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Opinion
Matt Levine, Columnist
NOBODY WANTS MUTUAL FUNDS NOW
Also contract redlines, bank bail-ins and carbon capture.
October 23, 2023 at 8:26 AM HST
By Matt Levine
Matt Levine is a Bloomberg Opinion columnist. A former investment banker at
Goldman Sachs, he was a mergers and acquisitions lawyer at Wachtell, Lipton,
Rosen & Katz; a clerk for the U.S. Court of Appeals for the 3rd Circuit; and an
editor of Dealbreaker.
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BARBELL STRATEGY
It feels like there are two dominant retail investment strategies:
1. Buy and hold index funds, or
2. Actively trade individual stocks and, while you’re at it, maybe options or
crypto.
Many ordinary people do not want to think about their investments much, and
modern finance has designed a product that is ideally suited for them. It is the
index fund (or index exchange-traded fund), whose essential thesis is that
thinking about investments is unnecessary and in fact bad, and you should just
buy the market and save on costs.
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Other people, though, do want to think about their investments, and they want to
think about investments that are fun to think about: stocks (or options or
crypto) that are volatile, stocks of companies that do fun or interesting or
world-changing things, stocks of companies with charismatic and entertaining
chief executive officers, meme stocks.
There is not much in between. In particular, the whole industry of active mutual
fund management is built on the idea that, if you don’t want to manage your
investments, you can pay someone else to do it for you. But that idea feels
passé in 2023. These days, if you don’t want to manage your investments, the
accepted approach is to pay someone else almost nothing to almost not manage
them for you: An index fund will do almost no managing and charge almost no
fees, and that is widely considered the optimal approach. And if you want to
manage your investments, you want to manage your investments; you want to pick
fun stocks, not hire a star mutual fund manager to do the stock picking for
you.1
Where does that leave the active mutual fund managers? Bloomberg’s Silla Brush
and Loukia Gyftopoulou report that things are bad for them:
> Across the $100 trillion asset-management industry, money managers have
> confronted a tectonic shift in investor appetite for cheaper, passive
> strategies over the past decade. Now they’re facing something even more dire:
> The unprecedented run of bull markets that buoyed their investments and masked
> life-threatening vulnerabilities may be a thing of the past.
>
> About 90% of additional revenue taken in by money managers since 2006 is
> simply from rising markets, and not from any ability to attract new client
> money, according to Boston Consulting Group. Many senior executives and
> consultants now warn that it won’t take much to turn the industry's slow
> decline into a cliff-edge moment: One more bear market, and many of these
> firms will find themselves beyond repair. …
>
> More than $600 billion of client cash has headed for the exits since 2018 from
> investment funds at T. Rowe, Franklin, Abrdn, Janus Henderson Group Plc and
> Invesco Ltd. That’s more than all the money overseen by Abrdn, one of the UK’s
> largest standalone asset managers. Take these five firms as a proxy for the
> vast middle of the industry, which, after hemorrhaging client cash for the
> past decade, is trying to justify itself in a world that’s no longer buying
> what it’s selling. …
>
> “It’s a slow but surely declining trajectory,” said Markus Habbel, head of
> Bain & Co.’s global wealth- and asset-management practice. “There is a
> scenario for many of these players to survive for a few years while their
> assets and revenues decline until they die. This is the trend in the majority
> of the industry.”
Cheery! What do you do about this? One approach is to get into some adjacent
business that does not rely on stock-picking; Abrdn “cut the business into three
parts: a mutual fund business, a wealth unit that also serves retail investors
and a platform for financial advisers — a strategy that has yet to prove it’s
working.”
The other approach is for active managers to get out of liquid easily indexed
public markets and into something else. Abrdn has also “largely abandoned
competing in large-cap equity funds, choosing instead to emphasize small-cap and
emerging-market strategies.” And of course there is private credit:
> For many other firms, private markets — and, specifically, the private-credit
> craze — are now the latest perceived savior. Almost everyone, from small to
> giant stock-and-bond houses, is piling into the asset class, often for the
> first time. In the past year and a half, a surge in M&A in the space has been
> driven by such houses, including Franklin, that are eager to offer clients the
> increasingly popular strategies, which typically charge higher fees. Others
> have been poaching teams or announcing plans to enter the space.
