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Contents B LO OM BE RG MA R K E TS VOLU M E 26 / ISSU E 6

56 Industry Focus: Asset Management Investors continue to shift money into passive funds, threatening active managers. Even so, the value of actively managed assets has surged because of the extended bull market. Here’s a survey of the investment landscape, from the pressures to the most promising opportunities By Bloomberg Intelligence

72 The Banker Who Knew Too Much Alexei Kulikov was charged with looting a small Moscow bank. But his trial turned into a window on the shadowy—and seemingly uncontrollable—world of money laundering in Vladimir Putin’s Russia By Irina Reznik, Evgenia Pismennaya, and Gregory White

80 The Next Big One Almost 10 years after the financial crisis, equities keep hitting record highs and volatility hovers near historic lows, while geopolitical tensions abound. What could possibly go wrong? By Bloomberg News

A Tax Haven’s Final Days As the Paradise Papers cast an unflattering light on offshore financial centers, the exotic microstate of Vanuatu ponders its economic destiny By Brian Bremner

Q&A With ESMA’s Steven Maijoor He’s not an obvious master of the universe, yet the chairman of the European Securities and Markets Authority is perhaps the most powerful person in finance right now. That’s because of his role in implementing MiFID II, the far-reaching regulatory regime that takes effect on Jan. 3 By Neil Callanan and Stryker McGuire

P H OTO G R A P H BY J U L I E G L A S S B E R G / C OV E R A R T W O R K BY K AT E C O P E L A N D

Contents

13 Surveillance How has President Trump altered ESG investing?

17 Forward Guidance

Index Providers Rule the World—for Now, at Least Decisions about what to include are leaving some on the outs

22 <GO>

China’s Pollution Solution In the Inner Mongolian desert, a plan for fighting smog takes shape

24 Here’s a Cheat Sheet for MiFID II All the info and solutions you could ever want to address your regulatory needs

30 Matching Assets and Liabilities Using Optimization Here’s how to check that your investments will cover the outflows

34 Introducing the Pure Factor Indexes They let you see what’s really happening in real time

38 Macro Man on Myths vs. Realities Does global growth really drive emerging-markets returns?

43 The Fed’s Unwinding: How to Get Under the Hood See which of central banks’ bonds are maturing any given month

Did You Know MiFID Is Going To Change Bond Data?

Put Your CFA Program Knowledge to Work

There’s a silver lining of sorts: More transparency

A quiz on mapping your studies to the terminal

What David Tepper Sees in This Company

What to Talk About When You Talk About Brexit

Relative value appears to confirm an investment thesis

New flows functionality lets you see what U.K. stocks foreigners are holding

52 Manuel Henriquez Has Been Dealing With Some Things, OK? The CEO of the largest nonbank venture debt provider has had a busy year

94 Cheat Sheet The 19 most important functions you should know about right now

96 A Function I Love An easy way to see which factors are driving performance

Contributors

When Promsberbank, a lender in suburban Moscow, collapsed two years ago, it looked like just another small-time casualty in the grinding cleanup of Russia’s financial sector. But as Irina Reznik, Evgenia Pismennaya, and Gregory L. White found during more than a year of reporting after the arrest of one of its owners, Promsberbank was a key link in a giant money-laundering scheme that involved foreign giants such as Deutsche Bank AG. In “The Banker Who Knew Too Much” (p. 72), they expose a tale that’s more Hollywood than Wall Street, with apartments stuffed with cash and secret payoffs on the streets of Moscow. “This is a world that rarely opens up to journalists,” says Reznik.

Emerging markets have been on a tear this year, with the MSCI Emerging Markets Index up 31 percent through early November, more than doubling its U.S. benchmark. Obviously, it would seem, accelerating global growth has been driving that performance. Or has it? Cameron Crise, a macro strategist who writes for Bloomberg, decided to delve into just that question in “Global Growth Drives Emerging-Markets Performance: Market Myth or Reality?,” which begins on page 38. “There’s a lot of accepted wisdom in the market,” Crise says. “It usually pays to check it.” Crise’s Macro Man columns and podcasts are available at {NI MACROMAN <GO>}.

Editor Joel Weber Art Director Josef Reyes Features Editor Stryker McGuire <GO> Editor Jon Asmundsson Special Reports Editor Siobhan Wagner Graphics Editor Mark Glassman Photo Editor Donna Cohen Bloomberg Markets utilizes the resources of Bloomberg News, Bloomberg TV, Bloomberg Businessweek, Bloomberg Intelligence, and Bloomberg LP.

Editor-in-Chief John Micklethwait Deputy Editor-in-Chief Reto Gregori Advisory Board Tracy Alloway, Chris Collins, David Gillen, Christine Harper, Madeleine Lim, Marty Schenker, Joe Weisenthal Creative Director Robert Vargas Photo Director Clinton Cargill

In “Factor Returns Let You See What’s Actually Happening” (p. 34), Michael Reifel and Jose Menchero write about Bloomberg’s new pure factor portfolios. “The ones now available on the terminal allow you to cut through the noise and zero in on what’s really going on with style returns,” says Reifel, a New York-based business manager for Bloomberg’s Portfolio & Risk Analytics (PORT) platform. San Francisco-based Menchero, head of portfolio analytics research, adds that seeing the factors’ performance evolve in real time allows traders and portfolio managers to make informed decisions throughout the trading day. To track the factors, go to {FTW <GO>}.

Stephen Jonathan joined Bloomberg as a foreignexchange application specialist in 2009 after three decades on the currency desks at Citibank, Merrill Lynch, and JPMorgan Chase. Jonathan witnessed three changes in the guard at the Federal Reserve and says all chairs have shared “a dual mandate of maximum employment and stable prices.” The next chair will also likely continue to reduce the Fed’s $4.5 trillion balance sheet. In one of two stories he has in this issue (p. 43), Jonathan says you can position a portfolio for potential yield-curve shifts by understanding what’s maturing in the Fed’s portfolio and what’s due to be rolled off. Bloomberg has aggregated Fed holdings at {DEBT <GO>}.

Managing Editor Kristin Powers Copy Chief Lourdes Valeriano Copy Editors David Purcell, Brennen Wysong Production Manager Susan Fingerhut Map Manager Ilse Walton Production Associate Loly Chan Head of U.S. Financial Sales Michael Dukmejian / 212 617-2653 Head of EMEA Sales Viktoria Degtar / 44 20 3525-4026 Head of APAC Sales Mark Froude / 65 6499-2818 Production/Operations Debra Foley, Dan Leach, Carol Nelson, Steven DiSalvo, Bernie Schraml Global Chief Commercial Officer Andrew Benett / 212 617-8225 Global Chief Revenue Officer Keith A. Grossman / 212 617-3192 comments@bloombergmarkets.com

Surveillance We asked investors who focus on environmental, social, and governance matters about their insights into how the U.S. administration is affecting their strategies

By LAURA COLBY

How has Trump altered the landscape for ESG investors? 13

John Streur

Louise Dudley

P R ESID ENT A ND CEO CA LVERT RESE A RCH & MA NAG E M E N T

PORT FOL IO M ANAGER HERM ES GLOBAL EQU IT IES ADVISORS

Keep an eye on regulatory rollbacks

So far, says John Streur, “company managements are behaving better than the government” by adhering to international agreements. But the administration isn’t only easing regulations when it comes to climate and other issues, it’s also reducing the level of enforcement. Calvert is keeping an eye on companies that may be trying to benefit from that shift. “No companies are coming out publicly and saying, ‘We’re going to change our sustainability practices,’ ” he says. “But what we’re watching for is lobbying activity and political contributions and efforts to promote these alternativeinformation sources on

Why the green selloff hasn’t happened

scientific information.” One area of scrutiny is the auto industry, where Streur has seen efforts to roll back efficiency regulations. He expects to engage in the coming year with technology and media companies, not only about the sources of the information they’re publishing but also about the information they use to target consumers. Calvert’s Global Energy Research Index, which focuses on alternative energy, has surged more than 30 percent. “Even though there has been talk about using coal to light your home,” he says, “consumers want clean, safe, renewable energy.”

Geopolitical risk, such as the stormy U.S. relations with North Korea, has been high throughout the Trump administration. “The interesting thing is how quickly investors seem to get over anything that happens,” says Louise Dudley. Hermes has been able to take advantage of that with some short-term trades on what she calls “mispricings,” even though the company normally has a three- to five-year time horizon for its investments. Some investors are already looking beyond the Trump years, even though he’s yet to complete his first year in office. Many investors expect there to be no second term, she says, and

BLO O M B ERG M A R K ETS

“companies themselves are having discussions about the longer-term opportunities.” That may be one reason an expected selloff in green-tech companies failed to materialize. Dudley cites the former Dong Energy, now called Orsted A/S. The Danish utility company is moving from 40 percent coal power in 2014 to a goal of 100 percent renewables by 2023. Its shares have advanced about 26 percent this year. In the health sector, Trump’s attacks on high drug prices have had a positive effect on corporate behavior. “Companies are now very focused on releasing policies on drug pricing,” Dudley says.

Pat Miguel Tomaino

Jennifer Sireklove

ASSO CI ATE DI RECTOR OF SOC I A L LY R ES PON S I BL E IN V EST ING Z E V I N ASSE T MA N AG E M E N T L LC

DIRECTOR OF RESPONSIB L E INVEST ING PARAM ET RIC PORT FOL IO ASSOCIAT ES L LC

Advocating for better practices

As the administration takes actions that affect health, human capital, and the environment, Zevin is stepping up its shareholder advocacy. “Even if policy backslides, companies will not be setting themselves up for future success if they just race to the bottom,” Pat Miguel Tomaino says. Zevin is encouraging companies to adopt higherthan-required standards. An example: The administration pulled back from an Obama-era rule requiring companies to report pay data based on race and gender. Zevin is asking them to do it anyway, writing to companies including Apple, Oracle, and Amazon.com. It also will be filing shareholder

Investors are becoming more engaged

proposals on the issue in the coming year. After Trump’s slow response to the Charlottesville, Va., murder of an anti-Nazi demonstrator, Zevin wrote to the chief executive officers of portfolio companies such as Johnson & Johnson, urging them to resign from the president’s business advisory council. Zevin avoids investing in companies that operate prisons. Yet it owns shares in JPMorgan Chase & Co., which has a stake in prison operators, a sector this administration has favored. “We want to see the company divest or at a minimum to use its substantial influence to push toward better practices,” Tomaino says.

Investors in the past year or so have shown increasing interest in wielding their power by voting proxies or backing shareholder ESG resolutions. “I am seeing a shift in our clients,” says Jennifer Sireklove. “They’re moving away from a passive approach and moving toward a more thoughtful and informed approach.” Climate has been atop the list for sustainable investors for several years, and the administration’s easing of some regulations hasn’t changed that, she says. Investors have varied approaches to climate, which also can extend to downstream industries such as mining and chemicals,

Sireklove says. “Clients say, ‘We care about companies that have poor environmental practices,’ ” but they tend to evaluate them vs. peers, instead of screening out entire industries. “Gender parity and equal treatment of women in the workplace is up there with climate,” she says, adding that it became a top issue even before the 2016 presidential campaign. “There’s been a normalization of the conversation about how many women are on a company’s board.” Some clients persist in holding shares of companies with all-male boards so they can press them to change, Sireklove says.

Colby is a senior reporter at Bloomberg News in New York.

VO LUME 26 / ISSUE 6

Forward Guidance

Benchmark Bouncers: Index Providers Rule the World— For Now, at Least By TRACY ALLOWAY, DANI BURGER, and RACHEL EVANS I L L U S T R AT I O N B Y YA R E K W A S Z U L

Peru’s then-finance minister abruptly changed his plans and hopped on a jet to New York. By the time Alonso Segura Vasi landed in the U.S., officials from the country’s central bank and securities regulator were also en route to join him. What prompted a bevy of Peruvian officials to make the eight-hour journey wasn’t a matter of urgent statecraft or diplomacy. Instead, it was a rumor that the financial company MSCI Inc. might oust the South American country from its widely followed emergingmarkets index, a prospect that Vasi knew required immediate intervention. “Peru is not a name for the frontier market,” says Vasi, who’s now the finance director at Pontifical Catholic University of Peru. While he says that Peru has a small presence in the emerging-markets index, reclassifying it as a frontier market—turf occupied by Vietnam, Croatia, and Kenya, among others—would have created an unfortunate imbalance. “It would have been more than a fifth of the index,” he says. Something else that might be described as imbalanced: the growing clout of index providers such as MSCI, FTSE Russell, and S&P Dow Jones Indices. In a market increasingly characterized by passive investing, these players can direct billions of dollars of investment flows by reclassifying a single country or company, effectively redrawing the borders of markets, shaping the norms of what’s considered acceptable in international finance,

IN SEPTEMBER 2015,

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and occasionally upsetting the travel plans of government ministers. (Bloomberg LP, the parent company of Bloomberg News, owns the Bloomberg Barclays-branded bond indexes, the most widely followed measure of fixed-income performance worldwide.) Benchmark indexes trace their history to the late 1800s, when Charles Dow, co-founder of Dow Jones & Co., created the first as a way to gauge the general direction of the market (and to sell newspapers). Today the number of benchmarks outnumbers that of individual stocks. “The problem is that a lot of investors assume that the benchmarks are almost God-given and that they’re problem-free. Most of the time they’re not,” says Mohamed El-Erian, chief economic adviser at Allianz SE and a Bloomberg View contributor. “It’s a crucial issue. And it’s becoming even more important as more and more people migrate to passive products.” In the realm of emerging markets, the power of index providers has been on display in recent months with prominent and sometimes controversial reclassifications involving countries such as China, Argentina, and Venezuela. Yet even as the influence of these companies swells, there are those who would seek to unseat them—including some passive fund managers. that the modern borders of Kuwait were created by a British colonialist named Percy Cox as a way of placating an ambitious Saudi Arabia, whose eponymous ruler, Ibn Saud, wanted to expand his own territories. Almost a century later, there’s a “Kuwait problem” of a different sort— frontier-market investors wanting less Kuwait in a widely followed index. The tiny Gulf state accounts for almost 19 percent of the MSCI Frontier Markets Index, typically used by investors willing to stomach risk in exchange for rapid growth. Kuwait, with a population of 4 million and gross domestic product expansion in the low single digits, arguably doesn’t fit the bill. “Frontier investors would like more frontier stuff in the index and less Kuwait,” says Andrew Howell, strategist at Citigroup Inc. “They want more of countries like Bangladesh or Vietnam,

NOT MANY REMEMBER

large populations with lots of development potential.” The Kuwait problem is emblematic of the disagreements that can erupt in an area of finance that prides itself on its objectivity. Index providers say their decisions to include or exclude certain stocks, bonds, or countries are rulesbased, driven by impartial analysis of the size, liquidity, and overall “investability” of respective markets. “When we build an index, we want to make sure that it is representative of the opportunities that can be invested in,” says Chin Ping Chia, MSCI’s head of Asia-Pacific research. “Think of us as a mirror that reflects the various needs of investors and also to facilitate that communication process.” The worry, however, is that passive investing effectively passes the proverbial buck. These decisions can be especially noteworthy in emerging markets, where index providers must weigh the desires of investors hoping for early exposure to growth with the realities of underdeveloped capital markets. And for every Argentina—which made it back into JPMorgan Chase & Co.’s bond index earlier this year, despite a history of serial defaults—there’s a poster child of another sort. The moral quandaries of financing the Venezuelan government, for instance, recently exploded into the public consciousness, with critics deriding the inclusion of the country’s debt in various indexes. “Somebody is making very active decisions about which stocks will be in each index or ‘passive’ product,” says billionaire investor Howard Marks, co-founder of Oaktree Capital Management LP. According to him, passive investors are outsourcing decisions about portfolio allocation. “They’re not making decisions as to which stocks to invest in,” he says. “Instead, the people who create the indices are deciding which stocks will be invested in.” Making those decisions has become big business. Passive vehicles, especially cheap exchange-traded funds, rake in an average $3 billion per day. Every passive fund must replicate and track an index—it wouldn’t be passive otherwise—then pay license fees to third-party index providers, boosting the influence of the companies as well as

BLO O M B ERG M A R K ETS

their bottom lines. Index revenue at S&P Global, MSCI, and FTSE Russell surpassed $1 billion in the six months through June, up from $858 million the year before. “We’re not activists,” says Mark Makepeace, head of FTSE Russell, which this year banned companies that don’t give shareholders enough voting rights from joining its gauges. “We’re setting the minimum standards that investors generally will accept, and our role is to build consensus amongst that investor community as to what that minimum standard should be.” FTSE Russell upgraded Kuwait to its own emerging-markets stock index in September, a move that’s expected to spur as much as $822 million of inflows. who works within Vanguard Group Inc.’s vast equity indexing group, has watched MSCI wrestle with whether to include mainland Chinese shares in its key emergingmarkets benchmark. Buek says he wasn’t surprised that the country remained excluded in 2014, 2015, and 2016. “I knew based on the trading costs and investability it would take longer,” he says. MSCI finally unveiled plans to slowly add China’s domestic shares to its emerging-markets index last June. Of course, some investors want greater exposure—and faster. Others are still wondering why a market that remains marked by capital controls and restrictions on foreign investors has been included at all. Yet few decisions by index providers catch Buek by surprise. While he and other passive industry players are working increasingly closely with the third parties to form benchmarks, Buek says the “hypercompetition” among providers means that if Vanguard doesn’t like your index, there are plenty of others to choose from. (For its part, Vanguard parted ways with MSCI in 2012.) Another option has become increasingly tempting for ETF providers as they try to cut costs and escape the third-party stronghold: self-indexing. In October, State Street Global Advisors ditched FTSE Russell indexes for three of its SPDR products, opting to build propriety equity indexes instead. While the move sent ripples through the

MICHAEL BUEK,

RISE OF THE BENCHMARK

8k U.S.-listed stocks

Indexes 1975

2016

Sources: Sanford C. Bernstein, Bloomberg

market, it also meant that State Street, freed from licensing fees, was able to slash prices on the funds to as low as 3 basis points, making them some of the cheapest such products available. In the race to lower charges for investors, eliminating payments made to thirdparty index providers may ultimately prove the last step toward reaching the holy grail of zero percent fees. “I look at self-indexing as just another tool or opportunity when we evaluate new funds or changes to funds,” says Noel Archard, head of global product at State Street’s SPDR ETF business. “I view it as a future option, but it’s not something where we’re thinking, Yep, everything is going self-indexing or, There’s going to be no third party.” Despite the pressure to lower fees, ambivalence about the future of self-indexing can be found at most of the largest ETF providers. They’ve spent decades working with third parties such as S&P Global, forging the success of passive investing alongside one another. BlackRock, State Street, and Vanguard, which together control more than 80 percent of ETF assets, all have said that they don’t have any plans to convert completely—or even predominantly— to in-house indexes. “One of our close partners is MSCI,” says Mark Wiedman, global head of iShares and index investments at BlackRock Inc. “Often it’ll be MSCI that brings us to a client. In that case, they’ve

delivered huge value to us, and their client tends to think in MSCI terms.” But even if self-indexing fails to make much of an immediate dent in the dominance of major benchmark index providers, another threat looms in Europe. Benchmark regulation will subject the decisions of index providers to supervision and “added controls,” according to the European Securities and Markets Authority. It’s unclear what that might mean for self-indexing funds, which are striking out on their own just as regulators are taking an interest in third-party providers. But already there’s a hint of tension. “In Europe, we’re all about to be regulated. Self-indexing has not been called out directly, but a lot of the regulations in Europe are around eliminating conflicts of interests,” says Alex Matturri, chief executive officer of S&P Dow Jones Indices. “The idea of self-indexing is contrary to the concept of independence.” MORE CONTROVERSIAL decisions by index providers are nearing, including the potential inclusion of Saudi Arabia’s stock market in the MSCI Emerging Markets Index as early as next year. If included, the kingdom would essentially leapfrog frontier-market status and head straight into the bigger and broader emergingmarkets bucket, enjoying an estimated $4 billion of flows from new investors along the way. China’s domestic bonds are also up for inclusion in major indexes

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run by companies such as JPMorgan. In the meantime, market participants will mull just what the growing number of indexes, and the expanding sway of their providers, really means—especially when there’s a sense of unease that markets at record highs are being driven by investors chasing inflows rather than fundamentals. “People often say, what would happen if the world were all index? My great-grandchildren will face that question,” says BlackRock’s Wiedman. Like many managers of passive funds, he argues that too much indexed money will self-correct as active managers find more opportunities to outperform. Peru might feel differently. After government officials personally showcased the country’s planned market reforms, MSCI demurred from downgrading it to a frontier market. According to former Finance Minister Vasi, it was a narrow miss that would have generated cataclysmic outflows based on “incomplete information” of Peru’s plans. “You couldn’t take a chance,” Vasi says of his run-in with index providers. “Investors’ decisions to invest in the market are significantly guided by their decisions, whether they put you in the index or do not put you in the index. They do control the fates of companies’ and countries’ access to capital markets.” Alloway, Burger, and Evans cover markets for Bloomberg News.

