Squaring Your Personal Feelings with Unsavory Market Dynamics (w/ Matt Rowe & Jared Dillian)
MATT ROWE: So one of the things just right off the bat to dive into it that you mentioned in your article is about the collision of what people-- what investors do and how there's a bit of self-loathing or a conflict between what they do and negative commentary. How do you think about that? What's your view on that at this point as far as investors' behavior goes? JARED DILLIAN: Well, I think that there's-- I think money managers are greatly influenced by their personal feelings about things. We're all human beings. We all have a sense of right and wrong. And a lot of people who have worked in the industry for a long time and have seen the evolution of the Fed over the years-- they look at what the Fed is doing with unlimited quantitative easing and stimulus and buying junk ETFs and everything. And they say that this is socialism. This is bad. And what they kind of lose sight of is the idea that their job isn't really to have an opinion on these sorts of things. Their job is to make money for their clients. And oftentimes that involves doing things which they might find distasteful. And if the Fed is buying high-yield credit, then you should be buying high-yield credit. It doesn't matter about your personal feelings about it. But if there's explicit support for an asset class, then it pays to play along with the Fed. And that's what you should be doing. But there's a bunch of examples over the years where people get caught up with their personal feelings about something. They say, well, I'm not investing in this because it's a bubble, whatever. This is a bad stock. And you try to divorce those feelings from what your actual investment thesis is. MATT ROWE: Yeah. I mean, I can remember in years past running convertible bond portfolios looking at things like issues that had no takeover protection built into them and making a loud protest to the underwriters that that's ridiculous. You shouldn't remove that protection for bond holders. We shouldn't buy it if it's not in there. And then the new issue pricing is 102 bid in the gray market. And you have a choice of going in at par or not. And you know what? You probably participate at par. So I think that's an interesting topic, though, in a ESG-type world and even where we stand right now with the Sarbanes-Oxley and such. What do you think about things like the zone of insolvency for companies, where executives have- - publicly traded companies under Sarbanes-Oxley have a fiduciary duty or a legal requirement to do everything that they can to maximize shareholder value? But in times of distress, there's a legal concept called the "zone of insolvency," where the requirement of the executives of the publicly traded companies and other shifts towards defending assets of the company to benefit or to preserve value for debt holders. What do you see or think about that notion in a world where we've become so accustomed to the benefit of buybacks and other shareholder-friendly things? Do you think that there's a possibility for people to think about cap structures more broadly? Or are we still more in everything is good for equity, you should do it, and follow and chase? JARED DILLIAN: I still think we're at the point where everything is good for equity. And you should follow and chase. You know, it's funny. I haven't really thought about the zone of insolvency until you mentioned it and this idea that you would do things that are preferential for bondholders. But I don't think we're at that point yet, although I will say that now that buybacks are probably going to be mostly disappearing and that S&P dividends are probably going to be down about 40% that these are shareholder-unfriendly actions. But these considerations don't really have anything to do with capital structure. They have to do with, really, politics and the perception that companies would be rewarding shareholders during a time of crisis. So it's really about perception and politics. But for sure, that's definitely not benefiting shareholders. MATT ROWE: Yeah. I often have thought in the last couple of weeks that the answer to this situation, barring any influence or outside intervention from the government, that the right thing to do for companies is to do things that are dilutive. Because I've classically trained in cap structure that I view equity as a call option on the assets of a company above and beyond that the debt holders have a claim to. And it seems as though the behavior of the pricing is different for many reasons. But taken to its extreme, one thing where buybacks are concerned that seems ridiculous to me is, can you imagine if a company refuses to give guidance, yet they continue buying back their own shares? That seems to me to be a very risky move for companies. Because if you're spending shareholder capital to buy back stock and you can't even issue guidance, there seems to be some sort of new level of ludicrousness. But I'm sure it'll happen. I'm sure there is. As we sit here today, there are some companies with that. JARED DILLIAN: It's funny that you mention buybacks because buybacks are an example of what I was talking about with portfolio managers with their personal feelings about things. If you go back to 2017, '18, '19, there was plenty of data out there that showed that buybacks were responsible for most of the returns in the S&P 500. And as a money manager, you can sit there. And you can say, OK, we're doing a trillion in buybacks a year. This is rewarding people who are just long. But that's not really what happened. People complained about it. They thought it. They said, I don't want to participate in this. And they severely underperformed the market for a period of about 3 or 4 years as the buybacks were running about $800, $900 trillion a year. MATT ROWE: Yeah, I think you're right. And it's hard to argue that if times are good and executives of particularly publicly traded companies in this regard are doing what's best to maximize shareholder value, there's a pretty strong