>
> “I think that’s a big driver for many of these firms — they look at their own
> financials and think about what’s going to keep us afloat over the next few
> years,” Amanda Nelson, principal at Casey Quirk asset-management consultancy
> at Deloitte, said in an interview.
“Just buy all the stocks” is a cheap and easy investing strategy that is also
endorsed by academic research, but “just make private loans to all the buyouts”
sort of obviously doesn’t work. So there is room for investment selection, and
fees, there.
Meanwhile at the Wall Street Journal, Hannah Miao reports that actually retail
stock-picking works great:
> Wall Street has long derided amateur investors as unsophisticated market
> participants, prone to buying high and selling low. But the typical individual
> investor’s long-term mindset and penchant for risk-taking has proved fruitful
> in the technology-driven market of the past decade, defying the “dumb money”
> caricature.
>
> The average individual-investor stock portfolio has risen about 150% since the
> beginning of 2014, according to investment research firm Vanda Research, which
> began tracking the data nine years ago. That beats the S&P 500’s roughly 140%
> during the same period.
Some of this is about stock selection: Recent years have been good for the
stocks that retail investors tend to like.
> The typical small investor holds an outsize position in megacap tech
> companies. Apple, Tesla and Nvidia alone make up about 40% of the average
> individual’s stock portfolio, according to Vanda. Although big tech stocks
> plunged last year, those investments have dominated the market for most of the
> past decade and have helped fuel the S&P 500’s 10% advance this year.
But some of it is apparently behavioral: Individual investors can be more
contrarian than professionals can.
> One advantage small investors have over professionals: They don’t have to
> worry about reporting performance to clients. That helps some individuals feel
> comfortable riding out market downturns. …
>
> Everyday investors are known to buy the dip, piling into markets during weak
> periods. Many jumped into stocks in March 2020 when the market plunged at the
> onset of the Covid-19 pandemic, and rode the high as shares rebounded.
Crudely speaking, if index funds offer market performance, and retail investors
on average outperform the market, then professional investors on average will
underperform the market: “Over the past decade, about 86% of all large-cap U.S.
equity funds have underperformed the S&P 500, according to S&P Dow Jones
Indices.”
This seems bad for the big asset managers? They are squeezed from both sides:
There is the rise of indexing, but there’s also the pretty good performance of
individual investors who pick their own stocks. For a long time now, one
argument for active management has been along the lines of “sure index funds
look good in a rising market, but wait until the market goes down; then people
will see the value of active stock selection.” But in fact people have seen the
value of owning a lot of Apple and Tesla, which they can just do on their own.
The real argument for active management surely has to be something like “sure
index funds and also individual stock trading look good in a market dominated by
the biggest names, but wait until Tesla and Apple underperform and the way to
make money is by buying stocks that retail investors have never heard of.” Which
is a harder pitch.
BRIGHTLINE REDLINE
When I was a young mergers-and-acquisitions lawyer in New York, someone told me
that, when you do a merger in Germany, everyone has to get together and read the
entire contract out loud before signing it. This struck me as wild.2 Our merger
agreements were so long and boring, and I could not imagine reading them out
loud.
On the other hand the actual practice of corporate lawyering in New York is a
little rickety too, in a way that might benefit from spending four hours reading
the contract out loud to each other. Here is roughly how a corporate contract is
negotiated:
1. One side’s lawyers write the contract in Microsoft Word and email it to the
other side’s lawyers as an attachment.
2. Those lawyers summarize it for their clients, get feedback, and “turn” the
contract, writing in all of their proposals in Word and emailing it back to
the first side with a redline.
3. The first side’s lawyers get the contract back, summarize the changes for
their clients, and turn it back with their counter-proposals.
