Tagged: Citadel

Boxed Yellow Pencils

“How do you think about ESG?” said my friend Moriah Shilton at a San Francisco NIRI summit some weeks back with hedge fund Citadel.

Silence. The four panelists shifted around.  A couple whispered to each other. Finally, somebody offered with a throat-clearing cough, “It doesn’t factor into our portfolio decisions.”

For those not fluent in Investor Relations (IR) Speak, ESG is “Environmental, Social, Governance.”  NIRI is the National Investor Relations Institute, professional association for the liaison between public companies and Wall Street.

ESG dominates the contemporary IR educational platform. NIRI has made a policy statement on ESG. There are at least two ESG sessions here at the NIRI Senior Round Table meeting (and NIRI national board meeting) this week in Santa Barbara.

The ESG heat isn’t coming from stock-picking investors, the “long-only” audience of public companies spending billions annually on communication through compliance-driven reports like 10Ks, 10Qs, press releases and proxies and via proactive outreach aimed at increasing share-ownership.

Nor is it, apparently, coming from hedge funds like Citadel, the other key audience – and I’d argue now the vital IR constituency because of its capacity to compete with the Great Passive Investment Wave – for public companies.

In fact, the Citadel team later said, “We vote with management on proxy matters, or we vote with our feet by selling shares.”

It’s passive money that’s obsessed with ESG. Passive investment to us is any form of capital allocation for a day or more (by contrast Fast Trading is an investment horizon of a day or less) driven by rules. That’s index investing, Exchange Traded Funds, or any variety of quantitative investment, from global macro to statistical arbitrage.

True, passives may oppose a proxy measure that doesn’t comport with an ESG platform. They will, however, continue owning the stock. Index funds pegged to a benchmark like the S&P 500 are required to own the securities comprising the benchmark.

It’s cognitively dissonant to own things you oppose.

But aren’t they trying to promote practices that make companies better stewards for stakeholders?

From my first exposure to it, good business has been sound financial management, the right people, products, markets, capital structure, the advancement of the best interests of your customers, employees, communities. These are essential strands of business DNA.

In fact, turning those into a checklist promotes the possibility that mediocre firms are treated the same as stellar ones by virtue of filling out a form.  Rules breed uniformity.

Nowhere is that more apparent than in the stock market, where rules push prices toward a mean. Track the midpoint – as Passive money does – and returns become superior by pegging the average.

The investor-relations profession, the pursuit of excellence, Warren-Buffett-style investment strategies, are about unique differentiation.  What makes a company better, superior?

Rules-based investing makes things the same. Passive money has boomed because shares of companies are increasingly products defined by shared criteria, like ESG. The more of that there is, the greater the probability the market will become homogeneous.

Without dismissing its merits, I’m perplexed by why public companies and stock-picking investors would promote shared criteria like ESG (why not differentiate with ESG if you’re so moved?).  We don’t want the stock market to become a bunch of yellow pencils in a box.

I think a form of guilt has gripped the passive-investment colossus like what manifests among the Silicon Valley nouveau riche who ofttimes with minimal effort realize vast wealth, and then feel compelled to browbeat the rest about the “greater good.”

How one favors the greater good should be individually chosen, not directed by rules.

So from atop vast heaps of assets gained through doing nothing more than tracking a benchmark, Massive Passives are compelled to berate the market over purpose.

If that purpose is an ESG checklist, the purpose is a dictated set of rules.  The very thing passive investment promotes.  Ironic, right? By subtly suggesting moral superiority, passive investment advances its own self-interest: rules-based investing.

Rather than mindlessly embracing ESG as good for all, a sentient species capable of staggering creativity and achievement through the individual pursuit of happiness that inures to the benefit of the masses owes itself moments of objective reflection.

And the question to ponder is whether a uniform ESG blanket tossed over the capital markets furthers the pursuit of the excellence the IR profession and stock-pickers seek.

The Fortress

Happy birthday to Karen Quast! My beloved treasure, the delight of my soul, turns an elegant calendar page today. It’s my greatest privilege to share life with her.

Not only because she tolerates my market-structure screeds.

Speaking of which, I’m discussing market structure today at noon ET with Joe Saluzzi of Themis Trading and Mett Kinak from T Rowe Price. In an hour you’ll mint a goldmine of knowledge.  Don’t miss it.

A citadel by definition is a fortress.  I think of the one in Salzburg, Austria, the Hohensalzburg castle perched on the Salzach, “Salt River” in German, for when salt mined in Austria moved by barge.  We rode bikes there and loved the citadel.

It’s a good name for a hedge fund, is Citadel. We were in San Francisco last week and joined investor-relations colleagues for candid interaction with Citadel. IR pros, hedge funds are stock-picking investors capable of competing in today’s market.