<GO>

IN SID E T HE T E RMI N A L

China’s Pollution Solution

CHINA IS CHOKING on air pollution, and clean

energy is one of the ways the country aims to rise above its smog. The plan, in a nutshell: Go big and watch the costs come down. In August, China’s National Energy Administration called for an additional 86.5 gigawatts of new photovoltaics to be built by 2020 on top of the country’s previous plans. This would take China to about 290 gigawatts of solar power by 2020—almost as much as world capacity at the end of 2016, according to Bloomberg New Energy Finance. The sheer scale should help push solar power’s costs closer to parity with coal’s in the country. Clean energy may even gain an edge soon. BNEF forecasts that the levelized cost of electricity from utility-scale solar will be lower than the cost of new coal plants in 2021 in China’s sunniest regions. Which brings us to the desert you see here. For the past few years, Elion Resources Group Co. has been leveling dunes in the Kubuqi Desert in Inner Mongolia and installing panels for its solar megaproject, with an initial peak capacity of 200 megawatts. More solar is being rolled out across the region. Inner Mongolia is aiming to install 4 gigawatts of new ground-mounted, utility-scale PV from 2017 to 2020, says Yvonne Liu, a Beijing-based analyst at BNEF. Indeed, China’s future may be solar-powered. For more clean-energy coverage, go to {BNEF<GO>}. —Siobhan Wagner

P H OTO G R A P H BY G EO RG E ST E I N M E T Z

Cheat Sheet

Here’s Where to Find the Information and Tools You Need for MiFID II By JAMES BATTY

Overview {MIFI <GO>} The hub for all Bloomberg products and services related to the Markets in Financial Instruments Directive II regulations. This should be the starting point for help in meeting MiFID II obligations. Pre- and post-trade transparency The Pill and Sales-Trader Workflow/Voice-Taker Workflow Newly enhanced workflows for both the sell and buy sides allow users to capture key MiFID-related data points, such as timestamps, that can be used to meet reporting obligations. Sales-trader workflow: {TSOX <GO>} Voice-taker workflow: {IB <GO>} {RHUB <GO>} The Regulatory Reporting Hub is a blotter containing the information and report submission status of real-time pretrade quotes, post-trade details, transaction reports, Bloomberg Transaction Cost Analysis (BTCA) best-execution data, and Bloomberg Vault immutable storage. Real-time reporting APA Bloomberg’s Approved Publication Arrangement provides pretrade information such as quotes and post-trade reports. Transaction reporting ARM The Approved Reporting Mechanism allows users to submit trade data that can then be turned into reports suitable to be sent to regulators. Trading venues {BMTF <GO>} Bloomberg Multilateral Trading Facility is a venue for trading different asset classes, including fixed income and equities. Best execution {BTCA <GO>} A big part of MiFID regulations is ensuring that all sufficient efforts have been taken to achieve the best execution results for the client. BTCA analytics enables firms to monitor trades across

multiple asset classes for conformance with the firm’s order execution guidelines against a wide range of benchmarks. A highly flexible transaction surveillance engine provides forensic level tools for market abuse detection and investigation. Record keeping/trade reconstruction/surveillance {BVLT <GO>} Bloomberg Vault functionality helps firms meet MiFID II immutable storage record-keeping requirements including trade archiving, storage of electronic communications and voice/transcription. Trade archiving functionality enables firms to combine structured trade and market data with unstructured communications data for voice best-execution analysis and market abuse surveillance. Research {BRES <GO>} {BVOT <GO>} {RVAL <GO>} This suite of functions allows users to control the research permissions within a firm (making sure only the correct employees can see research), assess that research, and prepare future research budgets. Derivatives clearing and repository {BTRL <GO>} The Bloomberg Trade Repository allows users to submit and view trade records for derivatives. Know your customer {KYC <GO>} Across the globe, evolving customer document-handling regulations are providing firms with an opportunity to create a superior customer on-boarding experience. MiFID II requires investment firms to make a number of changes to their processes for documenting their relationship with clients. Firms will need to adapt their process to take account of the relevant national rules. BLOOMBERG’S ENTITY EXCHANGE delivers a fast, efficient, and flex-

ible service over a secure platform to enable trading counterparties to manage and share client data and documents in confidence. Batty is an editor at Bloomberg News in London.

< G O> I NS I D E THE TE RMI NA L

Regulation

Did You Know MiFID Is Going to Change Bond Data? By JOHN MORTON

the Markets in Financial Instruments Directive II with despair, especially if you’re responsible for ensuring your company complies with all the new rules. Chin up, though! Don’t forget that the European Union’s updated regulatory regime comes with some positive aspects. One of them: MiFID II will mean an enormous increase in over-thecounter trading data for bonds. Come Jan. 3, when the rules take effect, you can use the Bloomberg Professional service to monitor this new flow of data. To be sure, there will be a lot to digest. The legislation covers a broad range of asset classes and products, including cash and derivative instruments in foreign exchange, equities, and commodities as well as fixed income. (Please note: The changes to the functions described here are still under development, and exact layouts may change.) IT’S EASY TO LOOK UPON

FOR THE BOND MARKET, the rules will result in more pre- and post-

trade transparency. The terminal will bring together many sources

to provide an overview of trading activity. The new data will feed multiple functions, including those that give an overall view of the market and those that provide analytics to help with the valuation of bonds. THE TRADITIONAL WINDOW on the world of bond pricing has been

the All Quotes (ALLQ) function. That won’t change, but the function will get several additions. To see a demo version, run {ALLQ MIFID <GO>}. A new price source will appear in January: MIFQ, for pretrade published quotes from around the market. In the composite pricing section at the top of the ALLQ screen, there will be two new rows: Pretrade Aggregate (with the price source code MIFQ) and Last Trade. Click on either of those lines to open a panel at the bottom of the screen with more details. Click on the Pretrade Aggregate line, for example, and the lower part of the screen will display the MIFQ sources and their bids and offers.

< G O> I NS I D E THE TE RMI NA L

Run {ALLQ MIFID <GO>} for a demo version of the ALLQ with MiFID-related additions.

MIFQ is a new price source that aggregates pretrade quotes. Click here to open a panel at the bottom of the screen displaying its sources.

WITH SUCH A MULTIPLICITY of pricing, it can be helpful to see which

bonds are traded the most. Go to {MOSB MIFID <GO>} to see a demo version of the Most Active Traded Bonds (MOSB) function. MOSB shows which group of bonds has traded most heavily, useful for those that have some fund outflows to cover quickly. The function lets you filter bonds by maturity, currency, or country. For the first time, there will be data in this screen from non-exchangetraded bonds in Europe. To put the quote and trade histories from the different sources into context, the Intraday Market Chart (GIQ) function will give trade histories from a number of user-selected sources. There will be both the combined MIFQ price and all the different trading venues newly available. Other tools that will be populated with more data starting on Jan. 3 will be the Trade History (TDH) and Trade/Quote Recap (QR) functions. These will be the first changes implemented under the MiFID II rules. Later in the year, when the flow of data becomes clearer, Bloomberg will communicate any other changes.

Details of the new data and where to find it will be available on {MIFI <GO>} beginning in January. Bloomberg has been delivering regulatory-related data since 2004 following the advent of the Trade Reporting and Compliance Engine (Trace), the bond-price reporting system of the Financial Industry Regulatory Authority in the U.S. MiFID II is importantâ&#x20AC;&#x201D;given its impact on European market participants, as well as others around the globeâ&#x20AC;&#x201D;and Bloomberg is committed to delivering solutions for European bonds similar to those for bonds reported on Trace. information affect bond trading? The aim of the legislation is to make the market more transparent and encourage investors to participate. The actual impact remains to be determined, though, and a full understanding of its effects will only start on Jan. 3. These functions offer a good place to start. HOW WILL THIS NEW

Morton is a financial regulation specialist at Bloomberg in London.

<GO> I NS I D E THE TE RMI NA L

Alpha Insights

See What David Tepper Sees In This Undervalued Tech Company By BRANDON KOCHKODIN

Use {PORT <GO>} to perform factor-based attribution on Appaloosa’s reported holdings.

Appaloosa’s Micron position contributed 3.33 percentage points to the overall portfolio return.

speaks, markets listen. The founder of Appaloosa Management LP sent S&P 500 futures down during the “Tepper Tantrum” in May 2014, when he admonished fellow SkyBridge Alternatives Conference attendees not to be too “freakin’ long” and that it was a “dangerous market.” At the Robin Hood Investors Conference in New York in October, Tepper said shares of Micron Technology Inc. could double or triple. That sent stock prices up more than 1 percent in afterhours trading. You can use your terminal to track stocks that Appaloosa reported in quarterly filings with the U.S. Securities and Exchange Commission. Go to {FLNG <GO>}, enter “Appaloosa” in the field below Holder Name, and press <GO>. Click on the name of the firm. Next, run {PORT /P <GO>} to load the portfolio in the Portfolio & Risk Analytics function. Click on the Holdings tab. If you sort the list by market value, you can see that Micron was Appaloosa’s third-largest equity holding—that is, based on the position reported as of June 30 and at the price as of Nov. 6. (Bear in mind that this is a naive portfolio, based on a snapshot at a point in time. It may not WHEN DAVID TEPPER

include holdings the firm isn’t required to report, and it may have changed since the report.) A representative of Appaloosa declined to comment for this story. You can perform factor-based attribution by clicking on the Attribution tab. Select YTD from the Time drop-down menu, then hit <GO> to see how each stock has contributed to return this year. Click on the CTR column heading to sort the list by contribution to return. As of Nov. 6, the reported holdings of Micron contributed 3.33 percentage points of the portfolio’s 23 percent return. Micron’s contribution trailed only that of Chinese e-commerce giant Alibaba Group Holding Ltd., which accounted for a bigger weight in the portfolio. Driving Micron’s contribution was the 97 percent rise in shares of the Boise, Idaho-based memory chip maker this year through Nov. 6. SO WHAT DOES the head of Appaloosa see in Micron? Relative value.

A Bloomberg news story from October reported that Tepper told attendees at the Robin Hood conference that Micron was undervalued. Here’s how to use your Bloomberg to test the billionaire hedge funder’s hypothesis. The simplest way to check how Micron stacks

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To compare Micron with peers, go to {MU US Equity RV <GO>}.

Micron leads peers on metrics such as sales growth and on valuation measures such as forward price-earnings.

To search for investors in Micron, run {IS <GO>}, type “hedge fund managers invested in Micron” in the field, and press <GO>.

up against its peers is to go to {MU US Equity RV <GO>} for the Relative Valuation function. First, to compare Micron with the set of peer companies selected by Bloomberg Intelligence analysts, click on the arrow to the right of Comp Source and select Analyst Curated (BI). Now, take a look at the ratio overview in the upper right corner of the screen. You’ll quickly see something along the lines of what Tepper sees. Micron’s forward price-earnings ratio is the lowest in the group, while its forward enterprise-value-to-earnings-beforeinterest-tax-depreciation-and-amortization multiple is second-lowest—and well below the median. The semiconductor company takes first in sales growth, Ebitda margin, and gross margin. So who else has been in on the Micron trade? To find out, run

{IS <GO>} for the Investor Search function. Type in “hedge fund managers invested in Micron” and hit <GO>. To specify a date, enter “Filing Date” in the Narrow This Search field and click on the match. Enter dates and click on Update. You’ll see that Citadel Advisors LLC is the biggest holder of Micron among hedge funds, followed by Appaloosa. Using Bloomberg’s relative value tools makes it easy to see why Tepper is advocating Micron. With valuation ratios on the low side of its peer group even after doubling this year, Micron may look attractive to both value and momentum investors. Kochkodin is a managing editor at Bloomberg News in New York. With assistance from Hema Parmar.

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Fixed Income

How to Match Assets and Liabilities By Running an Optimization By CONSTANTIN COSEREANU

A simple spreadsheet shows a portfolio of future liabilities to upload via {BBU <GO>}.

Periodicity can be set to monthly, quarterly, or yearly (M, Q, or Y).

is an investment strategy that seeks to match the duration of a portfolio’s assets with that of its liabilities. Instead of trying to beat a benchmark, for example, a pension fund or an insurance company may aim to generate the amount of money it needs to pay out to its retirees or for its claims. The approach comes in a variety of flavors and goes by different names: liability-driven investing and immunization, among others. Pension funds do it. Insurers do it. Maybe you want to do it, too. Say you’re running a family office. You have an idea of the future cash needs of the family. In fact, you have a spreadsheet estimating outgoing cash flows over the next two decades. Problem AS SET- LIABILIT Y MANAGEMENT

is, it’s very difficult—or even impossible—in Excel to find the set of assets that would best cover those liabilities. Enter the Portfolio & Risk Analytics (PORT) function, where you can now match assets and liabilities using the optimizer. The basic idea is to upload a set of liability cash flows as a benchmark. You can then compare your portfolio of assets against them. If there are key-rate duration mismatches, the optimizer can identify trades that could more closely align the two. WHAT DOES A PORTFOLIO of liabilities even look like? At its simplest,

a series of outgoing cash flows can be represented in a spreadsheet with only four data items: name, periodicity of payments, amount,

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Run {BBU <GO>} to upload your liabilities.

Click here and select Liabilities.

Use the drop-down menus to specify the data in each column.

Run {PORT <GO>}, select your portfolio and the liabilities that you uploaded via BBU.

In this case, the portfolio is long duration at the one-year tenor while short duration further out on the curve.

and the date that the payments will be made. For a sample liabilities file, go to {BBU <GO>} for the Bloomberg Uploader function. Click on the Sample Files tab and then on Liabilities for Immunization. Once you have your liabilities set up in a spreadsheet, run {BBU <GO>} again and upload the file. When the Status column says Ready to Map, click on that link. Under File Setup, enter the line number on which the data begins in the field to the right of Start Data Upload at Line. Click on the Next button. BBU’s default assumption is that your uploaded file is a portfolio. To specify instead that you’re uploading a set of liabilities, click on the arrow to the right of Upload Type and select Liabilities.

Use the drop-down menus above each column to identify the data that it contains. Click on the Finish button when you’re done. Next, go to {PRTU <GO>} for the Portfolio Administration function. To see your uploaded liabilities, click on Benchmarks. (The main calculating engine underlying the benchmark is the Swap Manager function, {SWPM <GO>}, which represents the liabilities benchmark as a one-legged swap.) Run {PORT <GO>} and select your portfolio of assets. Next, choose your liabilities as the benchmark in the Vs field. You can then compare the two by using metrics such as key rate duration, for example, by clicking on the Characteristics tab and then on the Key Rates subtab. (Key rate duration—a gauge of interest

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A ready-made task in the optimizer lets you in essence “hug” the benchmark duration by suggesting trades that would bring partial durations to within 0.1 percentage points of the benchmark at key maturities.

The optimizer proposed 5 buys and 13 sells in this case. To limit the number of sells, you could add a trade constraint, as well.

To dig into the proposed portfolio, click here.

rate sensitivity developed by Thomas Ho of New York-based financial engineering firm Thomas Ho Co.—is the change in the price of a bond or the value of a portfolio given a small shift in rates at certain maturities along the curve.) To run an optimization that would more closely align the portfolio with the liabilities, click on the Trade Simulation button and select Launch Optimizer. The Portfolio Optimization screen is divided into four sections that let you specify the parameters for your optimization: Goals, Trade Universes, Constraints, and Security Properties. In this case, let’s use a ready-made task. Click on the Tasks button and select Load Task. Under Category, click on Fixed Income Tasks

and select Fixed Income: Minimize Turnover and Match Key Rates. That will set a goal of minimizing turnover while trading from your portfolio with a series of constraints that aim to match the partial duration of the liabilities benchmark at key maturities. To run the optimization, click on the Run button. The optimizer will then propose a list of trades. To analyze the simulated portfolio, click on the Analyze in PORT button and you can see how the trades will affect the overall option-adjusted duration. This simple but sophisticated matching exercise, executed monthly, can shed light on how to position yourself. Cosereanu is a portfolio and risk specialist at Bloomberg in New York.

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Quant Research

Factor Returns Let You See What’s Actually Happening By MICHAEL REIFEL and JOSE MENCHERO

devastated many quantitative fund managers. The broad U.S. equity market was up slightly the second week of that month, yet returns of many managers using quant strategies were in the red. As the rout unfolded, the fund managers watched their portfolios underperform in real time—they just didn’t know why it was happening. We now know that many managers were making bets on the same factors, such as value and momentum. Some were also highly leveraged, forcing them to unwind positions as their portfolios began to lose money. The selling pushed down factor returns and forced still more deleveraging. What if those managers had been able to observe intraday factor returns during the meltdown? At the very least, that could have helped inform investment decisions. AUGUST 2007

themes or factors drive returns has become widely accepted by academics and investment professionals. For stocks, factors include the overall market, industries, countries, currencies, and styles—value, size, and momentum, for example. For fixed-income instruments, common factors are TH E I D E A THAT CO M M O N

movements in the yield curve and changes in credit spreads. The applications of the idea are diverse. Investors use multifactor models to forecast and attribute ex ante, or predicted, risk in portfolios. Portfolio managers use them to analyze sources of realized returns through a process known as factor-based performance attribution. Consultants use them to gauge the value added by an investment manager. Quantitative investors use them for portfolio construction. Factor investing has gained additional prominence with the advent of smart-beta exchange-traded funds that use factor-based strategies. Factors are available within the multifactor risk model that forms part of the Portfolio & Risk Analytics (PORT) function. The PORT multifactor risk model contains more than 1,800 factors that span multiple asset classes. Now, for the first time, you can see pure factor returns in real time on the Bloomberg Professional service. To monitor them, go to {FTW <GO>} for the Factors to Watch function. Select United States or a U.S. benchmark such as the Russell 3000 Index, and click on the Pure Factor Returns tab. For a chart of the intraday performance of a selected factor, click on it.

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To monitor factors in real time, run {FTW <GO>}, select United States or a U.S. index, and click on the Pure Factor Returns tab.

Click on a factor to chart its performance in the lower panel of the screen.

the impact of a style factor is to form a dollar-neutral portfolio that simply goes long on stocks with positive exposure to the factor and takes short positions in stocks with negative exposure. The size factor, for example, could be tracked with a portfolio that’s long large-cap stocks and short small-caps. While this simple factor portfolio would certainly measure the return difference between large and small stocks, it would also be affected—perhaps strongly—by “incidental” exposures to other factors. If certain industries are dominated by largecap stocks, then the returns of the size factor portfolio will also be driven, in part, by the returns of those industries. Moreover, if small-cap stocks have recently outperformed large ones, the size factor portfolio would have an incidental negative exposure to the momentum factor. These incidental exposures can mask the true impact of the underlying factor. A better approach to assess the performance difference between large and small stocks is to form a pure factor portfolio. Obtained by cross-sectional regression, the resulting dollar-neutral portfolio has unit exposure to the size factor—and zero exposure to all other style factors and industries. The return of this pure ONE WAY TO CAPTURE

size factor portfolio would thus be driven solely by that factor’s effect. Pure portfolios can be constructed in a like manner for any other style. Bloomberg has built pure factor portfolios for each of the 10 style factors in the PORT U.S. equity model. (For more information on the methodology, go to {DOCS 2086425 <GO>} and download Pure Factor Returns in Real Time, a white paper by Jose Menchero and Lei Ji.) ONE PRACTICAL DRAWBACK of a pure factor portfolio is that it may

be difficult to replicate in real life. These portfolios are long-short and dollar-neutral. Some of the short positions might be in shares that are difficult or expensive to borrow. Also, maintaining the “purity” of a portfolio requires frequent rebalancing. This may create significant turnover, increasing transaction costs. While pure factor portfolios are investable in principle, they may be difficult to replicate in practice. As a result, the main purpose of a pure factor portfolio is not as an investment vehicle, but rather as an analytic device to help put different market dynamics to work in investment decisions. You can use the factor portfolios in a return-based analysis with the Fund Style Analysis (FSTA) function. To graph the value

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You can chart the Bloomberg U.S. pure factors intraday or over longer periods.

Earnings variability was the best performer this year through early November, just ahead of momentum.

Value, the top returner overall since 1999, has trailed this year.