4. This continues for a while, with each redline being a bit less red.
5. Eventually the contract is close enough that each side’s lawyers print out a
signature page — just the last page of the contract, with page number 71 or
whatever printed on it, with a signature block for the client to sign — and
hand it to their client. The client signs it and scans it and sends the PDF
back to the lawyers.
6. At like 3:47 a.m., one side’s lawyers email the draft contract in Word to
the other side’s lawyers saying “I think this is final,” and the other
side’s lawyers email back “looks good, here are our signature pages,”
attaching the PDF, and the first side’s lawyers email back “here are our
signature pages, congratulations.”
7. The most junior associate uses Acrobat to make a PDF of the final contract
and combine it with the signature pages, so there is one PDF containing the
official signed contract. Then she sends it out to everyone else, though
they are all in bed by this point.
8. Probably nobody ever reads that final PDF.
This always troubled me. In law school you think that there is “a contract,”
that it is a piece of literal paper signed in ink by two human beings sitting in
a room with each other, and that if there is a dispute about what the contract
says you can just get it and open it. But in actual high-stakes corporate
contracts, there are like 40 different Word versions that exist only as
attachments to emails between junior law firm associates, attachments that
probably even they didn’t read. The signature means nothing; it’s a blank page
that someone signed and handed to the lawyers before the contract was agreed. If
there is a dispute about what the contract says, you have to go back through the
email chain to pick out which attachment everyone thought they were signing off
on. The dispute will likely take the form “we signed off on the 2:12 a.m.
version and did not realize that you made changes to the 3:47 a.m. version that
you did not flag to us.”
If the final step of this process was for the lawyers to say “looks good, let’s
get some sleep and then meet up in the morning to read the whole thing out
loud,” some misunderstandings might be avoided.
Last month a group of credit funds (Certares Management and Knighthead Capital
Management LLC) sued Morgan Stanley and Brightline Holdings LLC (a train company
owned by Fortress Investment Group) for, I am going to say, fairly standard
debt-restructuring shenanigans. Here is the complaint. Brightline has a term
loan, Morgan Stanley is the administrative agent and also a lender in the term
loan, and it sold some of the loan to Certares/Knighthead funds. (Morgan Stanley
is the Tranche A lender; Certares/Knighthead are in the Tranche B.) Certares and
Knighthead think that Brightline is looking to borrow more money elsewhere,
which, they say, would trigger prepayment of the term loan with a big makewhole
payment to them. But Brightline has reshuffled its corporate structure to move
some of its subsidiaries out of the borrower group, so that they can borrow more
money without repaying Certares/Knighthead. Certares/Knighthead argue that this
reshuffling was not allowed under the terms of the credit agreement.
Again this is the standard form of debt restructuring fight: A borrower has a
loan, it wants to borrow more money cheaply, it finds a way to take away some of
its existing lenders’ collateral and give it to new lenders so it can borrow
more money, the existing lenders say “that’s not allowed by the terms of the
credit agreement,” the borrower says “sure it is,” and they argue about what the
terms of the credit agreement mean.
Usually, though, they agree about what the credit agreement says. Here, Certares
and Knighthead claim that Brightline/Morgan Stanley trickily slapped their
signature pages onto the wrong contract. From the complaint:
> On or about December 15, 2022, Morgan Stanley’s outside counsel sent
> Knighthead a draft amendment to the Credit Agreement, which included a draft
> “Amendment No. 5,” and an amended version of the Credit Agreement (the “Draft
> Fifth Amended Credit Agreement”). ...
>
> The Draft Fifth Amended Credit Agreement included the following new language,
> added as proposed section 2.11(h), in the section relating to mandatory
> prepayments:
>
> “Sale of Preferred Equity. On or prior to December [22], 2022, the Borrower
> shall prepay Tranche A Term loans in an aggregate amount of $25,000,000. For
> the avoidance of doubt, the Borrower shall make such prepayment regardless of
> the ability of the Borrower to directly apply any applicable proceeds from the
> sale of Capital Stock of the Borrower or any of its Subsidiaries to prepay
> Tranche A Term Loans.” ...