Blasphemy?  Alchemy?  I’ve gone daft?

No, it’s market structure. Exchange Traded Funds (ETFs) have proliferated at the expense of what we call in the IR profession “long-only” investors, conventional Active managers buying stocks but not shorting them.

Since 2007 when Regulation National Market System transformed the stock market into a sea of changing stock-prices around averages, assets have fled Active funds for Passive ones.  ETF assets since 2009 have quadrupled, an unmatched modern asset-class boom.

Underperformance has fueled the flight from the core IR audience of “long-onlys.” Returns minus management fees for pricey stock-pickers trails tracking a benchmark. So funds like SPY, the ETF mirroring the S&P 500 from State Street, win assets.

Why would a mindless model beat smart stock-pickers versed in financial results? As we’ve written, famous long-only manager Ron Baron said if you back out 15 stocks from the 2,500 he’s owned since the early 80s, his returns are pedestrian. Average.

That’s 1%. Smart stock-pickers can still win by finding them.

But. Why are 99% of stocks average? Data show no such uniformity in financial results. We come to why IR must embrace hedge funds in the 21st century.

Long-onlys are “40 Act” pooled investments with custodial assets spent on a thesis meant to beat the market.  Most of these funds must be fully invested. That is, 90% of the money raised from shareholders must be spent.  To buy, they most times must first sell.

Well, these funds have seen TRILLIONS OF DOLLARS the past decade leave for ETFs and indexes (and bonds, and target-date mixed funds). Most are net sellers, not buyers.

Let’s not blindly chase competitively disadvantaged and vanishing assets. That confuses busy with productive. And “action” isn’t getting more of the shrinking stock-picking pie.

First, understand WHY ETFs are winning:

  • ETFs don’t hold custodial assets for shareholders. No customer accounts, no costs associated with caring for customers like stock-pickers support.
  • They don’t pay commissions on trades. ETFs are created and redeemed in large off-market blocks (averaging $26 million a pop, as we explained).
  • They don’t pay taxes.  ETFs are created and redeemed tax-free through in-kind exchanges.
  • ETFs avoid the volatility characterizing the stock market, which averages about 3% daily in the Russell 3000, by creating and redeeming ETFs off-market.
  • And fifth, to me the biggest, stock-market rules force trades toward average prices. All stocks must trade between the best bid to buy and offer to sell. The average.

So.  Stocks are moved by rule toward their average prices. Some few buck it.  Stock-pickers must find that 1%. Money tracking benchmarks picks the 99% that are average. Who’s got the probability advantage?

Now add in the other four factors. Who wins?  ETFs. Boom! Drop the mic.

Except dropping the mic defies market rules prohibiting discrimination against any constituency – such as stock-pickers and issuers.

SEC, are you listening? Unless you want all stocks to become ETF collateral, and all prices to reflect short-term flipping, and all money to own substitutes for stocks, you should stop. What. You. Are. Doing.

Back to Citadel. The Fortress. They admit they’re market neutral – 50% long and short. They use leverage, yes. Real economic reach isn’t $32 billion. It’s $90 billion.

But they’re stock-pickers, with better genes. Every analyst is covering 25-55 stocks, each modeled meticulously by smart people. Whether long or short they meter every business in the portfolio. Even analysts have buy-sell authority (don’t poo-poo the analysts!). And they’re nimble. Dry powder. Agile in shifting market sand.

They can compete with the superiority modern market structure unfairly affords ETFs.

So. Understand market structure. Build relationships with hedge funds. This is the future for our profession. It’s not long-onlys, folks. They’re bleeding on the wall of the fortress. And don’t miss today’s panel.

Behind the Trade

We were in King Soopers and they were out of lemons.

For those of you elsewhere in the country and world, King Soopers is a Kroger-run grocery chain and I’m sure you’re thinking as I did when I first saw one, “Who names a store King Soopers?”

I bet you’re also thinking, how do you run out of lemons? Answer: deliveries hadn’t arrived. We take for granted that stuff will be on the shelves. Having lived a year in Sri Lanka in college, where oftentimes there wasn’t anything on the shelf because no shipments had come, I grasp limited liquidity.

When stocks rise in price, we figure there must be more buyers than sellers. When they decline, the opposite must be true. You laugh, yes. But how do shares get on shelves in the first place?

A long time ago, there were just a couple stores, like the New York Stock Exchange, owned by the firms who stocked the shelves – literally. Brokers had books of business comprised of owners of shares. In 1792 under a buttonwood tree in lower downtown New York City one May day, 24 brokers agreed to confederate, recognizing that pooling business would create a marketplace. The NYSE was born (next week it becomes a subsidiary of derivatives market The ICE). (more…)