TRACKING FACTOR RETURNS U.S. Pure Equity Style Factor Portfolios Style

Ticker

Factor Description

Earnings Variability

PEARNVUS

Gauges consistency in earnings, cash flows, and sales

Momentum

PMOMENUS

Differentiates between stocks that outperform and underperform

Size

PSIZEUS

Distinguishes between large and small stocks

Profitability

PPROFTUS

Measures company profitability by combining multiple earnings variables

Growth

PGRWTHUS

Reflects growth along different fundamental dimensions

Trading Activity

PTRADEUS

Measures stocks’ average trading volume normalized by shares outstanding

Volatility

PVOLAUS

Distinguishes more volatile stocks and less volatile ones

Dividend Yield

PDIVYUS

Gauges another dimension of value by analyzing dividend payout policies

Leverage

PLEVERUS

Differentiates stocks with high and low leverage

Value

PVALUEUS

Measures stocks’ “cheapness” by combining multiple fundamental metrics Source: Bloomberg

factor, run {PVALUEUS Index GP M <GO>}. Since its inception at the end of 1999, value has been the best-performing pure factor portfolio—further evidence of the efficacy of value investing. During several periods over the past 17 years, it really paid to be a value investor. One such span lasted from 2000 through mid-2007. That likely will make sense to anyone who remembers the bursting of the internet bubble, when the high-growth expensive names that dominated markets in the late 1990s fell out of favor. Another period of value outperformance began in the first half of 2009, following the financial crisis, when investors came back to the

market and bought beaten-down, inexpensive companies. This year is a different story. The factor rotation that started in 2016 continues: Although the value factor is underperforming, investors seem to prefer chasing past winners (momentum) and those with high earnings variability (often associated with growth investing). Factor portfolios thus provide great insight on what is driving current market dynamics. Reifel is a PORT business manager at Bloomberg in New York. Menchero is head of portfolio analytics research in San Francisco.

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Macro Man

Global Growth Drives Emerging-Markets Performance: Market Myth or Reality? By CAMERON CRISE

GROWTH STORY Percentage-point difference between Chinese and U.S. GDP growth 0.99

Ratio of MSCI Emerging Markets Index to MSCI USA Index

0.45

1/31/95

9/29/17

Sources: {CNGDPYOY Index <GP>}; {GDP CYOY Index <GP>}; {MXEF Index <GP>}; {MXUS Index <GP>}

have been one of the investment darlings of 2017, handily outpacing their developed-market peers on a narrative of accelerating global growth. The idea that a booming world economy is consistent with EM outperformance seems so obvious that it isn’t even worth checking—but is that actually the case? I decided to take a look at what really drives the relative returns of emerging markets. EMERGING-MARKET EQUITIES

GIVEN THE SIZE AND liquidity of the U.S. stock market, I used that as the performance benchmark for emerging-market equities. It turns out that global growth considerations do provide a decent contemporaneous explanation for relative EM performance. Using monthly data since 1995, I found a correlation of 0.3 between a global purchasing managers’ index (a proxy for world

growth) and trailing one-year relative EM out- or underperformance vs. the U.S. market. In a sense, we can distill the essence of relative emerging-market performance even more: The ratio of the MSCI EM Index to the MSCI USA Index seems to track the trends in the spread between Chinese and U.S. gross domestic product growth pretty closely. This is all well and good, but simply explaining prior performance doesn’t necessarily tell us much about the future relative returns of EM and U.S. stocks. What does information available today say about relative returns in the future? I ran a regression using a few simple factors to explain oneyear forward relative performance of EM and U.S. stocks. The results were fascinating. It turns out that current global PMI readings are negatively

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VALUE BEATS GROWTH A multifactor regression shows that a higher relative earnings yield suggests that emerging-markets stocks are likely to outperform the developed-market equities.

Factor

Tickers

Coefficient

T-statistic*

Value (earnings yield ratio)

{MXEF Index}, {MXUS Index}

3.126541

7.075082

Inflation (U.S. CPI)

{CPI YOY Index}

-0.00435

-2.14346

Growth (Global PMI)

{KXGLMHE Index}**

-0.02639

-8.02451

Momentum

{MXEF Index}, {MXUS Index}

0.556149

10.25575

* Based on monthly data from 1995 through 2016. T-statistics are gauges of the importance of explanatory variables. An absolute value of 2 is unlikely to occur by chance; a negative figure implies an inverse relationship. ** Since 1998. {NAPMPMI Index} from 1995-1997. Source: Bloomberg

correlated with one-year forward relative EM returns. The better the PMI numbers today, the worse that EM stocks do relative to the U.S. over the next 12 months on average. The correlation since 1995 is -0.3. Unsurprisingly, the global PMI gets a negative coefficient in the regression formula, with a t-statistic that is statistically significant. I specifically excluded the dollar from the regression—it’s almost tautological that U.S. stocks will outperform (in dollar terms) when the USD appreciates and underperform when it falls. Which factors do the best job of forecasting future EM performance? Valuation and momentum. I defined valuation as the spread in the earnings yield—that is, the inverse of the priceearnings ratios—between EM and U.S. stocks. The regression shows a positive, statistically significant relationship: The higher the EM earnings yield relative to the U.S., the better the subsequent performance. On this basis, it sure looks like EM stocks are a value play in a growth narrative’s clothing! Interestingly, though, the factor with the highest statistical significance turns out to be momentum. If EM stocks have outperformed over the previous year, it turns out they do well over the next 12 months, too. While we also tend to think of EM stocks as a reflation play, generally speaking inflation isn’t so good for them—at least U.S. inflation. The negative relationship is fairly modest, however, and I’d put it down to the monetary policy response from the Federal Reserve. I should emphasize, however, that the relationship between several of the factors and EM performance doesn’t seem to be stable. The r-squared, a measure of the predictive power of the model, is 0.4. That’s decent but certainly doesn’t suggest that the modeled factors can explain the majority of future EM returns. AS A SENSE CHECK , I broke each of the input factors into deciles and

spread in earnings yields and subsequent performance. It turns out that if you buy the market that’s cheap, it tends to do better. Chalk one up for Graham and Dodd there. For what it’s worth, the current EM earnings yield premium to the U.S.—1.7 percent—is in the sixth decile: That’s broadly consistent with EM stocks matching the performance of their U.S. equivalents. What about that counterintuitive finding that growth, as represented by global PMI, is bad for subsequent EM relative performance? Well, there does seem to be a compelling case that buying EM when the growth outlook seems especially dire can pay handsome dividends. (It’s always darkest before the dawn.) However, while the negative relationship between PMI readings and subsequent EM outperformance seems broadly linear, there are some exceptions. While it may be a stretch to say that strong PMI readings are an active detriment to EM returns, at the very least we can conclude that they are far from an unalloyed positive—contrary to popular belief. What about momentum, the strongest signal in the regression? Again, there looks to be a strong linear relationship … with a twist. At extreme levels of EM outperformance, it seems as though some sort of mean reversion kicks in and emerging-market stocks cease to outperform. A similar analysis comparing the U.S. consumer price index with subsequent EM returns shows no evidence of a stable relationship— small wonder it had the lowest t-statistic in the regression. So if we add everything up, what does our framework suggest about EM performance moving forward? The prognosis is a little less than optimistic: The model is forecasting that EM stocks will slightly lag their U.S. counterparts over the next 12 months. While that, of course, is no guarantee that the EM narrative is about to end, the results of this study seem sufficiently compelling that we can probably conclude that “strong PMI data leads EM relative performance” is false.

calculated the subsequent one-year relative returns from each. In effect, this helped separate the wheat from the statistical chaff. For example, there’s a strong linear relationship between the

Crise is a macro strategist who writes the Macro Man column for Bloomberg and blogs for Markets Live.

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Fixed Income

Help Your Portfolio Win As the Fed’s Unwinding Begins By STEPHEN JONATHAN

To view maturities of the Fed’s bond holdings, go to {DEBT <GO>}, select United States, and click on the Fed Holdings tab.

Click here and select Monthly.

For details of the bonds maturing in January, for example, click on the month.

began to reduce its $4.5 trillion balance sheet in October. The U.S. central bank plans gradually to trim its holdings of Treasuries and mortgage-backed securities (MBSs) by limiting the reinvestment of principal payments it receives each month. It began by allowing up to $6 billion in Treasuries to mature each month without reinvesting the proceeds, according to the Federal Open Market Committee’s June addendum to its Policy Normalization Principles and Plans. Reinvestment of non-Treasuries was cut back by as much as $4 billion a month. These so-called caps will rise over time. They jump to $12 billion for Treasuries and $8 billion for non-Treasuries in the first quarter of 2018 and then rise incrementally to $30 billion and $20 billion, respectively, in October 2018. THE FEDERAL RESERVE

As the Fed offers less bid to the market, you may be able to better position your portfolios for potential shifts in the yield curve by understanding what’s maturing and what will be rolling off.

in context of the Fed’s overall portfolio, Bloomberg has aggregated Fed holdings by their maturities. Run {DEBT <GO>} for the Sovereign Debt Ownership function and select United States using the drop-down menu in the top left. Next, click on the Fed Holdings tab. The chart and table will open to show maturities aggregated by year. Use the drop-down menu to the right of Period to select Monthly. The bar chart in the upper left of the screen shows the maturities of Treasuries in green and non-Treasury holdings in yellow. Non-Treasuries are predominantly mortgage-backed TO P U T T H E P O LI CY

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The dollar amount held is shown here.

This column shows the percentage of the issue that’s held by the Fed.

securities guaranteed by Freddie Mac, Fannie Mae, or Ginnie Mae. The maturities of the Fed’s Treasury holdings are clustered from 1 to 10 years from now, while maturities of its non-Treasury securities are longer-term, with significant maturities out toward 30 years. That doesn’t reflect the principal the Fed receives when mortgages are prepaid, however; its principal cash flows from its mortgage holdings could be more front-loaded than the yellow bars in the chart suggest. The table on the right side of the screen shows the amount of debt in both categories that’s due to mature each month. Select a particular month to tap into the Bond Details screen. Clicking on 01/2018, for example, reveals that the $30 billion in Treasuries maturing in January is made up of five issues. You can see the securities, the dollar amount held, and what percentage of the total

amount outstanding the Fed holds. The final column will even show the monthly change in the Fed’s ownership. Monthly maturity and Fed holding data, when compared with the bank’s reinvestment caps, may provide insight into demand for Treasuries and yields across the entire curve, helping you to more efficiently manage your own Treasury and MBS portfolios. The $30 billion in Treasuries maturing in January, for instance, is $18 billion more than the $12 billion it may unwind that month. With the Fed buying fewer Treasuries, you may be looking to figure out what impact that will have on yields. Visibility on what’s maturing is likely to be helpful. Jonathan is an FX and economics market specialist at Bloomberg in New York.

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Workflow

Ready to Put Your CFA Program Knowledge to Work? Take This Pop Quiz By ROB LANGRICK

THIS PAST JUNE, 31,631 candidates around the world took Level III

of the three-part Chartered Financial Analyst Program exam. About 54 percent passed and became CFA charterholders. (If you’re one of them, congratulations!) If you’re still studying, better get cracking—it takes a while to master 8,500 pages of material. Once you have, though, you may want to bridge the gap between theory and practice. To apply what you’ve learned to your daily work, go to {CFAPRO <GO>} for a new function that maps the CFA Program Candidate Body of Knowledge to the Bloomberg terminal. Been studying? Here’s a quiz: Choose the most appropriate function to illustrate each of the seven CFA Program Learning Outcome Statements* below.

“Explain the relationships among a bond’s holding period return, its duration, and the investment horizon.” FIHG FIHR FIBC FIHZ 4.

“Explain the swap rate curve and why and how market participants use it in valuation.” ICVS DLIB IRDD USSW 5.

“Explain the relationships between monetary policy and economic growth, inflation, interest rates, and exchange rates.” ECWB ECST ECOW ECOS

“Calculate and interpret the value, price return, and total return of an index.” ERA TRA HRA MRA

“Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system.” HCS ICS PCS MCS

* CFA is a trademark owned by CFA Institute. Learning Outcome Statements reproduced with permission from CFA Institute.

“Compare the life cycle of commodity sectors from production through trading or consumption.” AGSD CFVL GLCO COT

Answers: 1. ECWB, 2. TRA, 3. ICS, 4. FIHZ, 5. ICVS, 6. VCUB, 7. AGSD

“Explain the maturity structure of yield volatilities and their effect on price volatility.” VCUB OVDV VOLC WVOL

Langrick leads Bloomberg for Education in New York.

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Flows

What to Talk About When You Talk About Brexit By OWEN MINDE and STEPHEN JONATHAN

FLOWS CAN PROVIDE powerful insights into economic and market

trends. Both long-term foreign direct investment and shorter-term portfolio flows can be viewed as the business and investing communities’ judgment on policymakers’ economic and regulatory decisions. Buying a stake in a company or shares of an exchange-traded fund, for instance, could imply a vote of confidence. For insights into long- and short-term capital flows, you can use a couple of Bloomberg data analytics, which cover both cross-border M&A activity and portfolio flows. THE U.K.’S JUNE 2016 Brexit vote provides a perfect case study in

how an unexpected political outcome can have a significant impact on perceptions by the global investor community. As Brexit nears its expected implementation of March 2019, one of the biggest fears is that multinational companies will no longer see the U.K. as a gateway to Europe and may prefer to invest on the Continent instead. Start by running {FLMA <GO>} for the Cross Border Mergers and Acquisitions function. Select the United Kingdom in the top left amber box and change the Position to Inward. That shows in a selected period, such as last month, the total foreign direct investment—that is, M&A transactions in which buyers are acquiring stakes in the U.K., as reported by either the company or the adviser. The chart at the bottom displays a history of these flows. It may be surprising to see the spike in inward investment in October 2016, after the vote to exit the European Union. However, that October data point reflects deals that happened to be completed that month. If you use the radio button in the upper left part of the screen to select Announced Deals and uncheck Include

Terminated Deals, you’ll see that the deals completed that October were generally announced before the vote. Change the periodicity in the top right to quarterly, and you’ll see that the announced deal volume hasn’t fallen off a cliff since the referendum. M&A deals involving U.K. companies continue to be announced. That’s a bullish indicator for the U.K. economy and the British pound. The chart in the top-right corner displays the geographical breakdown of the origin of the investment: In the third quarter of 2017, 65 percent of total investment in the U.K. came from North America. To drill down further into the specific deals themselves, click on the magnifying glass icon next to North America, which will take you into the {MA <GO>} function. To see all the deals in the third quarter ranked by announced total value, sort the Deal List section accordingly; click into any deal to see its details. are a focus of both investors and regulators. Investors focus on trends in fixed-income, equity, or alternative portfolio flows to understand sentiment by the larger investor community, while regulators are increasingly looking to monitor those flows to get real-time data regarding trends that could affect local markets. To analyze trends in cross-border capital flows and changes in investor holdings, check out Bloomberg’s Flow of Fund Portfolio at {FOFP <GO>}. The function displays Bloomberg’s in-house holdings database, which is updated on a quarterly basis, along with monthly estimates between official quarterly releases. Select United Kingdom in the top left. Use the radio button to select Flow. To see investment flows into the U.K., change the Financial SHORT-TERM CAPITAL FLOWS

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To track foreign direct investment flows, go to {FLMA <GO>}.

To switch the view to Announced Deals, click here and you can see that a lot of the deals that closed in October 2016 were announced before the vote.

The volume of completed deals spiked, surprisingly, in October 2016, after the Brexit vote.

To track trends in cross-border portfolio investment flows, run {FOFP <GO>}.

Flows from China turned positive in the second quarter after seven quarters of outflows. For a history of flows from China into and out of U.K. bonds, click here.

Position to Liabilities (money coming into the U.K. to buy assets, of course, creates a liability from the perspective of the country). Next, to see investment in U.K. bonds from abroad, select Debt as the Indicator. FOFP shows that the biggest inflow from the second quarter to the end of September came from China: $2.2 billion. Now, click on the red China bar to chart the history of this flow. Interestingly, China started withdrawing its investment in U.K. bonds in the third quarter of 2015, shortly before the Brexit referendum was announced. China then continued to pull money out of U.K. bonds until the second quarter of 2017, when flows turned positive. Perhaps even more powerful in terms of current positioning,

you can now see the breakdown of the stock of equity investment in the U.K. in the Portfolio & Risk Analytics (PORT) function. Close the History window. Use the radio button to select Stock rather than Flow. Change the indicator to Equity. The table at the bottom right of the FOFP screen shows the total U.K. market value: $3.6 trillion as of late October. Of that, Bloomberg had holdings data on 62 percent of the market. Whatâ&#x20AC;&#x2122;s more, 45 percent of the total market was owned by foreigners: $1.6 trillion. U.S. investors were the largest holders of U.K. stocks, followed by Canadians and Norwegians. To display the entire portfolio of the worldâ&#x20AC;&#x2122;s equity investment in the U.K., click on the View in PORT button on the red toolbar. Click on the Holdings tab, and you can see that the Global

<GO> I NS I D E THE TE RMI NA L

Click on the View in PORT button in FOFP to display the portfolio of foreign holdings of U.K. stocks in PORT.

Click here for a list of U.K. financial companies held by foreigners.

To track ETF flows, run {FFLO <GO>}.

For a map of flows, click here.

To dig into data on U.K. ETFs, click here.

Industry Classification Standard sector that has attracted the biggest share of the worldâ&#x20AC;&#x2122;s investment into the U.K. is financials. To drill down into the individual names that foreign investors hold, click on the plus sign to the left of financials and then sort by weighting. Among the companies with the most foreign ownership by value are HSBC Holdings, Prudential, and AON. This list of foreign-held U.K. stocks could be a place to start examining a companyâ&#x20AC;&#x2122;s exposure to a hard Brexit scenario in which financial passport rights to do business in Europe are denied. THE FLOOD OF MONEY pouring into passive investments has led to

increased interest in real-time analysis of these flows. To view ETF

flows on a country or regional basis, run {FFLO <GO>}. To track ETF flows into and out of the U.K., use the dropdown menu to the right of View to select Countries. Select Netflow in the Show field. Net flow into U.K. ETFs has been $1.5 billion this year through October, with inflows of $7.4 billion and outflows of $5.9 billion. For a map of flows, click on the Map tab. For more detail on U.K. ETFs, click on United Kingdom. You can use the tabs to analyze flows, performance, and liquidity. Minde and Jonathan are FX and economics market specialists at Bloomberg in New York.

< G O> I NS I D E THE TE RMI NA L

Credit

Manuel Henriquez Has Been Dealing With a Few Things, OK? By JON ASMUNDSSON P H O T O G R A P H B Y C H R I S T I E H E M M K LO K

FOR MANUEL HENRIQUEZ, the founder and chief executive officer

of Hercules Capital Inc., if ever there were a year to remember—or maybe forget—this would be it. Before May, things had been going pretty well for Hercules, the largest nonbank venture-debt provider. Its shares had risen almost 27 percent in the previous 12 months. Total return, including dividends of $1.24 per share paid out over the same period, was running about 39 percent—more than twice that of the S&P 500 index. And then the press release went out. It was 5:04 p.m. Eastern Daylight Time on Wednesday, May 3, so markets were closed. The reaction from investors came the next day, when shares of Hercules plunged 12 percent. The release said the company had filed proxy materials seeking approval from shareholders for a newly proposed advisory agreement. No longer would an in-house team of 33 investment professionals originate and oversee Hercules’ investments. The plan was to move those people into a newly created entity—called Hamilton Advisers LLC for the street in Palo Alto where Hercules has its headquarters—and charge fees to the now externally managed business development company, or BDC. Why did Henriquez want to externalize? The business was getting tougher, for one thing. New players—hedge funds that want to do direct lending, for example—had moved into the space, increasing competition for deals. So core yield, Hercules’ metric for income from its portfolio excluding early repayments and one-time fees, had declined to 12.2 percent in the first quarter, the lowest level in years. Venture capital firms, meanwhile, were offering more equity than ever, making debt less attractive to entrepreneurs. And the ceiling on how big a company could be to qualify as an eligible asset under BDC regulations—$250 million—was getting a bit dated. “Nearly every

small microcap company is now worth $250 million,” Henriquez told Bloomberg Markets during an October visit to New York, where he was to speak at a private-debt conference and meet with investors. Externalizing would enable the adviser to oversee other pools of capital in addition to the BDC. All compelling reasons, to be sure—which is exactly what TCW Group, a Los Angeles-based asset manager, said in a letter to the Hercules board on May 6: “We fully agree with the notion that the Company should adopt an external management structure and endorse the reasons identified by the Company.” The twist: TCW wanted to be the external manager.

< G O> I NS I D E THE TE RMI NA L

of unwanted attention for Hercules, a company that might be said to be nichey in two respects. First, the BDC structure is somewhat esoteric. BDCs are a species of closed-end fund that the U.S. Congress created by amending the Investment Company Act of 1940 in a bid to funnel capital to small businesses. John Cole Scott, who tracks BDCs for Richmond, Va.-based Closed-End Fund Advisors Inc., describes their creation like this: “It was 1980, Ronald Reagan was president, and Congress did something useful.” There are 55 BDCs that trade on U.S. exchanges, with a total market cap of about $32 billion, according to data compiled by Bloomberg. The biggest, with a value THAT WAS A BIT

of almost $7 billion, is Ares Capital Corp., which focuses on middlemarket lending. Hercules, with a market cap of $1.2 billion, is the seventh-largest BDC and the largest in the venture lending area. Second, venture debt is a relatively obscure corner of the capital markets. While the National Venture Capital Association publishes data on VC investment, it doesn’t track venture debt, according to a spokesman. Lending to VC-funded companies was pioneered by Silicon Valley Bank, which opened in 1982. A handful of other banks also specialize in making loans to startups. Venture lending is concentrated in Silicon Valley and, to a degree, in Boston, according to Eric Green, global co-head of private markets at

<GO> I NS I D E THE TE RMI NA L

For a chart of Hercules shares, run {HTGC US Equity GP <GO>}.