>
> After Knighthead and Certares reviewed the Draft Fifth Amended Credit
> Agreement and provided it to outside counsel for review, Knighthead emailed
> Morgan Stanley and its outside counsel, attaching a signature page for CK
> Opportunities Fund.
>
> Yet when Morgan Stanley’s outside counsel returned a purportedly “fully
> executed” version of the amendment (copying Morgan Stanley personnel) on
> December 16, 2022, the supposedly fully executed version included important
> language in the new section 2.11(h) that Knighthead and Certares had not
> before seen and had not agreed to.
>
> Section 2.11(h) of the purportedly “fully executed” version of the fifth
> amended credit agreement stated (relevant new language in bold):
>
> “Sale of Preferred Equity. Notwithstanding any other provision of this Section
> 2.11, in connection with the sale or issuance of Capital Stock of BL West
> Holdings LLC on or about December 15, 2022, the Borrower shall prepay Tranche
> A Term Loans in an aggregate amount of $25,000,000 on or prior to December 22,
> 2022. For the avoidance of doubt, the Borrower shall make such prepayment
> regardless of the ability of the Borrower to directly apply any applicable
> proceeds from the sale of Capital Stock of the Borrower or any of its
> Subsidiaries to prepay Tranche A Term Loans.”
The details are not particularly important.3 What’s important is the email
chain. A contract exists, in the form of a PDF with the Certares/Knighthead
fund’s signature, but the two sides disagree about what it says.
BAIL-IN
A general problem in banking crises is:
1. If a bank is in trouble, the best way to fix that trouble is ordinarily for
the bank to issue equity, but
2. If the bank tells potential investors how much trouble it is in, they might
not want to buy that equity.
This problem can create a tension between regulators. Financial stability
regulators will want banks that are in trouble to be able to raise equity
quickly and reliably; they will mostly be concerned about getting a deal done.
Meanwhile securities regulators care about disclosure and securities fraud, and
will want to make sure that banks that are in trouble fully disclose their
trouble to potential investors.
This spring, Silicon Valley Bank actually had a deal to raise equity by selling
new stock to investors, but as it was lining up the deal it also continued to
lose deposits. Its lawyers “said the deal couldn’t go forward without a
disclosure about the deposit losses,” and its bankers decided that that
disclosure would kill the deal; they canceled it instead, and the bank failed.
Had it just not told investors the extent of the problem, it might have raised
enough money to fix it. If SVB had called up the US Securities and Exchange
Commission and said “hey can we do this deal without disclosing our huge deposit
outflows,” the SEC would probably have said “nah sounds like fraud.” But if it
had called up the Federal Reserve and asked that question, the Fed might have
been tempted to say yes.
One bizarre place that this has come up is in “bail-in bonds.” European banking
regulators have a financial stability tool called the “bail-in,” in which the
regulator can decide that a bank is in trouble and replace some of its bonds —
the bonds that make up part of its “total loss absorbing capital,” or TLAC4 —
with equity. This improves the bank’s financial situation: It no longer owes as
much money, and it has more equity. It also neatly resolves the general problem
we started with: The bank raises more equity, not by lying to investors to
convince them to invest, and also not by telling them the truth and hoping they
will invest anyway, but by forcing them to invest. Holders of the bail-in bonds
just become equity investors whether they want to or not, and of course they
don’t. By automatically converting the bonds, the financial stability regulator
avoids the tension between the need for full disclosure and the need to get
equity fast.
Or does it? Earlier this month the Financial Stability Board released a report
on “2023 Bank Failures: Preliminary lessons learnt for resolution.”5 The report
discusses bail-ins as a way to fix struggling banks, but includes this worry
that a bail-in might be blocked by the US Securities and Exchange Commission:
> According to the SEC staff, there would have been legal challenges relating to
> US securities laws in executing a bail-in; they noted that banks need to
> prepare sufficiently to comply with US securities laws after an open bank
> bail-in. US investors held bail-in bonds issued by Credit Suisse representing
> a significant portion of the firm’s TLAC. US securities laws apply to any TLAC
> instruments held by US investors, irrespective of the currency or governing
> law of that TLAC instrument.
