of conflicts between traditional AM and HFs that result from adjacency, and taking on board proponents likely counterpoints, I ask investors to consider aspects common to much of the fraud and malfeasance.  Most - excepting the most sociopathic - do not embark upon a grand pre-meditated fraud a-la "The Sting".  They do not set out to be fraudsters. In fact, rather the opposite. They embark upon a venture that has a plausible kernel of success at its core. Madoff, Lauer, Peter Young, Leeson,  Tom&Jack@BeaconHill, all apparently took a perditious route as a result of something that didn't go their way as expected. All, in their own ways, shared the existence of easy opportunity which they could call upon in that moment of errrr..... ummm..... personal need, shame, embarrassment, or greed. All expected their transgressions to be temporary and transitory. Of course there comes a point of no return, and here, their actions diverge down their respective paths of ignominy and the rest is history.
The point is, their intentions at the outset were precisely the intentions of those who will try and convince investors that potential conflicts of interest are not a problem, and their risk therefore inconsequential because of integrity, controls, compliance, surveillance, skin-in-the-game blah blah blah. They want it all, but as an investor, you needn't give it to them at your expense.

As a Hedge Fund investor, this shouldn't frighten you. In fact, it should, and probably will excite opportunity-detector in the most astute of you, the same way SAC excited you: an edge, is an edge, is an edge, so do not ask questions, put the moral compass back in the drawer, and the net transfers will likely be made in your general direction in your favor at the expense of someone less astute and, well, more trusting. However, if I were a long investor in a collective investment scheme assuming what I will term as a large and growing "adjacency risk, I cannot think of the mitigating circumstance(s) that would give me comfort with the exception that they are managing my index fund. Even here, you may be skimmed as there will be a reasonable incentive for the adjacently-managed HF to secure hard-to-borrow shares at less than market rates - an easy pilfer in a highly untransparent unaudited stock-loan market market.

What, would give me comfort as an allocator? Full publicly-available transaction level transparency across the entire fund complex - both public funds and private partnerships, the way it is in Canada. Even if delayed a a quarter, if there is something to be found, it will be found here. Second, culpability both personally and financially, by direct portfolio managers, and supervisors including holdbacks and clawbacks. Neither is complicated, nor difficult. Managers' own back-office systems, or independent administrators can spit out time and sales with great accuracy and easy at the click of button. And no one is asking them to do so in real time (quarterly dumps are fine). Marshmallow-eaters will of course use hyperbolic language such as "draconian disclosure" to describe this, but Canadian firms and managers seems to be doing just fine thank-you-very-much. They will wheel out the "threats to proprietary strategy" or competitive advantage, but none of these pose a threat to the public interest for none of this affects the real flow of capital to enterprises, but only the shuffling of paper in the secondary markets between existing game-players. Until then, however, investors should have the dial of bullshit detectors set to "High", and prepare their due-diligence questions accordingly.    

8 comments:

Behavioral Investors said...

evidence:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526737

"Cassandra" said...

Awesome! Don't know how I missed that one.

To quote from the abstract:
We find that the reported returns of mutual funds in these “side-by-side” associations with hedge funds significantly underperformed those of mutual funds that shared similar fund and family characteristics but differed in that they were not affiliated with hedge funds. Digging deeper into performance, we find that the underperformance was confined to return gaps, a return measure that captures the impact of unobservable managerial actions. Interestingly, mutual funds with investment styles that were most closely aligned to affiliated hedge funds generated reported-return alphas and return gaps that underperformed by the greatest amount.

"Cassandra" said...

And THAT was BEFORE the party started cookin'!

Anonymous said...

Rentech Medallion vs other funds? Um, yes.

Scott said...

Nice post. Even better than transparency would be for managers to focus on doing one thing well (mutual fund or hedge fund) and avoid the skewed incentives and conflicts issue altogether.

stone said...

Hi Cassandra, nice post.

AWB said...

Fiduciary responsibility is not a legal requirement in all financial positions. Such being the case, the ethical option to place clients' interests first falls short.

"Cassandra" said...

AWB: So you agree adjacent investors are f*cked, or at best are in a sub-optimal situation visa-vis investors in the adjacent HF ?