On its third-quarter earnings call, Henriquez said that the BDC would remain internally managed after all. The next day, shares rose 7.6 percent.

When the company announced that it was seeking to externalize management, shares plunged 12 percent.

Muzinich & Co. “You need to be local because your ability to both source the opportunities as well as execute and portfolio manage them is all about being local,” Green says. Hercules focuses on technology, life sciences, and sustainable and renewable tech. It’s invested in 390 companies since Henriquez started it in 2003, making total commitments of more than $7 billion, usually first lien senior secured loans. “First and foremost, we tell people—and this usually scares everybody—substantially all of our companies don’t have revenues,” Henriquez, 54, says. “They’re in high-growth mode; they’re in research and development mode; and so they’re burning a lot of money.” That sounds risky. As a result, venture debt deals are typically costly: prime rate plus 5 percent to 9 percent. In addition, the deals usually include equity kickers in the form of stock warrants, which can pay off when companies go public or are acquired. Gains from warrants have largely offset loan losses at Hercules over time. Total net realized losses are only $29.3 million since inception. That’s roughly 55 basis points of its $5.3 billion in total fundings. So what kind of companies does Hercules lend to? One recently set a world record. Burlingame, Calif.-based Proterra Inc. makes zero-emission mass transit vehicles. In September a Proterra bus traveled 1,101.2 miles at the Navistar Proving Grounds in Indiana—the farthest any electric vehicle has gone on a single charge. “It’s the first large-scale American bus manufacturer using electric technology,” Henriquez says. TransMedics Inc. is another Hercules company. Henriquez says the company solves a problem involving transplant organs. For the past 50 years, the main method of transporting a donated heart hasn’t changed much: The organ is packed in ice in an Igloo cooler and rushed to a recipient, who must be no more than four hours away.

TransMedics, based in Andover, Mass., is developing machinery that keeps organs alive in transit. “It’s an incredible thing to watch—a human heart functioning inside this container,” Henriquez says. VENTURE LENDING sounds like a pretty good gig, to hear Henriquez

tell it. “Every day I go to work, we’re seeing incredibly innovative, incredibly cool companies,” he says. There’s a caveat, though. It may be easy to make venture loans to cool startups, but it can be hard to get paid back. “You have to be a geek in understanding technology or life sciences as well as a geek in credit,” Henriquez says. “If you can’t merge that industry expertise and credit paradigm of underwriting like a helix—you got nothing.” Confirmation of a sort came on Nov. 2. That morning, Hercules announced it had bought a portfolio of venture loans for $125 million from Ares Capital, the largest BDC. On the Ares earnings call that afternoon, CEO Kipp deVeer was asked about the deal and explained why Ares was exiting the business. “The loans are small, they’re complicated,” he said. “They require a lot of oversight, and they just became something that was for us too challenging to monitor in terms as a percentage of fair value.” Henriquez had his own announcement on Hercules’ earnings call later that day: The board had decided the company would remain internally managed after all. “We think that the externalization process will continue to be a distraction from the core business, which happens to be improving,” he said. Core yields, he noted, had started to rise. “I am so done with externalization,” Henriquez told Bloomberg Markets after the call. Shares of Hercules rose 7.6 percent the next day. Asmundsson is <GO> editor of Bloomberg Markets.

< G O> I NS I D E THE TE RMI NA L

10 Easy Ways to Improve Your 2018 Bloomberg’s market specialists help you get the most out of the terminal. Think of them as seasoned ﬁnance professionals who understand the tools you need. Here are just a few ideas to contact them about as you plot your 2018. Email the team at marketspec@bloomberg.net for assistance.

Understand Your Bond Portfolio

Balance All Those Assets

The Federal Reserve is beginning to reduce its $4.5 trillion balance sheet. What do potential shifts in the yield curve mean for your portfolio? Find Fed holdings aggregated by their maturity dates and the percentage of each individual issue owned by the central bank.

Regulatory frameworks created since the 2008 Lehman Brothers crisis aim to reduce the systemic risk of the ﬁnancial sector. While market risk measures are near their lowest levels since the crisis, are you prepared for them to increase? Measure the impact of potential shocks on your multi-asset-class portfolio.

Pay Attention to Subtle Signals The U.S. stock market has been on a tear over the past year. Can the momentum continue in 2018? Check dividend growth forecasts and compare sales and earnings growth predictions for potentially bearish signs.

Stay Ahead of the Fed

Don’t Let an Election Surprise You

President Trump tapped Jerome Powell to replace Janet Yellen as Fed chair. What does this mean for the pace of rate increases? Discover which ﬁnancial indicators the Fed chair typically monitors when setting interest rate policy.

From Brexit to Trump, many investors were caught off guard by the events of 2016. What could the results of the presiden-

tial elections in Brazil and Mexico mean for markets next year? Stay informed as races in Latin America’s biggest economies heat up, and follow the movements of the real and peso.

Find Research Management Solutions

Remember That Brexit Hasn’t Happened Yet

Display your internal research and data within Bloomberg analytics to improve transparency across your team. Also, manage external research. Analyze and evaluate broker services provided to you. Establish a research budget and broker vote to meet MiFID II requirements or best practices.

The U.K. is continuing exit negotiations with the European Union. What do the details mean for sterling and U.K. assets? Track the health of the U.K. economy as the talks proceed.

Keep Your Eye on the Tiger China’s Bond Connect gave global funds access to 10,000-plus

corporate bonds in the country, almost 6,000 of which are ranked A or above by local rating companies. Is lower-rated debt worth the risk? Learn how to ﬁnd and sort bonds by risk of delinquency over the next 12 months.

Navigate Risk in Emerging Markets For ﬁxed-income investors in emerging markets, the threat of default in Venezuela was one of the biggest stories in 2017. Should you be keeping your eye on any other countries? Learn how to model other nations’ potential distance from default.

10 Lower Your Carbon Footprint

The U.S. may be exiting the Paris climate agreement, but corporations are still sticking to their renewable energy targets. Where might you get the least carbon-intensive electricity from the grid? Find out where wind farms are located around the world.

For more actionable insights from Bloomberg’s market specialists, subscribe to Functions for the Market at {FFM <GO>} and browse their archive at {NI MARKETSPEC <GO>}. For their webinars, go to {SEMR <GO>} and sort by Topic: MARK.

Large-capitalization asset management stocks outperformed the broader world index in 2017 after lagging for three years

BLO O M B ERG M A R K ETS

Industry Focus

Asset Management

The pendulum of risks has swung wide in one direction for the assetmanagement industry, with low fees, passive products, and technology presenting significant challenges. Meanwhile, new European regulations could have game-changing global implications. As pressures to consolidate accelerate, dealmakers will look for strategic maneuvers. In these pages and at {BI <GO>}, Bloomberg Intelligence keeps you in the flow. VO LU M E 0 0 / ISS U E 0 0

Passive Gets More Aggressive

Investors continue to shift more money into passive funds at the expense of active managers. Through September, annual inflows into U.S. exchange-traded and index funds were at their highest level on record. One-third of U.S. ETF and mutual fund assets are in passive funds, up from 20 percent in 2010. If ever there was a stick-with-you statistic, it’s this: Money flowing into passive investments earns about 70 percent less in fee revenue for asset managers than flows into active strategies do. For more data and analysis on flows and fee trends, go to {BI FLOWG <GO>}. —BI Analyst Alison Williams

FUND FLOWS Actively managed

ETF and Index $500b

Inflows

Net flows 250

-250

2000

2017*

Market Gains Have Eased the Pain for Active Managers…

Even as investors pulled money away from active managers, the value of actively managed assets has surged with the bull market. Since 2010, cumulative gains of $5.7 trillion have dwarfed outflows of about $485 billion, or an average of about $65 billion annually. Perspective is everything, though. Active managers saw average inflows of $135 billion a year during the 2000s. —A.W.

BLO O M B ERG M A R K ETS

- 500

… But This May Finally Be Their Time to Shine

Stockpickers could continue to benefit from the current environment. Stock-specific risks account for the largest share of the variability that’s driving returns this cycle— much like they did in 2012, the last time active-management styles outperformed. Controlling for individual exposure to the market, plus value, size, and momentum, the median level of residual variance in the Russell 3000 index is tracking above 80 percent. The higher the percentage, the more stock returns can be explained by individual rather than market risks. —BI Equity Strategists Peter Chung and Gina Martin Adams

PREVIOUS SPREAD: PHOTO-ILLUSTRATION BY GLUEKIT FOR BLOOMBERG MARKETS; PHOTOS: BLOOMBERG (4); REDUX (1); COURTESY BNYMELLON (1)

Outflows

BlackRock And Vanguard Vs. Everybody

BLACKROCK’S AND VANGUARD’S SHARE OF THE U.S. MUTUAL FUND AND ETF MARKET As of Nov. 15, 2017

30%

BlackRock $1.5t

The growing dominance of BlackRock Inc. and Vanguard Group in asset management is likely to force a wave of consolidation. The two companies have combined global assets of about $9 trillion. In the U.S., they’ve doubled their share of the fund business in the past 15 years, to about 30 percent. If the trend continues, they’ll manage half of U.S. assets within a decade. —BI Analyst Eric Balchunas and A.W.

Combined share

25 Vanguard $3.8t

2005

Proﬁts Get Pinched by Falling Fees

Other $12.8t

It’s Not Just sure, Pricing Pres Silly

Even Passive Is Feeling The Pain

Declining fee yields could put even more pressure on asset managers. Fees have generally fallen across asset classes for more than two decades. A shift toward less risky assets has further weighed on fee revenue and may continue to do so. Fixed-income and passive assets, which generally carry lower fees, may keep gaining market share in the long term, and expanding scale would only partially offset pressures on fee margins. —A.W. and E.B

Passive funds have taken in an estimated $730 billion in the 12 months ended Sept. 7. About $500 billion of that went to funds charging 0.1 percent or less—a trend that benefits investors but not asset managers. The move toward the cheapest funds has been exacerbated by advisers who are anticipating the coming U.S. Department of Labor’s fiduciary rule, whose implementation has been delayed until 2019. —A.W. and E.B.

LONG-TERM MUTUAL FUND FEES

PASSIVE FUND FLOWS, BY EXPENSE RATIO

Average expense ratio, by fund type

Flows over the 12 months ended Sept. 7

0 to 0.10 Equity

ETFs

$500b

Index funds

0.11 to 0.20 0.9

Hybrid

Bond 0.7

1996

$250b

1.1%

ILLUSTRATIONS BY LA TIGRE FOR BLOOMBERG MARKETS

2017*

2016

0.5

0.21 to 0.30

A strong dollar, a shift toward lowerfee products, and technology investments have added to margin pressure for some asset managers. While the impact of low fees is secular, the dollar effect fluctuates and even reversed some in 2017 (so did the outperformance of emerging markets, which generally earn more fees). —A.W. and BI research associate Neil Sipes

VO LUME 26 / ISSUE 6

0.31 to 0.40 0.41 to 0.50 0.51 to 0.60 0.61 or over

Here Comes MiFID II

MiFID II, a package of European Union rules designed to increase transparency in trading, will take effect on Jan. 3. The separation of research and execution services may shake the financial industry. The move is designed to protect investors from conflicts of interest, but the transition could have global implications. For more MiFID II insights and to keep abreast of the decisions companies make in the coming weeks, go to {BIP <GO>} for BI’s investment research primer. You can subscribe to a weekly financial regulation newsletter at {BRIEF <GO>}. —BI Analyst Sarah Jane Mahmud and A.W.

In the U.S., a Stiﬀ Rule Softens ...

With most implementation of the Labor Department’s fiduciary rule likely delayed until July 1, 2019, financial advisers will monitor whether the agency makes tweaks before the new deadline. A revamp probably isn’t in the cards, but small changes are expected and could bring some relief. The measure, which will require advisers managing retirement accounts to put clients’ interests before their own, has forced many firms to change revenue streams from commission-based to fee-based. The regulation would let investors sue advisers if the fiduciary relationship is breached. —BI Analyst Nathan Dean

... But Don’t Rule Out The SEC

IRA ASSETS IN MUTUAL FUNDS At quarter end $4.0t

3.7

DOW JONES U.S. ASSET MANAGERS INDEX Weekly

U.S. election

230 2Q 2017

3.4

205

180

155

11/13/15

11/10/17

BLO O M B ERG M A R K ETS

130

The Labor Department’s decision to delay full compliance of its fiduciary rule by 18 months gives the Securities and Exchange Commission time to develop its own regulation, something that’s high on the financial industry’s wish list. Labor’s rule applies only to retirement accounts, but the SEC could pursue a more uniform standard, although its lengthy rulemaking process probably won’t start until early 2018. —N.D.

ILLUSTRATIONS BY LA TIGRE FOR BLOOMBERG MARKETS

3Q 2014

In Asset Management, Deal Talk Means More Green

As asset managers seek ever-greater economies of scale and a global presence, pressure on revenue and margins is driving consolidation. An extended bear market could accelerate that, as a halt or reversal in market gains could turn into a headwind for profits. So far this year, returns have been fueled by M&A and deal speculation. Still, the importance of a strong and consistent investment culture and the risk to alpha generation from fund size have been key impediments to deals. —A.W. STOCK PERFORMANCE OF LARGE-CAP ASSET MANAGERS Year-to-date total return, through Nov. 14 Involved in sizable M&A or reportedly targeted for consolidation in the last year 51.9%

Amundi 29.5

Legg Mason

28.4

T. Rowe Price

26.6

Affiliated Managers

25.9

BlackRock

25.6

Eaton Vance 20.5

IGM Financial 18.9

Schroders

17.6

Invesco 6.9

Waddell & Reed Financial 4.6

Franklin Resources CI Financial

1.7

Searching For a Perfect Marriage

The ETF industry’s gold standard for a successful acquisition is BlackRock’s 2009 purchase of iShares from Barclays Plc. The deal included many funds that were the most traded in their categories—a key point because ETF liquidity usually grows slowly over time and can’t be manufactured. The highly liquid funds provided a springboard for BlackRock to triple iShares’ assets and revenue while more than doubling the number of products. As ETF assets grow, liquid funds will become even more valuable. Active managers seeking to enter the passive space through M&A are running out of attractive targets; Invesco has mopped up several providers. Firms looking to buy their way into the ETF business may eye First Trust Bank, WisdomTree Investments, VanEck, and ProShares. —E.B.

VO LUME 26 / ISSUE 6

ISHARES UNDER BLACKROCK 2002-09 Before BlackRock purchase*

ETF assets under management at period end

20105/24/17 After purchase

$297b

$1.1t

Fund flows

$284b

$758b

New funds launched

102

165

351%

153%

$4.4b

$15.6b

Return of BlackRock shares

Estimated ETF management fees

The Markets Q&A

Steven Maijoor on

BLO O M B ERG M A R K ETS

MiFID II, Brexit, and Finance’s Low-Fee Future By NEIL CALLANAN and STRYKER MCGUIRE P H OTO G R A P H S BY J U L I E G L ASS B E RG

STEVEN MAIJOOR ISN’T an obvious master of the universe. He was a longtime

academic and then a financial markets regulator in the Netherlands before becoming chairman of the European Securities and Markets Authority in 2011. The far-reaching regulatory regime known as Markets in Financial Instruments Directive II, which takes effect on Jan. 3, has rapidly elevated the profile of Maijoor and a once-obscure bureaucracy beavering away in Paris. Working with national regulators within the European Union, Maijoor, 53, has helped to implement the legislation, which grew out of the financial crisis in an attempt to avoid another one by increasing transparency. While the rules—covering everything from unbundling research and execution costs to dark pools and interest rate swaps—are European, they will affect markets from New York to Singapore. MiFID II should mean lower fees for Europeans and “big opportunities” for asset managers, especially those offering cheaper products, according to Maijoor. Over the course of two recent interviews with Bloomberg Markets, Maijoor is serene in defense of his core mission: protecting investors and promoting orderly markets. And he has some surprising things to say about the dreaded prospect of MiFID III.

VO LUME 26 / ISSUE 6

Say you’re at a party, and someone who doesn’t work in finance asks, “What do you do?” How would you answer that? STEVEN MAIJOOR: It depends whether it’s a party for children or adults. But let’s say it’s adults. Typically, people know their national securities regulator, so I would say, “I’m the chairman of the European version of your national regulator, and what we do is help protect investors and make financial markets stable.” If they’re still interested and don’t want to start talking about soccer or politics, I would explain that we’re making rules for the EU’s financial markets. People know what a bank is. They also know what an insurance company is. The securities market is a bit more distant. Basically we regulate all of the financial markets aside from insurance companies and banks. We regulate all that’s left—which is a lot. It can be an investment firm, a trading venue, a crowdfunding platform, etc. If they’re still interested, I would say we also make sure the markets we regulate are supervised consistently across the 28 EU member states. I think that’s a very important ingredient of what ESMA does. It’s all about investor protection and the stability of financial markets in the EU. BM: People were probably less interested in this idea of protecting markets and investors before the financial crisis. How do they respond now? SM: What you have seen in the past 10 years is that the financial sector really got people’s attention. I think the markets have become safer, but for the time being the public will keep its attention on the financial sector. If there’s a track record over a longer period of time, if the sector functions well, I think you would expect that attention to lower. But clearly the fact that economies, and societies, were so affected by the financial crisis has really increased the public attention and political attention for the sector. BM: Say this party happens to include a few fund managers. What do they want to know from you right now? SM: There’s a lot of concern about the separation, or BLOOMBERG MARKETS:

unbundling, of execution and research. This will, in my view, really contribute to better performance for the asset management industry. If you look at the broader picture, Europe is a region where the asset management industry doesn’t play as big a role in households as in the U.S., for example. One of the important things that needs to change in Europe is a movement away from the banking sector and toward securities markets. In a typical EU household, there’s a much greater tendency to save through deposits. That’s not a desirable situation; it results in the long term in very low returns. If you want to have a decent return on investment, you need to participate in the capital markets. I see big opportunities for the asset management sector here, but can these opportunities be reaped? The typical cost of funds in the EU is higher than in the U.S. Also, the average fund in the EU is smaller than in the U.S. We know that in this business, size is extremely important. One of the possibilities would be to increase the size of these funds. I think we should work on a more competitive asset management industry in the EU. The unbundling of execution and research plays an important part in that. This is a very hot topic for the asset management industry, but I’m very happy that relatively early we’ve had large asset managers say, “We’ll start implementing MiFID II right away and covering expenses on our own account instead of billing the end consumers.” That’s much clearer and more transparent under MiFID II. BM: Let’s talk a little bit about the rules for inducements [monetary or otherwise, that accompany an investment-related service]. What are the objectives? SM: That focus is very much on the relationship between the brokers and the portfolio managers and the asset managers— those distributing the funds to their clients and the inducements they receive. I think what’s clear from the proposal is it’s a model where inducements are still possible. In some member states, inducements are banned. The EU has chosen a model where you can still receive inducements, but when you receive them they should be quality-enhancing. We