>
> Under US law, all offers and sales of securities need to be either registered
> or exempt from registration. The conversion of Credit Suisse’s bail-in-bonds
> to equity would have constituted a sale, thus requiring registration or an
> exemption.
>
> In the view of the SEC staff, among the challenges involved in executing
> open-bank bail-in in compliance with US federal securities laws is that it
> would require detailed preparation, including possibly adapting the bank’s
> systems to enable prompt provision to the market of current and accurate
> (pro-forma) financial statements. In an open-bank bail-in, the SEC staff
> considered that it would be difficult for an issuer to compile the disclosures
> required by securities regulations and anti-fraud laws over a resolution
> weekend and that ex ante preparations would be necessary to mitigate these
> challenges. In order to ensure confidence in the execution of bail-in, it is
> essential for authorities to cooperate among themselves and work together with
> the firms, as part of resolution planning, to reduce legal uncertainties.
> Further work will be planned with the SEC to explain potential legal
> challenges to effective bail-in of TLAC instruments and to describe how firms
> can undertake actions to comply with the US federal securities laws and
> thereby enhance the legal certainty of bail-in.
This seems like a very strange thing for the SEC to think? Investors in bail-in
bonds don’t get any choice in the matter, so you don’t really need to provide
them with disclosure before converting their bonds. And in fact the US
securities laws do contain an exemption from registration (Section 3(a)(9)) for
“any security exchanged by the issuer with its existing security holders
exclusively where no commission or other remuneration is paid or given directly
or indirectly for soliciting such exchange,” which would seem to cover a
bail-in. Here is a client memo from the law firm Cleary Gottlieb Steen &
Hamilton LLP, who share my puzzlement at the problem:
> In this memo, we explain that while there are U.S. securities laws that would
> be implicated in the event of a bail-in of a UK or European bank, these would
> not constitute an impediment to bail-in. ….
>
> Given the speed at which a bail-in may need to be exercised, it will likely
> not be feasible to register the exchange of bail-in bonds for new shares, as
> the registration process is lengthy and typically requires several months of
> review and comment by the SEC. In most cases, however, the exemption from
> registration under Section 3(a)(9) of the Securities Act should apply to the
> exchange of bail-in bonds.
Of course the SEC is right that the bank really ought to “enable prompt
provision to the market of current and accurate (pro-forma) financial
statements”: Presumably its stock will continue to trade after the bail-in
(that’s the point of the bail-in!), and stock investors will want accurate
disclosure if they are buying and selling the stock. But that’s true without the
bail-in too: Any bank crisis is going to be complicated and fast-moving, and a
bank will have to figure out the frequency and details of its public disclosures
to keep shareholders informed. Vaporizing some debt into stock adds some
complication — you might want “current and accurate (pro-forma) financial
statements” to reflect the vaporization — but honestly it seems like less of a
big deal than, you know, huge deposit flight.
CARBON ACCOUNTING
Carbon credits are largely a matter of baselines. We talk about this a lot with
trees. One classic way to get carbon credits is by not chopping down a forest.
But the amount of credit you can claim for this is necessarily bound up with the
question of whether the forest would have been chopped down without your
intervention. This creates oddities. We talked last week about a carbon-offset
project in Zimbabwe that ran into trouble because too few trees were chopped
down: Sure the trees that the project protected weren’t chopped down, but
neither were trees in a nearby “reference” forest, so the impact of the
carbon-offset project was limited. “That seems good,” I wrote. “For the climate?
But bad for the people hawking carbon credits.”
Direct carbon capture technology — where you build a big machine to “suck carbon
dioxide out of the atmosphere and bury it deep underground” — has less of this
baseline problem. But not none!
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For instance: If you have a natural gas processing plant, it will produce
natural gas, which creates carbon dioxide emissions, which are bad for the
climate. If you build a carbon capture plant at the gas processing plant to
capture and store carbon dioxide from the gas it processes, that will reduce the
carbon dioxide that the plant produces, which is good for the climate. On net,
the plant will be bad for the climate — it will produce more carbon dioxide than
it captures — but people need energy and this might be better than the
alternative.