case to say that you should be doing buybacks even over dividends. I know that the dividend versus buyback case studies are an oftendebated point of business school theoretical and engineering process. But to me, the buyback wave has been the most recent chapter. And it's getting further and further out on the risk spectrum from '08. And I guess if we walk it back to, Jared, where you and I were in more constant conversation while you were at Lehman and I was running a highly levered convertible arbitrage firm, we saw things get fractured for various reasons in '08. And then we've been working back from that, in my opinion, since, where in '08, there was-- secured debt was trading at a significant discount to liquidation value. Then you've got preferred equity. And then you had various forms of other risk premia, as they're now defined, that were at different levels of cheap. And now it's about creating cheapness. And the buybacks are creating scarcity value or cheapness and equity as we've moved further out here. And it seems that the step one of getting back to more normal times, I guess, you maybe could say-- I don't know what normal is anymore. But stopping buybacks seems like a very rational thing to do. But at the same time, it seems like the US government, Treasury, Fed is starting in a slowmotion LBO of the market. So to your point, if you don't like it, you could get a job doing something else. If you continue to manage money, you should probably play along. What do you think about the government buying high yield and us moving into that part of the market? JARED DILLIAN: Well, I think you and I are about the same age. And when I first got my job in the capital markets on the Florida [INAUDIBLE], it was 1999. And back then, interest rates were-- Fed funds were 6 and 1/2%. There was no QE. There was no asset purchases. There was nothing like that. It was a very different environment. Fast forward to today, and we're talking about-- one of the things I've been doing work on is we're about to issue $3 trillion in treasuries over a 3-month period. You're going to have auctions in 10's that are $100, $150 $200 billion worth of 10's at the same time at 0.66% interest rates. And there's the possibility that people show up at these auctions because we have the only debt that is positive on a nominal basis. And the dollar has been strong. And it's just-- the progression that we've had over the last 20 years to this new era in finance, I guess, has just been unbelievable to watch. MATT ROWE: I would agree with you. And actually, I think when I worked-- you and I have the Pacific options exchange in common as well when I worked on the floor straight out of college. One of the things I did was to walk around and ask people what their strategy is. How do you think about this? What do you do? How do you manage risk? And I quickly learned that there were a lot of gamblers on the floor. Even outside of running a sports book, there were a lot of people who were not running delta-neutral vol risk. It was more various forms of directional bets. But probably the most shocking conversation that I had was a guy who told me that his secret-- and it still probably took me a couple weeks for him to trust me well enough to open up on his trading secret. But his trading secret was to get short gamma and trade it as if he's long. And I thought to myself, now, that makes absolutely no sense. Why in the world would somebody do this, right? But the reality of the situation that I didn't really understand or appreciate at the time is that he was basically identifying that his clearing firm had all the risk. And if he could leverage himself to the put that he's long by the clearing firm, he can only lose as much money as he has on deposit at the clearing firm. And if he loses more than that, it's on them. So it kind of feels that way now. I feel like we're back to a point where in order to really maximize the benefit or to understand the risk framework, you have to understand where the risks lie and where you have backstops and things like that. And here comes the Fed with buying high yield again, to your point. And you should probably just, at the very least, understand that that mechanism is in place if you're trading high yield or equity volatility and at best figure out a way to get ahead of it. And I think that's really what the market has done to date, although I will say, when I look back on the last month since the low right around mid March to today, I believe that the S&P and the NASDAQ are up somewhere around 24%, 25%, 26% since the lows in mid March. But the highyield spread is roughly the same. I find that to be strange. What's your take on that? JARED DILLIAN: Yeah. High yield is kind of in a funny place right now. The market is kind of divided in two. The Fed isn't buying all bonds. They're buying some bonds. And the bonds that the Fed is buying have yields of 4%. And the bonds that the Fed is not buying have yields of 10%. And what's interesting is that people are piling into the bonds that are supported by the Fed, but it's totally bifurcated. And there's a lot of opportunity in some of these issues that-- I don't invest in credit on a daily basis. I jump into credit in times of crisis. I jumped into credit in 2002. I jumped into credit in 2009. Any time you start getting nominal yields out to double digits, I started to get interested. So obviously, there's an economic bet here about the virus and how quick we're going to recover and stuff like that and how long the recession is going to be. But I think there's some opportunity in the stuff that the Fed is not buying. MATT ROWE: Yeah. Well, that's a good point. I think it seems very-- I don't know if "alarming" is the right word. But to your point of your article, there are certain points in my career where I've become either irritated or personally offended by certain things that have been done or haven't been done. In the GM, bankruptcy is something that I was intimately involved with that reminds me of that. And I continually think about what could come