BLO O M B ERG M A R K ETS

“Markets need to thrive. They need innovation. ... The whole market system is basically one big innovation”

have followed this line when we’ve given our advice to the European Commission, which isn’t a technical standard. In some places we write the rules; in others we advise on the rules that are made by the commission. This is an area where we advise the commission and give them a number of examples we consider to be quality-enhancing. We’re currently looking into the issue and into whether or not we need further Q&As [tools ESMA uses to collect and address public questions from stakeholders] to help us decide. But inducements are still allowed as long as they are quality-enhancing. BM: You were talking about size and how much that matters. Will larger asset managers be better suited to these new regulations than smaller ones? SM: First of all, there is the risk that, with bundling, it’s unclear who pays for research. Who consumes the thing is different than who pays for it. The departure point is this: If a portfolio manager can improve his performance by buying a certain amount of research, why wouldn’t he pay for it? It’s classic economics. If it helps a smaller asset manager improve, I see no rational incentive why he wouldn’t be willing to pay for it. That there are distortions in this world is very clear to me. When we look at those asset managers that pursue an active investment strategy, obviously their performance has been problematic—we know that from many studies. That this market is not functioning at this stage is, I think, very clear. That’s the reason I very much support this unbundling. And as I said, if a smaller portfolio manager can improve his performance because he can see that an independent research house can help him with his performance, I do not see why he would not be willing to pay for it. If I were an asset manager and could improve my performance, I do not see why there wouldn’t be a market developing for research in this area. BM: If you fix what you see as a European problem, do you in effect create an unlevel playing field that allows, say, American fund managers to come in with a competitive advantage? SM: This is a separate story on its own. We regulate regionally,

while these markets are global. And so we try to harmonize with other regulators and be as consistent as possible across the globe. The reality is we are still regulating at a regional or national level. It would be impossible to move ahead with new requirements only when everyone agrees. Europe is going ahead with this separation [of execution and research]. In the U.S., we know that some categories of brokers are not allowed to receive payments for research because then they need to be registered as an investment adviser. This should not affect a level playing field in the EU. We’re not saying anything about a U.S. broker offering research for free in the U.S.; that’s not for Europe to decide. What we’re concerned with is when a European asset manager can choose between an EU broker and a U.S. broker. There should be a level playing field between the EU broker and the U.S. broker providing those services to a European asset manager. We have said that needs to be done on a level playing field. So when the U.S. broker provides those services, it’s important that research is not an inducement and that there’s the unbundling of research. BM: The Securities and Exchange Commission will have a 30-month period during which it will decide what to do about MiFID. What’s your role in that process? Do they go off and decide by themselves, or do you talk to them on a regular basis? SM: We’ll provide our views, but clearly the decision and the policy response are their responsibilities. We stand ready to provide any information or technical support to the SEC, but this is something on their side and not on ours. BM: Will MiFID II go global? SM: I would not be surprised if it becomes a model used outside the EU. There are increased competitive pressures on asset managers in general, and I would not be surprised if, as part of that pressure, unbundling becomes a more standard model. BM: Is there a way in which harmonization can create a global regulator? In other words, can you have so much harmony that you get what amounts to a global consensus? And are things already moving in that direction? SM: One of the positive side effects of the crisis has been an

VO LUME 26 / ISSUE 6

enormous step forward in global rule-making. And the fact that after the crisis we have had these G-20 commitments means that rules become more consistent across the globe. What’s also clear is that we influence each other. To some extent your question is also going in the direction of extraterritoriality, which is the negative side of this conversation. The principal element has always been that there needs to be a level playing field within the EU. Of course, people within the industry will say, “Yeah, but you require that I need to make changes here in the U.S. I need to provide services to an EU portfolio manager, and because of that, I have to change my system.” My response is, you only need to do it when you provide those services to European clients. We’re coming from the perspective of wanting a level playing field within the EU, not from the perspective that this should be the global model. BM: Are you worried about regulatory breakdowns following implementation on Jan. 3? SM: Obviously what we have been doing—and I think you would expect it from me as chair of the European authority—is to try to be as consistent as possible across the EU. I truly believe in the consistent protection of investors. We should avoid any cross-border financial risk, but it’s also beneficial to the industry to have a level playing field because we want to avoid barriers. Any difference from one member state to another would quickly become a barrier for market participants who wanted to do business across the EU. As you can see, European financial markets are moving more and more toward identical requirements across the EU. And subsequently my role, and our role as an authority, is to limit as much as possible the discretion and supervision where it’s not warranted. A certain market might have higher risks requiring a specific national response, and MiFID provides discretion for member states. Obviously I accept that. I also fully understand that for certain reasons, member states need to argue this is an EU directive. We need to take national factors into account in terms of how it’s regulated. I understand that. I accept that. At the same time, we want to avoid more barriers between the member states. We need to be transparent in that position. BM: Do you need to crack the whip or be respectful of the national regulators? SM: It depends very much on how it’s described in the law. To be honest, this comes back to the legal reading. What is the discretion at the national level, and what is the law? The general wish I would say is to converge, to be consistent—that is part of the DNA of regulators. So this is a case-by-case assessment. BM: When you talk about a level playing field within the EU now, you’re talking about 28 members. With Brexit, it could be 27. SM: Will be 27 … BM: Fair enough. Are you concerned that a huge financial player—London—might end up within a different regulatory framework after Brexit? SM: It’s always been part of our thinking that capital markets benefit from size and from scale. I would have obviously preferred that we continue with 28, as we are now, because the U.K. is the largest capital market. Our whole focus in the past 30 or 40 years has been lowering barriers, trying to increase the size

of the EU capital market, giving benefits of scale, etc. That is obviously negatively impacted by the U.K. leaving the EU. How that will impact EU capital markets will depend on what kind of model exists at the end of the day. We’re looking into three areas on Brexit. One area is, how do we work together with countries outside the EU and their regulators? We have done some thinking on so-called equivalency models. How does Brexit change our relationship with non-EU regulators, especially in the context of the biggest financial market moving outside the EU? How do we adjust the equivalency models we currently have? So that’s one important issue. The second important issue is the so-called regulatory competition issue. We know some U.K. market participants are looking to relocate to the EU 27 because they want to continue their access to the EU 27, and that’s understandable. It is also understandable that market participants in the U.K. will select one of the EU 27 and then, on the basis of generous outsourcing and delegation arrangements, basically delegate and outsource everything back to the U.K. and be left with a shell company in the EU 27. I’m just exaggerating to explain the issue, but that’s something we want to avoid. The third area is the consequences of Brexit on stability: the cliff-edge effect. What would happen? How do EU regulators need to respond in the event the U.K. exits in March 2019 without arrangements in place? That would most certainly impact the financial markets. BM: Could you see the U.K. and ESMA working alongside each other as a region? SM: The U.K. [Financial Conduct Authority] and especially [Chief Executive Officer] Andrew Bailey have been extremely committed to MiFID II. He has always been very clear that the FCA wants to implement MiFID II in full. And I think that is very helpful. What the precise arrangement with the FCA will be after 2019—I’m not in a position to comment, because that is really dependent on the bigger negotiation and what is coming out of that. BM: OK, let’s pretend we can forget about Brexit. When MiFID II goes into effect, there are bound to be unintended consequences. If anything goes wrong with the rules, how quickly do you think you can react? SM: It depends very much on the issue at hand. As a regulator, we basically look at the toolbox and say, “OK, there’s an issue here, how do we solve it?” Sometimes you can solve an issue with a Q&A. Sometimes you need something heavier, like a guideline. And in some cases you might need to revise the implementation rules by means of what we call a Level 2 measure—going back to the European Parliament and the European Commission. I don’t want to use the phrase “goes wrong,” but if there are unintended consequences or if MiFID doesn’t go as expected, we will look at the issue and decide how we will repair it. Sometimes you need to repair it with a Level 1 measure [creating a new EU law]. The biggest Level 1 change we made was asking for a delay. Moving MiFID II from January 2017 to January 2018 required a Level 1 change—a process that took half a year to get accomplished. One of the benefits of these technical standards is that we don’t have to wait for MiFID III. I don’t think anybody would like to wait for MiFID III.

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Right, let’s discuss MiFID III. Presumably all this data you’re going to collect will make it easier to draw up? SM: Let’s not talk about MiFID III. I must say I would like to drop that word. We have just gone through the evaluation process with EMIR [European Market Infrastructure Regulation, which covers over-the-counter derivatives], and a number of changes have been made. I think it resulted in very sensible changes to EMIR, so we don’t have to wait for MiFID III to make changes to MiFID or MiFID II. Obviously the Level 1 principles cannot be changed or amended. So if at some point in time someone would like to change these fundamental principles, then we would be talking about a MiFID III. But there’s no special reason to believe MiFID III will be needed. It’s a matter of regulatory hygiene. BM: That’s a catchy phrase. SM: I’m looking for the right words here; maybe it’s “better rules” or “better rule-making.” Once MiFID II starts, we’ll monitor how it’s implemented. On a daily basis we’ll get Q&As from stakeholders and from national regulators, and on that basis we’ll adjust guidelines—as we already are. I would expect BM:

that at some point, just as we made changes to EMIR, there will be changes to MiFID II. You need to work with stakeholders on a daily basis, and when you do that, you get all kinds of questions: How do you do this? How would this general rule apply to the fixed-income market? And so you give guidance, of course, always respecting what the European legislators intended. BM: How would you frame MiFID II’s importance in terms of global regulation overall? SM: What can I say about it? It’s the biggest overhaul of financial markets in a decade. On the consumer side, you have product governance, target markets, target intervention to ban certain practices, the area around inducements. Cost transparency is also big on the consumer side. On the market side, MiFID II is moving to a much wider coverage of financial instruments. Under MiFID I, there’s a stronger focus on regulated markets. MiFID II is covering a wider range of trading venues—and is going to cover all financial instruments with more transparency on a wider range of transactions. BM: This is such a huge undertaking. Did you have to increase staff? Do you anticipate needing to do so again?

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“There’s no special reason to believe MiFID III will be needed. It’s a matter of regulatory hygiene”

SM: Overall, our staff has been increasing at ESMA, so the total numbers are getting close to 250. But we have also said that the number of people we have is not sufficient, and not just because of MiFID. We are underresourced, and so we definitely should get more staff in the years to come. It’s not like in January the work is done and at that moment in time you can reduce the number of people who are available for MiFID work. There will continue to be implementation issues as we have seen in the past. So having sufficient resources at ESMA continues to be a concern. BM: Presumably you’ll be looking to hire, and by hiring you’ll be competing with banks for compliance staff. Is that fair to say? SM: The people we are hiring—the mix we are getting— are a reflection of a lot of things, like different nationalities. There are more than 20 nationalities. In addition to that, we hire people with different backgrounds—people with experience as a national supervisor, people who have more of a policy background, who have been working at the European Commission or at a ministry. But also we get people straight from practice. And of course we’re not the only ones trying to get them. In some cases, we can see people from ESMA going to the private sector. These exchanges between the private and public sector are only natural, and it helps ESMA in terms of having the right mix of expertise in the organization. BM: Would you expect that in the early stages of implementation you’re going to have to be flexible, even lenient? SM: It is important to realize that in terms of day-to-day supervision of the application of MiFID, it’s up to the national supervisors. Noncompliance on the 4th of January will be judged differently from noncompliance sometime later in the year—you would expect national regulators to take that into account in their supervisory priorities. But it’s not up to me to make that judgment. BM: How concerned are you about regulatory fragmentation, forum shopping, country arbitrage, that sort of thing? SM: Regulatory competition is one of the main reasons why ESMA was established in 2011. It is also one of the reasons

the financial crisis developed in the EU. We want to avoid regulatory competition and forum shopping. BM: What about outside Europe—New York, Hong Kong, Singapore? Do you know whether they’re going to be putting MiFID-like rules in place, or are they going to take advantage of the fact that they don’t have the same kind of regulation? SM: We know that global markets are interconnected. So the risks in one region might become the risks in another jurisdiction. It’s extremely important that we keep this level playing field across the globe. There have been some signals that this will become more difficult because of political developments, but I will say that so far we have worked well together with our regulators across the world, and I would say, let’s see how practices develop. BM: Is it fair to say that President Trump’s attitude toward regulation is one of the concerns you have? SM: In addition to Brexit, some signals from the Trump government might suggest that global rule-making will become more difficult. At the same time, I think what is very important is to look at what the actual decisions are, how the actual cooperation is going. And I would say, so far so good. Let the evidence speak for itself. The unbundling of research is an example of where there’s been very good cooperation between the U.S. regulatory authorities and the EU regulatory authorities. BM: There are some bigger metaquestions beyond what we’re talking about. One would be: Should regulation direct finance? Another: Are markets free or not free? SM: I think it is important to realize that markets need good regulation and good supervision. The reason being that financial markets—probably more than other parts of markets—are susceptible to information asymmetries, market failures, opportunistic behavior. Therefore it’s important that you have good, solid regulation and supervision. On the other hand, markets need to thrive. They need innovation. At the end of the day, the whole market system is basically one big innovation. Stock exchanges or mutual funds are human innovations that have brought us a lot as societies.

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So going back to the philosophical questions, we need to have balance between these two things. To make innovation work, trust is important, stability is important. And this requires good regulation and good supervision. BM: People who see themselves as wealth creators often seem to manage to be one step ahead of regulators. That’s a fairly common perception, at least. Do you think that’s a fair perception or an unfair perception? SM: Obviously it’s the role of market participants to innovate. I don’t think our role as regulators is to be the ones developing products for financial markets. It’s only logical that we would not be very good at it. I think that’s something for market participants. I think it is only natural then that you have the innovation first—and then think about how can we regulate this. You couldn’t do it the other way around. If that results in any impressions of markets being first and supervision being second, so be it. I have no problems with that. BM: If you had to guess, where would you think the next financial crisis is going to come from? SM: Four times a year we publish what we think are the biggest risks in financial markets. And what we have identified systemically are the implications of low interest rates. The fact that we have low interest rates increases the risk that asset managers, for example, are trying to increase returns by going into products that are more leveraged and less liquid. A low-yield environment raises concerns about the appropriate valuations in financial markets. BM: Focusing on the bond market for a second. Obviously many of the issues with the financial crisis originated there. You’ve moved to boost transparency. Still, only about 2 percent of bonds will be caught up initially by the rules on trade reporting. Is that a mistake? SM: Let’s try to be precise on this one. We have always been very clear that you need to treat transparency in bond markets differently from transparency in equity markets and liquidity in bond markets differently from liquidity in equity markets. So you need to be careful with your calibration of transparency because in some cases it might harm or reduce liquidity. The European Commission wanted us to be careful. That’s the reason for having a staggered system in which over a couple of years we can increase the number of bonds subject to the transparency requirement. BM: A provision that would have given some dark pools a competitive advantage over stock exchanges was being reconsidered by national regulators as MiFID II implementation neared. Why? SM: The intention of MiFID II is to indeed increase trading in the lit market—the rationale being that the lit market plays a very important role in terms of price formation and benefits the dark parts of the market. But you have to make sure there is this right balance between what is traded dark and what is traded lit. One of the analyses of MiFID I was that too much trading was going into the dark. That’s what MiFID II hopes to improve. We want to see how it develops, and as we discussed earlier we’ll use our tools as needed to try to correct if there are unintended consequences in the area. BM: You’ve talked about the need to help ordinary people see lower fees in their investments. Would you expect there would be a rapid growth in exchange-traded funds?

SM: I think what we’ve been seeing across the world in the past few years is more and more pressures on fees. I don’t think that what will happen in January will be a Big Bang. That’s because some of the market participants have already pre-empted or taken on board some of the MiFID requirements regarding the separation of research and execution. So, yes, I would expect there would be a further reduction in fees. Research and execution will help, transparency will help, but I think this is part of a longer-term process. I would expect MiFID to accelerate this but not necessarily cause a big jump. It’s part of a longer-term process. BM: You’ve told us what you do. What would you say is the biggest misconception about MiFID and what it does? SM: That’s an interesting question. I think it was quite bold from our standpoint to go to the politicians to get a one-year delay on MiFID II. As we got closer to the implementation date, there were even more calls for delays. I think that’s probably what surprised me the most. BM: How long would you expect to be in this job? SM: From a formal standpoint, the [ESMA] board of supervisors and the European Parliament are my bosses. You have the possibility of two terms, of five years each, and there’s no possibility, rightly so, of a third term. I’m about one and a half years into my second term. Those are the formalities. I plan to do this for another three and a half years, and then it will be for somebody else to take on. BM: What do you think you’ll do at that point? SM: I have no idea. I’m focused now on this work. This is taking up all my energy. I like doing my job. I liked being a national regulator. [Maijoor previously worked as a Dutch regulator.] I like my current role as a European regulator. But let’s first accomplish that, and then we’ll take it from there. BM: Your office is in Paris; your bosses are in Brussels. Where do you spend most of your time? SM: I have an apartment in Paris. I live with my family close to Amsterdam. My work is about half in Paris and half somewhere else, either in Europe or outside of Europe. BM: Do you have any time for hobbies? SM: The only hobby I have is running. I like running, and there is the benefit of course of keeping healthy. So I’m into running. That is my regular hobby. Last September, I did a half-marathon in the Netherlands. I could possibly try for a marathon again, but I should admit that the last one I ran was three or four years ago. BM: You, personally, are at the center of a really enormous change in this industry you regulate. During this process, when you’ve been at the heart of something so massive, what have you learned about yourself? SM: First of all, I think it’s important to realize this is definitely not about me. This is a big process where many are involved— the European Commission plays a key role, the national regulators play a key role, and of course ESMA plays an important role. This all needs to be implemented by the practitioners themselves. I definitely don’t see myself as a key person in the process. At the end of the day this is about financial markets. MiFID II is about markets and not regulation and supervision. It’s about bringing greater transparency to financial markets.

Callanan is the investing team leader for Bloomberg News in London. McGuire is the features editor for the magazine.

VO LUME 26 / ISSUE 6

The Banker Who Knew Too Much

By IRINA REZNIK, EVGENIA PISMENNAYA, and GREGORY L. WHITE I L L U S T R AT I O N S B Y PAT R I C K L E G E R

Alexei Kulikov was charged with looting a small Moscow bank. But his trial turned into a window on the shadowy— and seemingly uncontrollable— world of money laundering in Putin’s Russia

the door begins at about 6 a.m. on a wintry Moscow day in March 2016. Insistent knocking at that hour usually means just one thing: police. Inside the apartment on tony Kutuzovsky Prospekt, Alexei Kulikov’s partner, Maria Plyushkina, 23, cares for their infant son. She begs Kulikov not to open the door. Kulikov, a banker stunned by the possibility of arrest, knows better than to consider that option. Ignoring the appeals from the men outside but desperately seeking help, he starts making calls—first to his lawyer, then to any and every friend who might have some pull with law enforcement. It’s all for nothing. He’s alone. The knocking continues for hours, eventually slowing but never entirely stopping. Around 5 p.m., police wrench the heavy steel door open with a crowbar. A half-dozen tired- looking officers conduct a desultory search of the apartment, plucking a wad of cash from Plyushkina’s purse—“spending money,” she recalls later. The police count every bill they find in the apartment: 2,010,000 rubles ($34,409) and $59,243, according to court records. The officers take Kulikov, who’d turned 40 just days earlier, to the headquarters of the Investigative Department of the Russian Ministry of the Interior near the Kremlin on suspicion of defrauding a bank in which he owns a stake. Questioned until 4 the next morning, he denies any wrongdoing. Later that day, a judge at Tverskoi District Court in Moscow orders him held without bail. Kulikov hasn’t been home since. Charged with fraud and embezzlement and facing a 10-year prison sentence, he went on trial in March in the Podolsk City Court, just south of Moscow. The main allegations centered around the alleged looting of 3.3 billion rubles from Promsberbank, a small lender that the Central Bank of Russia had shut down about a year before Kulikov’s arrest. By Russian standards, it was pretty typical treatment for a businessman in trouble with the law. Kulikov’s arrest got little notice in the local media. He lived large, driving a Mercedes-Benz SLR sports car and hiring stars from Comedy Club, Russia’s hottest TV-comedy show, to perform at a birthday party, says an associate, who spoke on condition of anonymity because of the sensitivity of the case. But he was no oligarch. As for Promsberbank, it looked like just another casualty in regulators’ efforts to clean up the financial sector. Its collapse drew scant attention beyond its home base in the gritty suburb of Podolsk. Despite appearances, Promsberbank was, according to the central bank, a “crucial link” in one of the biggest money laundering schemes ever exposed in Russia. Kulikov wasn’t charged with laundering funds, but from its unprepossessing office on Kirov Street, his bank helped pump more than $10 billion out of Russia, the regulator says. Promsberbank was a key conduit into a channel that used stock transactions called “mirror trades.” These transactions involved buying shares of Russian blue-chip stocks through local brokers in Moscow for rubles and simultaneously selling them in London for dollars or euros, effectively bypassing regulations to move funds out of the country. Some of the laundering benefited members of President Vladimir Putin’s inner circle, say people familiar with the investigations. Igor Putin, the son of the younger brother of the president’s father, served on Promsberbank’s board of directors before regulators shuttered it. To help avoid detection, the brokers in Moscow made these THE POUNDING ON

trades through big Western banks, according to Russian regulators. The bulk of them went through Deutsche Bank AG from 2012 to 2014. Revelations about the mirror trades, first reported by Bloomberg News in 2015, rocked Germany’s largest lender, already battered by legal troubles and fines in the wake of the financial crisis. Deutsche Bank admitted to “systemic” failures in its internal controls, shut down its Russia trading desk, and agreed to pay a total of $630 million in fines to the U.K.’s Financial Conduct Authority and the New York State Department of Financial Services for lax anti-money laundering practices. The U.S. Department of Justice is pursuing a criminal investigation in the case. Russia’s treatment of Deutsche Bank wasn’t quite so harsh. Regulators fined it 300,000 rubles, praised it for cooperating, and closed the case. Although Kulikov’s criminal prosecution makes no mention of the German lender by name, investigators did quiz several witnesses in detail about Deutsche Bank and the mirror trades, say lawyers and witnesses in the case. At his trial, Kulikov pleaded his innocence and said he was being made the fall guy for the more powerful players who really controlled Promsberbank. Only Kulikov was charged in the Promsberbank affair, but the names of his partners in the bank read like a who’s who of Russian money laundering. Two of the bank’s investors, Igor Putin and Alexander Grigoriev, were shareholders in Russky Zemelny Bank, which was shut down for suspicious activities in 2014 after being linked to a $20 billion-plus money laundering scheme, an operation so large it came to be known simply as the “Russian Laundromat.” another time. In September 2016 police turn up at No. 284 on the 11th floor of the newly completed Dominion luxury complex near Moscow State University. They’re there as part of an investigation into corruption allegations against a police colonel named Dmitry Zakharchenko. They remove the door with power tools. Nobody is home, but something gets their attention: a custom-built vault. In the vault, police find so much cash—$124 million and €1.5 million ($1.7 million)—that it takes them all night to count it. It’s stashed in wine boxes and plastic tote bags embossed in faux-Burberry plaid. There are bricks of stiff $100 bills shrink-wrapped in $100,000 bundles. The raid on Kulikov’s home may not have made headlines in Moscow, but the story of the Dominion vault did. Investigators still haven’t publicly disclosed where the huge amount of cash came from. Local media reports were full of speculation about the money’s origins: the strongrooms of failed banks or maybe bribes and other illicit payments known as chorny nal (black cash). Zakharchenko was charged with abuse of office, bribery, and obstruction of justice. He said in a court hearing in August that the charges were “fabricated.” Further hearings in his case, which hasn’t gone to trial yet, were declared closed to the public because prosecutors feared the disclosure of sensitive information. Zakharchenko said he didn’t live in the apartment, which belonged to his sister. She didn’t actually live there either. Apparently, only the money did. As with the Dominion stash, some illicit funds, whether proceeds of crime or business profits that the wealthy want to conceal from the Kremlin’s prying eyes, stay home, perhaps to be used for crooked or off-the-books dealings. But huge tranches of it—as much as $100 billion a year, according to official estimates— ANOTHER APARTMENT,