What if you shut down the plant? No gas, no carbon capture. Is that good or bad?
Well, if the plant was on net producing carbon dioxide, then shutting it down
will produce no carbon dioxide, which seems good. On the other hand, the
accounting for natural gas emissions and carbon capture are separate. There are
lots of natural gas plants, and only so many carbon capture plants. If you shut
down the whole thing, some other plant will pick up the natural-gas-processing
slack, but nobody else will pick up the carbon-capture slack. People need
energy, and if your plant — your natural-gas-plus-carbon-capture plant — was
better than the alternative, and you shut it down, then the world will get the
worse alternative instead.
Here is a Bloomberg Green story about how Occidental Petroleum Corp. built “a
mega-plant for carbon capture and storage … into a natural gas processing
plant”; the project was called Century. But:
> A Bloomberg Green investigation has revealed that Century never operated at
> more than a third of its capacity in the 13 years it’s been running. The
> technology worked but the economics didn’t hold up because of limited gas
> supplied from a nearby field, leading to disuse and eventual divestment. Oxy
> quietly sold off the project last year for a fraction of the build cost. …
>
> It might seem, from a climate perspective, like a boon that Century never
> reached its full potential since its performance was inextricably linked to
> natural gas production. But picking the wrong location for an expensive carbon
> capture project carried real climate costs. Cheaper shale gas elsewhere met
> the same demand, without the benefit of carbon capture. As a result, total
> emissions likely ended up higher.
THINGS HAPPEN
Chevron to Buy Hess for $53 Billion in Latest Oil Megadeal. Treasury 10-Year
Yield Breaches 5% for First Time Since 2007. Qatar’s Hamas Ties Could Thwart
$475 Billion Investing Ambition. Private-Equity Professionals Remain Upbeat on
Pay Despite Industry Slump. Investors Find Value in Seemingly Valueless
Convertible Bonds. Pimco Is Selling Hung Debt It Bought From Banks for a
Premium. There’s Never Been a Worse Time to Buy Instead of Rent. Car Owners Fall
Behind on Payments at Highest Rate on Record. Business Schools Grapple With How
To Teach Artificial Intelligence. The fake hitman, the crypto king and a wild
revenge plan gone bad.
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1. One important element here is that mutual funds were once a way to diversify
your stock portfolio in a world where the normal way to buy individual
stocks was in round lots of 100 shares. If you had $10,000 to invest, that
might get you 100 shares of one or two stocks, whereas a mutual fund could
buy dozens of stocks for you and give you fractional ownership of each of
them. But now you can trade individual stocks for free and buy fractional
shares directly from your broker, so that benefit of mutual funds is much
less important.
View in article
2. Casual Googling suggests that this is true, but oh man is this not German
legal advice.
View in article
3. Basically Brightline’s position appears to be that if subsidiaries sell new
stock, then they stop being guarantor subsidiaries and so can go borrow new
money without repaying Certares/Knighthead. Certares/Knighthead disagree
with this position. But if the credit agreement was amended to specifically
acknowledge the sale of stock by a subsidiary, and Certares/Knighthead
signed off on it, then Brightline would have an easier time arguing “you
agreed to let us do this trade so it must be fine.”
View in article
4. This is distinct from banks’ additional tier 1 capital securities, hybrid
instruments that by their terms convert into equity (or are written down) in
some bad scenarios. But it is conceptually similar.
View in article
5. Robin Wigglesworth at FT Alphaville discussed it at the time.
View in article
This column does not necessarily reflect the opinion of the editorial board or
Bloomberg LP and its owners.
To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net
To contact the editor responsible for this story:
Wendy Pollack at wpollack@bloomberg.net
LinkCopy Link
Matt Levine is a Bloomberg Opinion columnist. A former investment banker at
Goldman Sachs, he was a mergers and acquisitions lawyer at Wachtell, Lipton,
Rosen & Katz; a clerk for the U.S. Court of Appeals for the 3rd Circuit; and an
editor of Dealbreaker.
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