out of left field and just shock everybody. Crude oil trading negative is one. To your point about treasury auctions coming up, what would shock the world? If we had a 10-year auction that went off with such massive demand for some reason that it traded at a shocking rate or flat-- things like that, I think, will just cause people to be offended, shocked, otherwise caught off guard. But I think when thinking about things like the General Motors bankruptcy, I come back to this notion that the government is almost doing a slow-motion LBO of equity in the US markets and how to play along with that. I have a hard time making sense of which companies are going to be allowed to fail and which ones aren't. I think that's probably the question that I have the fewest answers for. What do you think? If you were going to tell somebody your thought on which companies are going to be allowed to fail and which ones aren't, what are the characteristics or the criteria of what goes into the "friend of the government" bucket versus the "not friend of the government" bucket? JARED DILLIAN: Well, I want to answer this question in sort of a roundabout way. You talked about ESG a couple of minutes ago. And I think ESG is a pretty good framework for how to talk about this. So under an ESG framework, you say, OK, this is a tobacco company. This is a bad company. And we are going to exclude it. Or this is an energy company or whatever. And if you think about this in terms of constraints, an ESG manager has explicit constraints. There are things that they simply cannot buy, refuse to buy. And then you have-- on the other hand, you have somebody who's an unconstrained manager. They can buy anything they want. How can you expect a constrained investor to outperform an unconstrained investor? So if you think about a portfolio manager today, and they say, I disagree with what the Fed is doing. I find it offensive, whatever. So I'm not going to participate in this. I'm not going to buy these bonds, in effect, what happens to them is that they become a constrained investor. They don't have explicit constraints. They don't have rules that they have to follow where they exclude certain bonds. But they say, there are implicit constraints. These are things that I will not buy. And then they become constrained investors. And then you can't expect them to outperform unconstrained investors. MATT ROWE: Right. I think that's-- it's funny. When we talk about the moral hazard or that topic, which you just illustrated well, it then sort of begs the conversation or argument of, well, isn't this how we got into covenant-lite loans? Or isn't this how we got into-- people would say, well, why in the world would you buy a basket of fixed income that didn't have these protections built in? Or the market pushed this far. And it's like, well, if you're being paid to manage money for people and you are personally offended or morally offended to a point where you're handicapped to a degree where you can't do your job, you really have to choose. Well, do I play along? Or do sit over here and hope that somebody is going to pay me to do nothing? So I think that maybe is a good segue to talking about what I think is the agency risk and the business in the asset management and hedge fund business these days and something that I've observed for years. The people managing portfolios, managing assets for investors definitely have a different time horizon than the end pool of money that they're managing. So most of the people in our business have some sort of an incentive fee alignment and are expected to take action, to make changes, to buy things that are on new issue, to identify things that are uniquely cheap and buy them quickly. There's not much reward for being patient or being uninvested. And what I hear from Sam Zell and Warren Buffett today-- not that I'm a disciple of Warren Buffett, but I pay attention-- is that they haven't seen anything that has caused them to get excited to buy, even in the middle of March. So if you have a bunch of portfolio managers and hedge funds, if you didn't buy something in March, you're probably out of a job. And then you have a lot of bigger, more patient money that didn't touch anything in March. What do you think about the agency risk or the personal compensation risk that drives a lot of market behavior in this? Is it a misalignment of interests? Or what do you think? JARED DILLIAN: Well, I think it all comes down to time horizons. And I think people have different time horizons. One of the things I've talked about in my newsletter is the performance of private equity versus hedge funds and how private equity has had this outperformance. But private equity doesn't really mark to market. But the reason that private equity outperforms is because they have a 10-year lockup. They say, we'll lock up your money for 10 years. You can't get it. And now everybody's time horizon is aligned. But if you're a hedge fund and you're providing people with quarterly liquidity, then what that does is it prevents you from taking positions which could be illiquid, which could be hard to sell that you would like to hold for a long period of time. But you may be forced to liquidate those positions if somebody redeems your fund. MATT ROWE: Yeah. I think you're right. I've often thought of-- you really need the vehicle to match the liquidity of the asset class that you're going to be trading. And part of the post-'08 story in my mind was that there was a premium for things that were liquid at the beginning. And then out to today, even as we sit here today, there's a premium paid for opacity in private equity. If you don't have to own up to the mark-to-market shifts in private equity, if you can pave over-- if this truly is a quick one-quarter interruption to the economy, which I don't necessarily believe in myself-- but if it were, your mark-to-market experience in private equity would be pretty much zero. I don't think that's going to be the case. I actually think that that's going to be a pocket of significant pain as we come out of this.