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Kremlin critic, is a banker and former member of parliament who’s investigated money laundering. “Individual bankers are arrested,” he says, “but, as a rule, it’s usually for small-time things.”

flow out of Russia into safe havens. VTB Group, one of the country’s biggest state banks, says wealthy Russians keep three-quarters of their money outside the country. To stay ahead of regulators, money launderers frequently alter the complex chains of transactions, banks, and front companies they use to get the money out of Russia and into the global financial system. Mirror trades were a favored conduit in the first half of this decade, regulators say, but they’ve been replaced by other mechanisms for moving money, including illicit reinsurance contracts and fraudulent court orders. Other laundering channels seek to take advantage of weak regulatory environments in former Soviet nations such as Moldova. “It’s always easier to steal money than it is to earn it,” says Pavel Medvedev, ombudsman at the Association of Russian Banks. But then you need to clean it and keep it safe, which explains why so much of it ends up outside Russia. “The protections for money overseas are better,” Medvedev says. He would know: As a member of parliament representing Kremlin-aligned parties for two decades, he helped write much of Russia’s banking law. “In Russia,” he says, “the rules of the game aren’t reliable, the shadow economy is very big, and corruption is high.” For years, Russian regulators fought a losing battle to stem the outflows. But after tensions with the West surged in the 2014 Ukraine crisis, and U.S. and European Union sanctions targeted the overseas wealth of President Putin’s inner circle, the Kremlin began to put more muscle behind the crackdown. Putin called on Russia’s rich to bring their money home to strengthen the country’s economic defenses. The plunge in the price of oil, Russia’s main export, only intensified the need to bring back the cash. “Economic security became more important than the loyalty of the elite,” says Kirill Kabanov, a member of a Kremlin advisory panel and head of an anticorruption group. “It became political.” Publicly, senior Russian officials insist the crackdown on illicit financial flows is working. But in private, they admit the effort has targeted mainly low- and midlevel players, leaving the masterminds behind the huge trade largely untouched. That’s certainly the way Alexander Lebedev sees it. Lebedev, a frequent

DURING HIS TRIAL, Kulikov sat behind the corrugated bars of a defendant’s cage, a signature element of any Russian criminal courtroom. Thin and bookish, wearing rimless glasses, taking notes on the proceedings in a thick notebook, the banker projected an academic air. Indeed, as he recalls during a break one day, he used his time in jail to complete a doctoral dissertation on Russian economics, adding to the law degree he already has. Kulikov, a native Muscovite, was a relatively low-profile player in the city’s financial world for years before he invested in the bank that would land him in jail. He dabbled in politics. In 2007 he was one of more than 500 parliamentary candidates put up by a pro-Kremlin socialist party that won only 39 of 450 seats. Kulikov, who lost, wasn’t exactly a fixture on the campaign trail. “The only time I saw him was in his picture on the campaign poster,” says Alexei Andreyev, who was on the party ticket in the same region. When he ran for office, Kulikov listed his job as “adviser to the chairman” of Kreditimpex Bank, a midsize lender in Moscow. He also appears to have been a shareholder: A company he owned, OOO Ordkom, is listed in public disclosures as having a 20 percent stake in the bank. Investigators raided Kreditimpex’s Moscow offices in March 2013, alleging the bank had been part of a scheme to launder 8 billion rubles in fraudulent tax refunds on imported goods, according to Russia’s Investigative Committee. While there’s no indication that the criminal case progressed any further, the central bank revoked Kreditimpex’s license a year later, citing unspecified regulatory violations. By that time, Kulikov already had a backup in place. Promsberbank was founded in 1990 during the twilight of Soviet communism. The bank’s name is an abbreviated version of Russian for “Industrial Savings Bank,” and in those days the lender focused mostly on financing factories in Podolsk along the Pakhra River. Never very ambitious, Promsberbank was ranked 264th by assets among Russian banks at the end of 2012.

RUSSIAN CAPITAL FLOWS

VALUE OF DUBIOUS INTERNATIONAL TRANSACTIONS

Rubles

Inflows

100b

$50b

- 50

-100

Outflows

2000

2016*

-150

2000

*Through 3Q Source: Central Bank of Russia

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2017*

*Through June Source: Central Bank of Russia

Kulokov was arrested about a year after the central bank shut down Promsberbank, located in the gritty Moscow suburb of Podolsk

Around that time, the bank’s original owners sold out to Kulikov and his associates, including Igor Putin, who became one of seven board members, and Grigoriev. Kulikov took a 19 percent stake. Together with his co-investors, he paid 1.8 billion rubles for control of the bank. The new owners took over Promsberbank with plans to turn it into a major player, according to court documents. They moved quickly, former employees would later tell investigators. New clients got massive loans days after opening accounts, a radical departure from the previous management’s go-slow approach. One of the bank’s executives later testified that file folders pertaining to big new clients were marked with the letter “A” to denote VIP handling. As transaction volumes surged, longtime clients found themselves sidelined, according to court records. Kulikov, meanwhile, was aiming high. Twice during the year after buying into Promsberbank, he visited the Moscow headquarters of Deutsche Bank’s Russian operations, seeking to persuade the German lender’s top executive there to open a correspondent account for Promsberbank, according to Kulikov’s statement to police on the night he was arrested. Such an account would have allowed Promsberbank to do business through Deutsche Bank. (Deutsche Bank declined to comment.) There’s no indication Kulikov succeeded. No matter. Kulikov and his associates still managed to do billions of rubles in business with Deutsche Bank. THE MIRROR TRADES began in 2012, according to Deutsche Bank’s

internal investigation. Among the first participants was a Moscow brokerage company, IK Financial Bridge. It was one of several local players that placed big orders with Deutsche Bank in Russia to buy large blocks of popular Russian blue chips such as Lukoil and Sberbank. Simultaneously, seemingly unconnected companies based in the U.K. or one of its overseas protectorates, the British Virgin Islands, placed matching sell orders for the same shares in the same amounts with Deutsche Bank in London. The German lender paid them the proceeds in dollars or euros. The mirror-image transactions—thousands of them over a four-year period—didn’t yield any profit on the stocks, because

they were conducted usually within moments of each other. This wasn’t about making money; it was about moving money. Russian regulators eventually caught up with Financial Bridge, revoking its license in August 2013 for repeatedly violating securities and money laundering laws. By then, however, according to the central bank, the mirror trades had been diverted to other brokerages. One was Lotus Capital. According to Russian central bank records, Lotus paid for its side of the mirror trades with rubles from an account at Promsberbank. It held the stocks it bought through Laros Finance, a share depository that was also owned by Kulikov’s Promsberbank associates. By late 2014 regulators were closing in on the network. They’d been tipped off by the large volumes of trades that all seemed to go one way, either all buying or all selling. In April 2015, Deutsche Bank cut off Lotus Capital after the central bank warned that Lotus was conducting suspicious transactions. In October, again after being alerted by the regulator, Deutsche Bank stopped doing business with another mirror-trade brokerage, Rye, Man & Gor Securities. And once again, Kulikov entered the picture. A longtime fixture in Moscow, Rye Man had recently come under new ownership and become an active mirror-trader. When its chief executive arrived at Deutsche Bank’s Moscow offices to lobby for a reprieve on the ban, he brought along Kulikov. Kulikov held no position at Rye Man. He told a convoluted story to explain his presence, according to a statement given to police by a Deutsche Bank official who was there. Kulikov said the investors behind the trades Deutsche Bank had found suspicious were in fact clients of a Cypriot bank. (He later told police he was a part-owner of a Nicosia-based bank, which he said was planning to buy Rye Man.) But he refused to name the investors or explain where the money for the transactions came from. Deutsche Bank’s compliance staff was unimpressed and demanded an explanation for the sudden surge in one-way trades and for where the money was coming from. They never got one. Kulikov didn’t give up. After the meeting, according to his police statement, he called a Deutsche Bank compliance officer

BLO O M B ERG M A R K ETS

and demanded an urgent meeting. They met in the Kofemania cafe on the ground floor of Deutsche Bank’s Moscow building. According to Deutsche Bank’s internal report, Kulikov told the compliance official it was vital that the German bank resume trading with Rye Man, insisting the transactions were legitimate. Then, according to the account the compliance official later gave the police, Kulikov said he had an “unofficial proposal” for the compliance officer and discreetly slid his cellphone across the table. The screen showed “0.1-0.2% of monthly volume,” the official told police. He said he refused what he understood to be a bribe, which he later reported to Deutsche Bank. Asked about this during a break in his trial, Kulikov confirmed the meetings but denied offering a bribe. By this time, Deutsche Bank’s mirror-trading days were numbered. Within two months, in February 2015, Russian police turned up at the bank’s Moscow office to investigate a fraud case against Lotus Capital, the broker with the accounts at Promsberbank. Then, within days, top Deutsche Bank executives ordered the internal probe that would expose the billions in mirror trades. By the spring, several Moscow staffers at the bank had been suspended, and all the clients involved were cut off. Even so, the mystery would get murkier. Regulators would discover that the mirror-trading customers were connected to each other through common directors, owners, employees, or addresses. But all those connections, according to a U.K. Financial Conduct Authority report earlier this year, were merely “intermediaries that traded on behalf of undisclosed underlying clients.” In the meantime, Promsberbank was running into trouble of its own. The aggressive expansion under its new owners, including sloppy lending to dubious clients, had left the bank overextended and short of cash. Auditors from the central bank pored over the bank’s records at the end of 2014 and found numerous instances of loans with little or no collateral, Promsberbank’s longtime chief accountant would later testify. The regulator demanded that the bank set aside heftier reserves for the loans, but there was no money to offset potential losses. By March 2015 the bank didn’t have enough cash to cover the withdrawals by nervous depositors amid a run on the bank. Files on some of the biggest loans deemed dubious by the regulators disappeared when they were moved from one office to another, according to court documents. On April 2 the central bank revoked Promsberbank’s license. Less than three months later, the Moscow Region Arbitration Court declared it bankrupt. an elite Interior Ministry undercover cop investigating money laundering, stops his Lexus near Moscow’s Bolshoi Theatre, opens the window, and exchanges words with a man standing on the corner. As Sharkevich puts the car back in gear, the man tosses a package through the still-open window. Agents of the Federal Security Service (better known by its Russian acronym, FSB) swarm in, surprising Sharkevich, who steps on the gas and takes off. The FSB agents catch up to him a few miles away, where he’s been trapped in Moscow’s legendary traffic. The package contains €350,000 in cash. After a two-hour standoff, Sharkevich tries to explain that he’s working undercover, assigned to worm his way into the confidence of a high-level money launderer. The FSB agents arrest him anyway. After a year and a half in jail, he manages to beat the corruption charges in 2009. ALEXANDER SHARKEVICH,

But the suspected money launderer he was targeting has gone free—shielded, Sharkevich says, by high-level protection within the security services. Now retired, Sharkevich offers a unique view of money laundering. He says it’s wired as deeply into Russia’s police and security apparatus as it is into business and finance. Bankers engaged in laundering often enjoy unofficial dispensation for their illicit businesses, which arms of the state themselves can use for everything including monitoring criminal flows and funding covert operations abroad. If the moneymen get caught and come to a “bad end,” he says, it’s usually because their powerful protectors have lost their jobs. “These bankers provide various services supposedly in the interests of the state,” Sharkevich says. In return, he says, “the bankers are allowed to not only break the law but also to take money out of the country.” Whether Kulikov was scapegoated in the Promsberbank case to protect people more powerful than he may never be known. He testified in court that he was just small fry, a minority shareholder with a 19 percent stake, and a dutiful son who gave the shares to his mother as a 70th birthday present. He didn’t sit on the board of directors. He didn’t even have a title. The 437-page indictment against him portrays him rather differently. He was the ringleader who put together the investor group to buy the bank in 2012, installed allies in key management posts, and began pumping out huge loans to new clients. Most of them were companies with no real operations—“one-day firms,” as they’re known in Russian business parlance—that never paid back the loans, prosecutors said. Kulikov’s partners in the Promsberbank takeover had a long record in the Russian financial industry—mostly involving failed banks. Igor Putin joined the Promsberbank board when Kulikov and the other investors took over, according to court documents. He left the board in 2014. By that time, two other lenders in which Putin was involved had been shut down by regulators. In a statement to the Russian press that year, he said he was getting out of banking and called for the industry “to be cleansed of banks headed by people with dubious reputations.” He has since disappeared from the public eye and couldn’t be reached for comment for this story. One of the failed banks Igor Putin was involved in—along with Promsberbank investor Grigoriev—was Russky Zemelny Bank, the largest single player in the notorious Laundromat affair. The Russian central bank puts the total amount of money run through the Laundromat over a period of about 18 months at $21 billion, most of it funneled through the impoverished former Soviet republic of Moldova; government investigators have said the figure could be twice that much. Russia’s Novaya Gazeta newspaper, along with the Organized Crime and Corruption Reporting Project, linked 70,000 transactions, 1,920 companies in the U.K., and 373 in the U.S. to the scheme. Grigoriev has been in jail since November 2015, charged with setting up a criminal organization at two other banks he owned. Through his lawyer, he denies those allegations and says he sold his Promsberbank stake before the crimes with which Kulikov is charged took place. Despite Igor Putin’s and Grigoriev’s somewhat lofty perches in the pantheon of Russian banking, Kulikov didn’t finger them as masterminds behind the Promsberbank affair. He pointed to another one of his investment partners: Ivan Myazin.

VO LUME 26 / ISSUE 6

One of the country’s biggest state banks says wealthy Russians keep three-quarters of their money outside the country

downtown Moscow isn’t the kind that draws attention to itself. There’s no name on the door. The place is barely furnished. Myazin, 53, is flanked by his lawyer as he gives his firstever interview. He’s slender and dressed in an expensive-looking blue blazer and jeans. He makes no apologies for his association with Vyacheslav Ivankov, a legendary Russian organized-crime boss known as “Yaponchik” (Little Japanese), who was gunned down on a Moscow street in 2009. “He was a quiet, smart, simple man,” Myazin says. “We used to celebrate New Year’s together with our families.” But Myazin says that association doesn’t make him a crook. He’s a “financial consultant” with no shortage of clients, he says, though he declines to identify any of them. Yes, three banks he’s invested in, including Promsberbank, all had their licenses revoked, he says, but that’s the result of overzealous regulators, not any wrongdoing on his part. As for the banker Lebedev’s allegation that he was “one of the creators” of the Laundromat operation, Myazin denies it, adding, “I got squeamish when I heard about it.” Myazin says Kulikov approached him in 2012 about investing in Promsberbank. “When Kulikov pitched the bank [to me], it looked like a sweetheart—only 0.3 percent bad loans,” he says. Adding to Myazin’s confidence in the Promsberbank deal was that Grigoriev, the now-jailed financier of Russky Zemelny Bank fame, was on board as a co-investor. “I’ve known Sasha Grigoriev since before he was a banker,” Myazin says. “He was a well-known fixer. He had great contacts.” Financial Bridge, the early mirrortrader, also participated, advising on the deal and holding stakes for some shareholders, Myazin testified. In the runup to Kulikov’s trial, the police questioned Myazin. He was never charged in connection with the Promsberbank affair. But he was definitely in the courtroom to testify against his erstwhile partner.

played a very active role in the activities of the bank,” Myazin testifies. “He had a very weighty vote.” Kulikov objects, saying it was Myazin, after all, who’d signed the employment contract hiring Boris Fomin, the Promsberbank chairman who allegedly went into hiding after his name showed up on a wanted list in connection with defrauding the bank. Judge Diana Almayeva orders Kulikov to be quiet. Later in the proceedings, Kulikov’s lawyer, Tatyana Galimardanova, presses Myazin on the contract issue—his signature is right there. “That’s surprising to me,” he admits. “There’s no way I should have signed that protocol, but I see my signature.” Shortly before the end of the trial, Kulikov gets a chance to question Myazin directly. The back and forth grows tense. When Kulikov presses Myazin on whether he was aware of the theft of assets from the bank, the judge shuts him down. “Don’t get carried away, Kulikov,” she says without further explanation, moving quickly to wrap up the testimony. Four months later, in October, Judge Almayeva begins reading her verdict aloud, as Russian court procedure requires. It takes almost a full week to get through the 400-odd pages. Her voice grows hoarse and hurried as she recites the arguments, accepting those of the prosecution and dismissing those of the defense. The final verdict and sentence come on a rainy Friday morning: guilty, nine years in prison. On one of the visitors’ benches, Kulikov’s mother sobs. Plyushkina, Kulikov’s partner, tries to comfort her, saying there’s still a chance for appeal. (His lawyers would file one a few weeks later.) In the defendant’s cage, Kulikov turns pale, lowers his face into his hands, and leans against the bars, tears welling up in his eyes. His hands grip the metal shafts so tightly his knuckles turn white. “Is the verdict understood?” Judge Almayeva asks. “Yes, your honor,” Kulikov says.

in Podolsk, midway through Kulikov’s trial. The defendant is in his cage, glowering. Myazin is at the witness stand, talking up Kulikov’s stature at Promsberbank. “Of course, Alexei

Reznik and Pismennaya are senior reporters for Bloomberg News in Moscow. White is an editor in Moscow. With assistance from Ksenia Galouchko and Alexander Sazonov.

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What Could

Wrong?

As a surreal bull market staggers onward, Bloomberg Markets asked around for reasons to worry I L L U S T R AT I O N S B Y AT E L I E R O L S C H I N S K Y

Quant Quake 2.0

WHEN YOU LOOK back at the financial crisis, the quants stand out as the canary in the coal mine. Model-driven funds experienced massive losses in August 2007—a full year before the rest of the financial system came to its knees. The event, dubbed the Quant Quake, may have resulted from one large liquidation: Leveraged quant funds pursuing similar bets then unwound at an unprecedented clip. AQR Capital Management, a $208 billion quantitative money manager, was among them, and the experience left some lingering bruises—and worries about the future. To AQR’s founder, Clifford Asness, Quant Quake 2.0 is inevitable. Quant strategies are popular, and popularity is what makes a coordinated action, whether it’s a run on the bank or a crash, possible. “In the early ’90s, when I first started doing these strategies, they were relatively unknown. There was a low chance of a significant amount of dollars fleeing at once,” he says. “What we don’t have now is a monopoly that protects you from common actions.” Asness is far from a neutral observer. Investors in quant land have been particularly keen on the strategy behind AQR’s success that he pioneered: factor investing, which groups stocks based on marketbeating characteristics such as volatility or value. That success, he concedes, heightens the likelihood of a historically large crash, an “event with a big left tail.” But that isn’t enough to deter Asness from factor investing. “We have a whole body of literature by smart people confirming what we think, another 25-or-so years of out-of-sample evidence that our strategies work and, despite all of this, reasonable pricing of these strategies,” he says.

The financial system also looks healthier than it was during the Quant Quake: less leverage, reasonable valuations, more conservative implementations. According to Asness, future crashes will be short-lived, a survivable “fact of life going forward and a consequence of being in good, well-tested strategies that other people know about.” Even so, there’s one scenario that concerns him, because of the ubiquitous media spotlight on the markets: a vicious feedback loop of selling fueled by negative coverage. “Crashes have a little bit of psychological magic to them. August of ’07 went by relatively unnoticed. I don’t think that will be the case this time,” Asness says. “In this case, the revolution will be televised. What kind of feedback loop that creates is a wild card I worry about.” Still, like most investors humbled by their experiences in 2007, the legendary quant isn’t ruling out any possibility for when Quant Quake 2.0 rolls around. “I expect an event to be not as bad. Or maybe as bad because we missed something. We’re honest nihilists about it,” he says. “With all that said, we’re still guessing. These are wild events.” —Dani Burger

Of course, you need only look at Sony, Anthem, or Equifax to get a sense of the scenarios that worry the McNabbs of the world. And defending against a WannaCry-like ransomware scenario doesn’t come cheap. “Our budget [for cybersecurity] has been multiplied by 10 times over the last seven or eight years,” McNabb says from his office in Malvern, Pa. “I don’t see any end to that. In one sense that’s a shame, but there are a lot of bad actors, so you’ve got to be willing to do it.” While cyber requires constant vigilance, McNabb’s a little more passive— ahem—about the markets. “Valuations are starting to get pretty rich,” he says. “You certainly worry about a flash point. A 10 to 15 percent move in equities would not be unprecedented in history from these kind of valuations. And whether that happens in 6 months, in 12 months, or in 18 months … sooner or later it’s going to happen. To deny that and think some policymakers can navigate things so that we never have another correction again, that won’t happen. The markets need to cleanse.” How do you say “Que será, será” in Pennsylvania Dutch? —Rachel Evans

The Wild Card

China, China, China

Vanguard Group Inc. just as the financial crisis hit. He’s since helped the buy-side behemoth add more than $3 trillion to its assets under management. As he prepares to leave the post of chief executive officer at the end of 2017, he says his biggest worry isn’t a big correction so much as “some sort of cyber event.” “Cyber is just morphing constantly and is probably the No. 1 risk that the whole system faces—not just financials, not just investment firms, not just financial services more broadly, but the entire corporate infrastructure,” he says. BILL MCNABB TOOK OVER

BLO O M B ERG M A R K ETS

KYLE BASS, THE FOUNDER and

chief investment officer of Hayman Capital Management LP, earned his reputation as a Cassandra when his misgivings about subprime mortgages, which he shorted, proved correct. He’s had his eyes on China for the past few years. Now he has a new noneconomic catalyst that could finally put a ball in motion: President Trump. “The politics are likely to accelerate the economics,” he says. Bass says China, the world’s second-largest economy, is overstating the health of its banking system, and doing so

TROUBLE IN CHINA China’s credit-to-GDP ratio Smoothed long-term trend 215% Credit-to-GDP gap A persistent gap is typically a signal that a reckoning is coming

170

3/31/09

3/31/17

125

Source: Bank for International Settlements

for political reasons. “You can’t grow your banking system 1,000 percent a decade and only grow your GDP 500 percent and not have a loss cycle,” he says. “When you’re moving from an export-led economy to an internal consumption-based economy, you have to remember that all the loans in your banking system were lent to your old economy and are going to have to be restructured.” About 20 percent of China’s banking system is nonperforming, he estimates—a far cry from the official low-single-digit number. Bass isn’t the only China bear, of course. Zhu Ning, deputy director of the National Institute of Financial Research at Tsinghua University in Beijing, raises similar themes in his 2016 book, China’s Guaranteed Bubble: How Implicit Government Support Has Propelled China’s Economy While Creating Systemic Risk. The huge amount of debt burdening the Chinese financial system, coupled with an overheated property market, poses broad risks to an economy that the rest of the world looks to for growth, he says. And any popping of asset prices could drag China into the kind of lost decade that Japan experienced in the 1990s, when debt-fueled growth and a red-hot property market screeched to a halt, Zhu says. “The government should allow zombie companies to default or go bankrupt,” he says. “It’s surprising to see the number of bankruptcies in China is even lower than that in Netherlands or Belgium.” China’s hope, according to Bass, is that the country’s nominal gross domestic product will grow fast enough to rescue the economy from its massive banking problem. “And what I’m saying is that’s not going to happen,” he says. “If you’re going to use your FX reserve pile to maintain stability in your currency, and if you’re going to continue to lie about where you are from an economic and asset perspective in your banking system, then sooner or later economic gravity is going to take over.” While Bass has been betting against China for years, he says the addition of Trump is an especially big X-factor, given the potential for his imposing sanctions on entities doing business with North Korea in an effort to “change the subject” from his domestic drama. That prospect would damage global trade—hurting the Chinese economy—inflicting “pain on

VO LUME 26 / ISSUE 6

their banking system a little bit sooner than it otherwise would have experienced.” And should the relationship between the U.S. and its biggest trade partner worsen, the knock-on effects for countries such as North Korea, Russia, and Taiwan could become catastrophic. “So financially speaking, it may be not as bad as 2008,” he says, “but kinetically speaking, it may be worse.” —Katia Porzecanski and Judy Chen

Watching the Clock

IF YOU BROKE every hour of the trading day

into quarters, none is quite as important— or as vulnerable—as the final 15 minutes. The period just before the U.S. stock market shuts at 4 p.m., when official endof-day prices are set, is an Achilles’ heel in the otherwise fairly muscular $29 trillion market. An entire exchange can go dark during normal trading hours without more than a hiccup for the rest of the market, because stocks can trade on any one of 12 official public venues. But at the end of the day, stocks return to their home-listing exchanges, where closing auctions determine final prices that affect millions of trading portfolios and retirement accounts. If a listing exchange fails during that auction—whether by internal error or an outside cyberattack—the backup system gets slippery. There’s an official Plan B in the event this ever happens. It calls for two of the New York Stock Exchange’s sister venues to back each other up, with Nasdaq in reserve as an additional fail-safe. Likewise, if Nasdaq goes dark, the NYSE would step in as a reinforcement. (The exchanges organize periodic tests of the arrangement.) But that plan hasn’t been put to the test in a period of extreme market stress, which means unanswered questions

remain. Just one example: The NYSE has a group of human floor traders who play a role in the market close, but that system doesn’t exist on the all-electronic NYSE Arca or Nasdaq. (Representatives from the NYSE and Nasdaq declined to comment.) A mishap in setting final stock prices could spin out to other types of securities, including options and over-the-counter derivatives, says Joanna Fields, principal founder and CEO of consulting firm Aplomb Strategies Inc. “There’s a ripple effect that could happen,” she says. A couple of recent wobbles have snapped this vulnerability into focus. An almost three-and-a-half-hour outage at the NYSE in 2015—now the subject of regulatory scrutiny—left traders fretting over what would happen if the problem stretched through the close. The NYSE got its exchange running by 3:10 p.m. that day, escaping catastrophe. But this year another error snarled trading on NYSE Arca, the largest exchange-traded-fundslisting venue, derailing closing auctions for some products. The playbook for handling problems around the close hasn’t been tested enough to be bulletproof, according to Bryan Harkins, head of U.S. markets and global FX at Cboe Global Markets Inc. “We’re certainly not there yet as an industry,” he says. —Annie Massa

he says. “So if you buy an S&P 500-indexed fund, it’s like ‘Oh, I own 500 stocks— I’m diversified.’ ” What most retail investors don’t realize, he says, is that the trade is very crowded—like 20 million-other-people crowded. According to Dillian, you need only look back to when commodity indexing became popular a decade ago for a sense of how things could go wrong. “When money goes indiscriminately into an asset class, valuations don’t make sense anymore,” he says. “What happened in the commodity markets is those flows reversed, and that entire trade unwound—and it unwound very quickly.” Crowded indexes don’t bring about a financial crisis, of course. You have to differentiate between what happens in the stock market and what happens in the economy, Dillian observes. And he says he’s not a “doomsday” guy; he’s just trying to point out that a selloff is a possibility—and that it could be 1, 5, or even 10 years away. “You could have a scenario where this trade unwinds, the stock market is down 30 percent, and we’re still not in a recession—that’s possible,” he says. “I would hesitate to call it a financial crisis, but I would call it an unwind, and if it unwinds, it has the potential to be on the scale of some of the big market crashes.” —R.E.

A CRYPTOCURRENCY AND ITS CURRENTS U.S. dollars per bitcoin, weekly $8k

The Index Trap Bitcoin 30-day volatility

Bubblicious Bitcoin

67.3 4

DIVERSIFICATION ISN’T always the safety net

it appears to be. So says Jared Dillian, who ran the exchange-traded-funds desk at Lehman Brothers in 2008 and is now editor of the market newsletter the Daily Dirtnap, an investment strategist at Maudlin Economics LLC, and a Bloomberg View contributor. “Retail investors who are buying ETFs or indexed funds are being sold on the idea that they’re diversified,”

25.5 2

11/11/16

11/10/17

Source: {XBTUSD Curncy <GP>}

BLO O M B ERG M A R K ETS

THE DEBATE ON WHETHER bitcoin is a bubble

about to burst or a great investment continues to divide the financial world. Billionaire bull Mike Novogratz has said he plans to “make a whole lot of money” on the boom; JPMorgan Chase & Co. chief naysayer Jamie Dimon called people who buy bitcoin “stupid.” Regardless of where you stand, the impact of a potential crash may be rather limited considering the relatively niche appeal of cryptocurrencies—

although that may be about to change. The entire cryptomarket is relatively small: $200 billion. Yet that’s already 10 times bigger than it was at the start of 2017. And the potential approval of bitcoin futures and ETFs means digital assets could soon start seeping into the mainstream. Themis Trading LLC partner and co-head of equity trading Joseph Saluzzi says cryptocurrency derivatives, including options and ETFs, are risky because they legitimize assets with prices derived from unregulated exchanges subject to manipulation and fraud. According to Saluzzi, this frontier could start to look like the collateralized debt obligations that contributed to the 2008 financial crisis. “Cryptos will be given a wrapper that makes them sound and look good,” he says—then they could seep into portfolios everywhere. Cryptocurrency risk could also spread into the broader economy if crypto-backed loans gain steam. Although the idea is still in its infancy, there already are startups offering dollar loans against digital assets such as bitcoin, which they hold as collateral. If the digital asset crashes, so will borrowers’ ability to pay back the loans. —Camila Russo

Recessions Are Inevitable

PEOPLE VS. COUNTRY Change since 4Q 1991 300%

Net worth of U.S. households

ONE OF TAD RIVELLE’S favorite charts shows

the widening gap between the value of U.S. household assets and GDP growth—a sign the economy is heading for a fall. Prices for stocks, bonds, homes, and even art that make up total household net worth have outrun U.S. GDP growth for years. This is an unsustainable deviation, according to Rivelle, CIO at TCW Group Inc., which oversees about $200 billion. The gulf is wider than before the bubbles that preceded two other notable recessions: the dot-com crash of 2001 and the housing crash of 2008. “Financial

200

100 U.S. GDP

4Q 1991

2Q 2017

Sources: {NWORVALU Index <GP>}; {GDP CUR$ Index <GP>}

VO LUME 26 / ISSUE 6

instability tends to follow periods when asset growth has been disproportionate to underlying measures of income,” Rivelle says. “People usually say a recession happens because consumers stopped spending. What really happens is the economy becomes malformed.” Recessions are an economic “feature, not a bug,” according to Rivelle, who co-manages the $80.4 billion Metropolitan West Total Return Bond Fund. They also offer opportunities for the well-prepared. The MetWest fund’s best year was 2009, when it returned 17.3 percent as the U.S. economy hit bottom and low-cost assets abounded. “Our best times historically were when there’s blood in the water,” says Rivelle’s co-manager, Stephen Kane. Adverse events can occur months or years before a financial cataclysm, according to Kane and Rivelle. Ameriquest Mortgage Co., one of the largest U.S. subprime lenders, announced plans to close all its branches in May 2006, more than two years before Lehman Brothers filed for bankruptcy and the global financial crisis ensued. “The catalysts are invisible until they’re visible,” Kane says. What’s most troubling for markets now, the two say, is that low and negative interest rate policies drove up prices and forced investors to accept more risk in their hunt for yield. “When the Europeans and the Japanese went to negative rates, you sort of knew that the central banks were jumping the shark,” Rivelle says. Historically, recessions begin when central banks overshoot their rate hikes, tightening credit to take the steam out of growth. The Federal Reserve started hiking rates in 2015. The European Central Bank has signaled plans to dial down its accommodation programs. For investors, that means it’s time to worry about the return of—not just the return on—your money, according to Kane and Rivelle. In other words, they say, you might want to consider an insurance policy. Harvest some profits from stock gains, shift fixed-income holdings away from high-yield and emerging-market debt, and add ballast to portfolios with higher-quality bonds— even if a downturn remains years off. “I’m highly confident my house won’t burn down in the next year, but I still have insurance on it,” Rivelle says. “The challenge,” Kane adds, “is to not pay too much for insurance.” —John Gittelsohn

A Collapse Of Confidence

of Houlihan Lokey Inc., David Preiser, is an alchemist of sorts. He picks up pieces of broken companies and makes something out of them. And what he sees as he focuses on the future isn’t pretty. “Until 2008, people thought debt problems were confined to specific sectors,” Preiser says. “But when the bubble burst, trouble popped up in unexpected areas.” People assumed certain sectors were very liquid, he recalls, only to learn that being unable to sell in an illiquid sector could also bring down prices in more liquid ones. In other words, markets were more correlated during a crisis than previously thought. “Financial complexity brings prosperity but also increased fragility,” he says. Similarly, the bankruptcy of Lehman Brothers brought back the issue of counterparty risk—something people had almost forgotten. “Since then, it’s been a long and slow recovery,” Preiser says. “But the underlying problem remains: The entire edifice is built on confidence, and that can evaporate pretty quickly. The next global crisis will stem from failure of confidence somewhere.” Preiser thinks the European Union and the euro zone will be among the likely triggers. While the EU has weathered a number of crises and even stared into the Greek abyss more than once, something changed on June 23, 2016, when the U.K. voted to go its own way. “For a long time, Europeans blinked and stuck together,” he says. “But with the Brexit vote, one of the main tenets has been undermined.” Elections and public opinion on the Continent seem to indicate otherwise, Preiser acknowledges. His point is that when the euro zone’s next crisis happens, there will be less confidence that the group THE EUROPEAN CHAIRMAN

will stick together. “So far, European countries have chosen to stay in,” he says. “But in the long term, the EU is not stable as constructed; the essence of the problem is that you have a monetary union without fiscal union. If confidence is shaken in the European structure, markets will sell off, big time.” —Luca Casiraghi

parts of the financial system. Add to that the number of ETFs that have become prominent credit investors, Hintze says, and you have a stress point to be wary of. —Sridhar Natarajan

All These Eggs Are in One Basket The Oil Trigger

corner of the U.S. financial markets, one buried deep within the plumbing of the debt markets, is about to become the only corner of its kind. Come mid-2018, just one entity— the Bank of New York Mellon Corp.—will be responsible for ensuring that almost $2 trillion of securities financed by so-called repurchase agreements are cleared and settled each and every day. JPMorgan Chase, its lone longtime rival, has elected to exit the business, in part because regulators pushing for banks to boost capital and cut leverage made the dealings costly and onerous. So while Bank of New York already was the dominant of the two—accounting most recently for 80 percent of market share—there’s no Plan B anymore. Even as Bank of New York has plowed billions into improving and upgrading its technology and systems, some investors worry that any sustained outage could cripple the country’s debt markets. Not only do repos support liquidity in the $14.3 trillion Treasury market, but the financing they provide also helps grease the wheels of trading in assets as varied as stocks, corporate bonds, and currencies. “A single point of failure in the U.S. government-collateralized repo market, which is huge and is essentially the liquidity engine for the country, is a little bit unnerving just in itself,” says Adam Dean, managing director at Square 1 Asset Management Inc. “It’s not an ideal situation.” —Liz Capo McCormick A SOMEWHAT OBSCURE

“DON’T DISMISS OIL just

because it smells like yesterday’s trade,” says Sir Michael Hintze. The British-Australian head of CQS U.K. LLP, the hedge fund he founded at the turn of the century now worth $14 billion, warns the one thing that could upend the status quo assumptions about global growth is a redux of cratering crude. “Such an event has the potential to spark a wider contagion,” he says. Hintze points to $35-a-barrel oil as that trigger point. That price may not feel imminent— and he emphasizes that he doesn’t see this scenario panning out anytime soon because of the recent developments in the Middle East—but that doesn’t make it improbable. The 64-year-old Hintze, a staple of the conference circuit and a member of the Vatican Bank board, says investors will have hell to pay if they turn a blind eye to what another spell of oil below $30 can wreak on the global financial system. Worse still is the risk that price level proves sticky, which could happen if suppliers such as Saudi Arabia and Russia keep pumping oil to fuel their fiscal compulsions. Such a scenario would hamper U.S. energy producers with low credit ratings and impair their ability to come good on their dues. And with credit investors heavily exposed to those companies, the resulting impulse to sell and then rush to contain losses could spread to other

BLO O M B ERG M A R K ETS

The Fire Next Time

nothing yet, says Deepak Gulati. The CEO and CIO of Argentiere Capital AG sees the next crisis having a broader impact than the last. “Risk premia are at the lowest ever, and in some cases you are now being paid to take insurance on risk,” says Gulati, who oversees about $1.2 billion. “Premia cannot drop much further.” Simultaneously, he adds, riskreward from owning volatility is higher in many investment classes than even in 2007. Volatility in equity markets is mispriced, Gulati says. A shock could cause something to falter and volatility to rise quickly. What’s more, the market has zero protection to the downside, he says, because everybody is looking for yield. As a result, any adverse effects will be amplified. While the last crisis “was all about greed, the next crisis will be about need,” he says. “Back then we had about 15 investment banks trying to generate profit. Now it’s thousands of market participants hunting for yield. And that’s because we’ve pushed Grandma into toxic investments. When those leveraged trades unwind, and they will end eventually, investors will get hurt.” —L.C. YOU AIN’T SEEN

GETTING LIQUID, FAST Share of Loomis Sayles Bond Fund assets in cash and equivalents 20%

Even Optimists Get Pessimistic 5

10/31/12

10/31/17

Source: Loomis, Sayles & Co.

BEFORE HE SAYS

anything else, Dan Fuss

VO LUME 26 / ISSUE 6

wants to make one thing clear: He’s an optimist. Still, there’s one thing the veteran investor with 59 years of experience in the market has noticed lately that gives him pause. It’s about how the U.S. is changing the way it wants to relate to foreign counterparts. He’s starting to sense a growing tentativeness among clients in Asia, in particular. “They’re wondering what’s happening, just like many of us are,” says Fuss, who helps oversee $261.3 billion in assets as vice chairman of Boston-based Loomis, Sayles & Co. “They’re starting to make some decisions that normally would have been investing in U.S. assets and they’re not—they’re investing elsewhere.” It reminds Fuss of 1973-74, the worst period for markets he’s encountered in stocks or bonds. In February 1973, following the Watergate break-in the year before, the U.S. House of Representatives appointed a select committee to investigate President Richard Nixon for “high crimes and misdemeanors.” By the time Nixon resigned in August 1974, U.S. stocks had fallen 25 percent in just over two years. “Distrust in the political process was very, very severe,” Fuss says. “Discussing this with many of our folks these days, they don’t quite understand that: How can that lead to a bear market? But I know what it felt like at the time. It was awful. Will this be that? I certainly don’t think so, but as it was happening, I didn’t think it was going to be that bad.” Overall, Fuss, like others, has been surprised at how stable markets have been recently. While it’s difficult to prepare for geopolitical disruptions, one thing Fuss is trying to figure out is the best investment strategy at a time when rates are finally rising from artificial lows. For its part, Loomis Sayles has cut the maturity of its funds. For example, the firm has reduced the maturity of its bond fund by half, to 6.5 years; duration is now even shorter than that, at 3.2 years. The $13.3 billion Loomis Sayles Bond Fund boosted its buying reserves to more than 20 percent of total assets, up from less than 2 percent two years ago. The idea, Fuss says, is to buy any decent credit or sector on the cheap once it ends up taking a hit. As for the next crisis, he’s candid in admitting that he’s never seen one coming. So his warning: Don’t believe anyone who says they have. —Nabila Ahmed

As the Paradise Papers cast an unflattering light on offshore financial centers, the exotic microstate of Vanuatu ponders its economic destiny By BRIAN BREMNER P H OTO G R A P H S BY G E O R G E V O U LG A R O P O U LO S L E T T E R I N G BY M AT T H E W TA P I A

a remote archipelago in the South Pacific, a popular tourist attraction is something called land diving. Villagers on the lush outer island of Pentecost jump headfirst from a tall wooden tower with tree vines tied to their ankles to break their fall. For the divers, the rite of passage is a plunge into the unknown—and that’s not a bad metaphor for where this secretive tax haven is headed these days. Anchored in the deep seas between Australia and Fiji, this exotic microstate has faced sanctions since last year for not complying with stricter anti-money-laundering standards established by the Financial Action Task Force. The FATF, an intergovernmental body created by the Group of Seven leading industrial countries, has placed the former Anglo-French colony on its “gray list,” which also includes Iraq, Syria, and Yemen. The action effectively turned Vanuatu banks into financial pariahs. Then in November the island state suffered another hit to its reputation with the unmasking of its offshore corporate clients’ hidden wealth in the leaked Paradise Papers. By then, the nation’s important banking sector was already limping. Vanuatu regulators and local bankers say that France’s central bank had ordered the institutions it regulates to steer clear of the country, while Germany’s Commerzbank AG and New York-based Citibank had dialed back on their correspondent bank relationships with lenders in Port Vila, the nation’s capital and offshore financial center. “It’s much more difficult to do funds transfers in and out of Vanuatu than probably anywhere in the world,” says Martin St-Hilaire, a managing director of AJC, an accounting and advisory firm, and chairman of the Vanuatu Financial Centre Association. Vanuatu and its 270,000 or so citizens already face 21st century vulnerabilities typical of a remote and tiny island chain in this age of rising sea levels and superstorms. It’s a less-developed country that relies heavily on international aid to survive. Now a key industry is threatened by the regulatory aftershocks of a global crackdown on tax havens. The nation is a bit player among tax refuges such as the English Channel island of Jersey and the Cayman Islands in the Caribbean. But singling it out for gray-listing poses grave economic consequences, according to Prime Minister Charlot Salwai. “Its effect,” he told Vanuatu legislators in June, “will be felt on imported food, such as rice, and fuel.” Amid this uncertainty, a debate is raging in Port Vila about the country’s economic destiny. On one side there’s Salwai, a French-trained accountant and ambitious economic reformer, who backs the introduction of an income and corporate tax to generate revenue that can be used to invest in the country’s future. On the other side there are Thomas Bayer, an American banker turned ni-Vanuatu, as local citizens are called, and a gaggle of expat bankers, lawyers, and financial advisers who’ve made nice livings helping the world’s moneyed elite protect their wealth. Neither side questions the urgent need for investment in some form to sustain the economy of this necklace of 80-odd islands. Vanuatu is one of the world’s poorest countries, with a per-capita gross domestic product of $2,860, according to the World Bank. Only 10 percent of the nation’s population earns more than $40 a month, according to data compiled by the Vanuatu National Provident Fund, the country’s national pension plan. Education levels— about 6.8 years on average—are well below the global average. Severe weather and climate change are a constant threat to health IN VANUATU,

BLO O M B ERG M A R K ETS

Prime Minister Salwai wants to transform Vanuatu’s tax system

Bayer, an American banker turned ni-Vanuatu, prefers the status quo

Pacific Ocean

Port Vila VANUATU FIJI Coral Sea

AUSTRALIA

NEW ZEALAND

and food security on the low-slung islands. In 2015, Cyclone Pam left 75,000 homeless and wrecked buildings across the capital. To pay the bills, the Vanuatu government relies primarily on import duties and a value-added consumption tax. There are no personal or corporate income taxes, no estate or capital gains taxes. Until recently the government has been relaxed about requiring companies to disclose ownership details. The offshore financial sector kicks in only about 4 percent of the country’s annual output of roughly $800 million, but its existence requires an ultralow tax environment that deprives the government of some revenue. The gray-listing by the FATF raises questions about the sector’s future, says Johnson Naviti, a Salwai policy adviser and director general of the Prime Minister’s Office: “Do we need the offshore sector? Are we better off without it? That’s a possibility.” THE INSPIRATION BEHIND James Michener’s 1947 Tales of the South

Pacific, Vanuatu is today a mix of old and new, rich and poor. Take a 40-minute flight from Port Vila to the outer island of Tanna, and you’ll encounter a world from another time, with

villagers living off the land, answering to tribal chiefs, and some even worshiping the U.K.’s Prince Philip, the Duke of Edinburgh and consort of Queen Elizabeth II, as the son of a local ancestral mountain god. Port Vila itself nestles alongside a glistening harbor on the island of Efate. Driving through the capital’s winding streets, you see striking contrasts in wealth. Visiting cruise ships regularly drop off tourists for shopping excursions to markets that sell colorful fabrics, tropical fruits, woven baskets, and pearls. Oceanfront resorts, boutiques, and international schools coexist with shantytown settlements, crater-filled streets, and piles of rotting refuse. It’s a city with traffic jams but no traffic lights. Vanuatu’s offshore financial center dates back to the early 1970s, when the British and French still shared administrative control over the islands, then known as the New Hebrides. The collapse of the Bretton Woods system of fixed-exchange rates, along with financial globalization, made capital far more mobile than it had ever been. For Pacific island-states such as Vanuatu, Samoa, Niue, the Cook Islands, Tonga, and Nauru, setting up attractive tax and

VO LUME 26 / ISSUE 6

regulatory regimes to promote the offshore financial industry was a way of luring skilled professionals, financial know-how, and hard currency. The expats who found their way here stirred demand for better schooling, health care, and services. That in turn helped some of these islands develop tourism, an industry that now represents 50 percent of Vanuatu’s economy. Then the haven experiment on the high seas began to unravel. The rise of global terrorism and tax evasion scandals that hit big international banks emboldened U.S. and European regulators to pressure global financial institutions and governments to hand over more information about suspicious transactions and complex money trails. Over time, some of Vanuatu’s neighbors have rethought the benefits and risks of remaining an offshore financial center. The Cook Islands and Samoa shifted their focus. They moved away from tax-minimization schemes and toward trusts designed for asset protection. Fiji, meanwhile, developed into a regional hub for call centers. By sticking with the offshore operations that had served it well, Vanuatu increasingly attracted the attention of faraway regulators. The country surfaced in U.S. prosecutions of moneylaundering cases. In 2015 it popped up in the leaked Panama Papers that detailed myriad offshore financial transactions worldwide. That year an evaluation by the Asia/Pacific Group on Money Laundering, a regional affiliate of FATF, claimed Vanuatu had been “infiltrated by transnational organized crime groups” and “used for weapons smuggling, as well as for transshipment of illicit drugs.” The island hasn’t been blind to what’s going on. “If we say there’s no money laundering, we’re not being realistic,” says Naviti, the adviser to Salwai. Floyd Mera, director of the Vanuatu Financial Intelligence Unit that guards against money laundering, says his team keeps an eye on drug trafficking—“It’s mostly cocaine and heroin from South America”—and any activity

involving Russian and East European organized crime gangs. In June, as part of a concerted effort to get back into FATF’s good graces, the Salwai government pushed a series of bills through Parliament designed to better expose and prosecute money laundering and offshore terrorism financing. Even so, the government will remain on FATF probation for at least a year until it convinces auditors it has the necessary investments in manpower and information technology in place. “It’s going to be expensive,” says Peter Tari, deputy governor of the Reserve Bank of Vanuatu. “It’s not easy for a country like Vanuatu, where you have limited resources.”

VANUATU GROSS DOMESTIC PRODUCT PER CAPITA

VANUATU CONSUMER PRICE INDEX

Current U.S. dollars

Year-over-year change

SINCE VANUATU’S INDEPENDENCE from Britain and France in 1980,

its prime ministers have dodged a bewildering series of shifting alliances, no-confidence votes, and outright corruption scandals. Enter Salwai, a Francophone who grew up on Pentecost, which, in addition to land diving, is known for its virgin rainforests and kava, which is used to make a popular intoxicating grog. Salwai came to power in early 2016 after an epic bribery scandal in which 14 lawmakers—about a quarter of the Parliament—were jailed for bribery. He took office as an agent of change, characterizing himself as such in a speech to the UN General Assembly in September 2016, when he described his plan to broaden the Vanuatu tax base as one of the “greatest” reforms since independence. Standing unapologetically in the way of Salwai’s efforts to transform Vanuatu’s tax system is Bayer, a Pennsylvania native who came to the islands in 1974 to run Pacific International Trust Company, which was then owned by Bank of America, Sumitomo Bank, Westpac Banking, and Montreal Trust, among others. Bayer is a no-nonsense former U.S. Army captain who was posted to the Pentagon during the Vietnam War. He says he was a top secret courier who traveled extensively. He put that

$3k

4 2 3

2 1 1

1996

2016

1996

Source: World Bank

BLO O M B ERG M A R K ETS

2016

Source: International Monetary Fund

By sticking with the offshore operations that had served it well, Vanuatu attracted the attention of faraway regulators

experience and an MBA from the Wharton School of Business to good use, pulling off a leveraged buyout of Pacific International in 1984 and then later taking over another rival in Vanuatu. Bayer renounced his American citizenship after Vanuatu’s independence and became a ni-Vanuatu. His Bayer Group controls 30 companies, spanning trust services and insurance businesses to exports. At 76, he remains a power broker in Port Vila—president of the Vanuatu Chamber of Commerce, chairman of the foundation that owns the weekly Vanuatu Independent newspaper, and a two-time member of the Reserve Bank of Vanuatu board. “I’m an entrepreneur,” says Bayer. “The people here are nice but lack capital. Luckily, I get along well with them.” Bayer faults past governments for failing to stay current with global anti-money-laundering laws. “They just didn’t see this as a priority politically,” he says. “Now they’ve rushed through legislation of international standards in an effort to move off the gray list.” He sees Vanuatu as a victim of the frenzy in postcrisis financial regulation. The international scolding that’s taking place, he says, amounts to rich-world governments trampling smaller players for commercial advantage. “The more powerful money centers are slowly driving out the smaller centers,” says Bayer. Bayer and like-minded businesspeople say Vanuatu is nowhere near ready for an income tax. Out of a population of 270,000, says St-Hilaire of the Vanuatu Financial Centre Association, “220,000, minimum, aren’t in the formal economy and wouldn’t be taxed.” That would place a disproportionate burden on urban residents and send expats fleeing, he says. Once the government, already the nation’s biggest employer, hired a corps of tax collectors, more money would leave state coffers than come in, Bayer says. He favors boosting the consumption tax and doing a better job of enforcing current tax laws to harvest revenue. Salwai welcomed the arrival of two Chinese People’s Liberation Army Navy warships. The following month, China opened a new embassy in Port Vila. The year before, Vanuatu had IN JUNE,

become the first Pacific nation to support China’s controversial territorial claims in the South China Sea. No surprise there. China has lent millions to the island-state for infrastructure projects, including a planned upgrade of the country’s major airfield in Port Vila—an obvious boon to Vanuatu’s essential tourism industry. In Parliament, Salwai is pushing ahead with a plan to introduce an approximate 10 percent tax on incomes of $6,800 to $32,000, and a 17 percent or so corporate tax rate. If he can wrangle the votes, the new tax regime will be up and running in 2019. Though Salwai has survived one no-confidence vote by a comfortable margin, not all lawmakers are on board for his reform agenda. “He has to be careful,” says Anthony van Fossen, a tax haven expert and social scientist at Griffith University in Brisbane, Australia. “If he’s too bold, he may not be prime minister.” Even if Salwai comes up short this time, Vanuatu’s days as a free-wheeling tax haven are over. The government has committed to joining the Common Reporting Standard, an informationexchange system developed by the Organization for Economic Cooperation and Development and the Group of 20 to fight financial fraud. Once that’s set up, tax authorities will have an easier time tracking down offshore accounts. St-Hilaire envisions a world in which financial watchdogs reflexively suspect the worst. “Everything that has to do with tax planning or tax minimization is now considered a fraud–a predicate offense deemed to be possibly money laundering and terrorist financing,” he says. For Vanuatu, there’s no turning back. One way or another, it faces disruptive change today as surely as it did back when Michener was stationed here as a young U.S. Navy officer during World War II. The noose is tightening on tax havens, and Salwai or his successors will need to find new strategies to attract overseas talent and capital. For this remarkable Bali Hai-like nation of azure lagoons, hidden waterfalls, and volcanic lava-showers, a second act can’t come soon enough. Bremner is an executive editor for Bloomberg News in Tokyo.

VO LUME 26 / ISSUE 6

Cheat Sheet

A Compendium of Functions— New or Featured In This Issue

FEATURED IN THIS ISSUE BNEF

NEW ENHANCEMENTS TO TRY RIGHT NOW

Displays clean energy research and data from Bloomberg New Energy Finance

MIFI

Puts everything you need to know about MiFID II and MiFIR at your fingertips in one portal 24, 27

RHUB

Centralizes access to tools for monitoring transactions and files and reporting to regulatory agencies

ALLQ MIFID Demos data that will be displayed in the ALLQ function once MiFID II takes effect

FLNG

Searches 13F filings to see reported holdings

PORT

Performs factor-based attribution analysis and runs optimizations

28-35

Compares the relative value of a stock with those of peers

Searches for investors that match your criteria

DEBT

Visualizes and ranks holders of U.S. and non-U.S. debt, including the Federal Reserve’s holdings 43, 44

FLMA FOFP

FFLO

Tracks trends in foreign direct investment into a selected company

IFRS 9, the International Accounting Standards Board’s new standard covering how financial instruments are reported, takes effect on Jan. 1, 2018. One major change under the standard is that accountants will need to measure risk looking forward. Use DRSK for default probability estimates for the risk calculations you’ll report under IFRS 9. For more information on Bloomberg’s regulatory and accounting products, go to {RAAP <GO>}

HFS

Hedge Fund Search allows you to find hedge funds and liquid alternatives based on characteristics such as strategy, style, and assets. The tool also lets you drag and drop funds from search to other functions and delve deeper into performance

BRM

Bloomberg Risk Management enables you to perform comprehensive risk reporting for your enterprise. The function breaks down exposure by category and lets you see which positions drive overall risk. BRM allows you to track risk over time, recognize trends, and assess the impact of various what-if scenarios

TWTL

Twitter Lists lets you create custom lists of Twitter handles so you can monitor real-time tweets from the most influential sources in finance and other people and organizations you follow

46 48, 49

Tracks trends in foreign portfolio investment and enables analysis of the cross-border portfolio of stock holdings in a selected country in PORT 48-50 Maps and views ETF flows data

DRSK 26, 27 27

CFAPRO Maps the CFA Program Learning Outcome Statements to Bloomberg functions

The new Factors to Watch function ranks more than 170 attributes of stocks so you can see which have historically driven equity performance. The function lets you gauge which factors have most influenced performance for a selected region, index, or sector and graph the historical performance of a particular factor. In addition, FTW lets you monitor returns of Bloomberg’s “pure” factors in real time 34, 35, 96

MOSB MIFID Demos a new version of MOSB with MiFID II-related bond data

FTW 23

Faster, better answers—24/7. <Help><Help> for Bloomberg Analytics

The BLOOMBERG PROFESSIONAL service (“BPS”), BLOOMBERG TERMINAL and Bloomberg data products (the “Services”) are owned and distributed by Bloomberg Finance L.P. (“BFLP”), except that Bloomberg L.P. and its subsidiaries distribute the BPS in Argentina, Bermuda, China, India, Japan, and Korea. Bloomberg Tradebook is provided by Bloomberg Tradebook LLC and its affiliates and is available on the BPS. BLOOMBERG, BLOOMBERG PROFESSIONAL, BLOOMBERG MARKETS, BLOOMBERG NEWS, BLOOMBERG ANYWHERE, and BLOOMBERG TRADEBOOK, BLOOMBERG TELEVISION, BLOOMBERG RADIO and BLOOMBERG.COM are trademarks and service marks of BFLP or its subsidiaries. The information detailed within this document and all related information (whether oral or written) is (1) provided for your information and discussion only, (2) non-binding and (3) subject to modification by Bloomberg. It is not a solicitation or offer to buy or sell any security or other financial instrument, nor is it an invitation or inducement to engage in investment activity. Nothing in this document is designed to be, or should be treated as, advice. If you are in any doubt as to your obligations or seek advice, you should consult your own professional advisers. Bloomberg does not guarantee the accuracy or completeness of the content of this document. Bloomberg does not accept liability for any loss arising from use or reliance placed upon this document and its content. Information provided in this document should be treated as confidential and proprietary to Bloomberg. Customer may not share, reproduce, publish, distribute or communicate this Proposal or information of any kind relating to these responses to any company, third parties or persons other than within Customer and only to such persons on a need-to-know basis in connection with this review. Certain features, functions, products and services are available only to sophisticated investors and only where permitted. BFLP, BLP and their affiliates do not guarantee the accuracy of prices or other information in the Services. Information available via the Services should not be considered as information sufficient upon which to base an investment decision. Communicated, as applicable, by Bloomberg Tradebook LLC; Bloomberg Tradebook Europe Ltd., authorized and regulated by the U.K. Financial Conduct Authority; Bloomberg Tradebook (Bermuda) Ltd.; Bloomberg Tradebook Services LLC. This communication is directed only to market professionals who are eligible to be customers of the relevant Bloomberg Tradebook entity. Neither Bloomberg Finance L.P. nor any of its affiliates is a Nationally Recognized Statistical Rating Organization (NRSRO) in the U.S. or an officially recognized credit rating agency in any other jurisdiction. Bloomberg’s ratings have not been solicited by issuers, and issuers do not pay Bloomberg any fees to rate them or their securities. Customers should not use or rely on Bloomberg’s ratings to comply with applicable laws or regulations that prescribe the use of ratings issued by accredited or otherwise recognized credit rating agencies. Bloomberg’s ratings and related data are not investment advice or recommendations of an investment strategy or whether to “buy,” “sell,” or “hold” an investment. For information on the BLOOMBERG PROFESSIONAL service, contact the sales office in your region: New York 212-318-2000, San Francisco 415-912-2960, Frankfurt 49-69-920410, Hong Kong 852-2977-6000, London 44-20-7330-7500, São Paulo 55-11-2395-9000, Singapore 65-6212-1000, Sydney 61-2-9777-8686, Tokyo 81-3-3201-8900. December 2017/January 2018, volume 26, issue 6, BLOOMBERG MARKETS (ISSN 1531-5061) (USPS 008-897) is published six times a year with issues in March, May, July, September, November and December by Bloomberg Finance L.P., 731 Lexington Avenue, New York, NY 10022, and distributed free to subscribers of the BLOOMBERG PROFESSIONAL service. POSTMASTER: Send address changes to Circulation, BLOOMBERG MARKETS, P.O. Box 1583, New York, NY 10150-1583. Periodicals postage paid in New York and at additional mailing offices. ©2017 Bloomberg L.P. Bloomberg reserves the exclusive right to reproduce or authorize reproduction of articles. Advertisers and ad agencies assume liability for all ad content.

A Function I Love

Expect the Unexpected By JOE WEISENTHAL

FTW <GO> CALL IT A middle ground. There’s still an aversion to expensive stockpicking active managers, yet some investors yearn for something spicier than the passive life, which is partly why we’ve seen a surge in factor investing. By harnessing attributes of outperforming stocks—value, momentum, and so on—you can try to bring their mojo into your portfolio. So how do you determine what’s working or not? Enter the new terminal function Factors to Watch, where you can tap more than 170 factors across 13 style categories. Loading {FTW <GO>} gives you a broad look at what’s outperforming. Right now, the No. 1 moneymaking factor for the entire market is a company’s ratio of research and development to sales over the last 12 months. That’s not too surprising; tech companies have crushed it of late and tend to have high levels of R&D.

But what if we wanted to look within a specific sector? When I select Consumer Goods from the drop-down menu, I see that one of the strongest factors for these companies is earnings-per-share growth; those exhibiting higher-than-average EPS growth over the past five years are outperforming. You can see in the Strength column how consistently they’ve performed over time. And what about in, say, oil and gas? In that sector, I notice companies with lower-than-average profit margins are actually outperforming companies with higher profit margins— an unexpected but interesting result that could turn out to be a gem. OK, but what if you don’t care about the relative performance of a big universe of factors and just want to know, straight up, which ones make money—and not just historically, but today, right now? Load the

U.S. and click the Pure Factor Returns tab; this analyzes the performance of the 10 style factors that underpin Bloomberg’s Portfolio & Risk Analytics (PORT) function and ranks them in a way that controls for the other style factors and industries. Momentum, I see, tops the 2017 YTD list, outperforming by 3.51 percent; value is at the bottom, to the chagrin of many investors. Size, surprisingly, has also been a big winner; leverage and dividends, not so much. There’s more: The long-term tab on the right reveals value’s 146.32 percent historical return. Or how about the far left intraday tab—a new and phenomenal way to see the market in real time. The present and future of investing is in that space where fundamentals meet quantitative techniques, and there’s no better place to get a feel for what’s working than Factors to Watch.

Weisenthal co-hosts What’d You Miss? on Bloomberg TV and is the executive editor of digital news at Bloomberg.

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