Messing With Models: Vanguard, Buffers, Two Sigma

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Speaker 1 Bloomberg Audio Studios.

Speaker 13 Podcasts, radio, news.

Speaker 14 Should I get closer?

Speaker 14 Yeah.

Speaker 14 Even though people like my audio, at least relative to Matt's. Yeah,

Speaker 12 I'm the audio of death.

Speaker 12 Sorry, I'm so low.

Speaker 12 Should I do this? Should I do like an E-Ro voice the whole time?

Speaker 14 Maybe they'd like it a little bit more.

Speaker 12 Hello and welcome to the Money Stuff podcast.

Speaker 14 And then maybe they would like your normal voice more.

Speaker 14 Hello and welcome to the Money Stuff Podcast.

Speaker 12 Your weekly podcast where we talk about stuff related to money. I'm Matt Levine and I write the Money Stuff column for Bloomberg Opinion.

Speaker 14 And I'm Katie Greifeld, a reporter for Bloomberg News and an anchor for Bloomberg Television.

Speaker 12 What are we talking about today, Katie?

Speaker 14 Well, Eeyore, we're talking about Vanguard getting put on the SEC's naughty list. We're going to talk about buffered Bitcoin ETFs, and then we're going to talk about Two Sigma.

Speaker 12 I wrote this, it might be the last SEC naughty list.

Speaker 12 Yeah, that's true.

Speaker 12 I'm really interested what's going to happen in the next few years in terms of like, like, I've made fun of the SEC over the past few years about some of its enforcement things, like the

Speaker 12 cell phone stuff, where like if you text about work, you get in trouble with the SEC.

Speaker 12 I don't know how much the SEC is like a sort of like self-operating mechanism that has inertia and will keep bringing cases and will keep going after securities fraud and how much of it is going to be like the tone from the top is securities fraud is great and then we just you know never see an SEC case again or you see SEC cases but they have a very different political posture you know yeah

Speaker 12 anti-ESG cases.

Speaker 14 It seems like that sentiment is shared because it was a real rush to the finish for the SEC. You had a very long column about everything that the SEC was doing.

Speaker 12 It was like one quarter of the things that the

Speaker 12 SEC did last week.

Speaker 14 There were so many things. Nestled at the bottom was something on Vanguard, of course.

Speaker 14 Vanguard to pay $106 million to resolve violations related to capital gains distributions in their target date funds.

Speaker 14 This is a rare moment where Matt and I both wrote about something, him in Money Stuff, me in the ETFIQ newsletter.

Speaker 12 Julie newsletters.

Speaker 14 Yeah, Matt, you find this aggressively boring, but I think it's kind of interesting.

Speaker 12 Say what?

Speaker 12 Okay.

Speaker 14 Well, this came down, and to me, it sort of read like the inverse of what we were talking about with Capital One. And let me tell you what

Speaker 12 I'm going to do. Okay.
All right.

Speaker 14 So you're buying in. So Vanguard basically lowered the minimum initial investment on its Vanguard institutional target retirement funds in December 2020.
But they also had a retail version of this.

Speaker 14 And the institutional version had a lower fee than the retail.

Speaker 14 And my crude explanation in my newsletter was that, okay, they told the investors in the retail product that they were lowering the minimum, and you had a bunch of these retirement investors switch to the now lower fee institutional TRFs that they could get access to.

Speaker 14 But the bad news came in when the retail funds, to meet those redemptions, then had to sell a bunch of assets, and the remaining holders were caught with big capital gains.

Speaker 12 Yeah. So there's the two classes: the investor fund and the institutional fund.
The investor fund is not exactly retail. It was like sub-100 million dollars.

Speaker 12 And so a lot of retirement funds had their money in the investor fund. And then they cut the minimum for the institutional fund to $5 million for $100 million.

Speaker 12 So all these like small and mid-sized retirement plans were like, okay, we'll get the lower fees by taking our money out of investor and putting it in institutional.

Speaker 12 But to get the lower fees, That's technically a like taxable transaction. Like technically the retail fund sells all those stocks and the institutional fund buys it.

Speaker 12 And that means that the retail fund has capital gains. And those capital gains are shared by not the redeeming holders, but also the continuing holders.

Speaker 12 So if you had money in that fund, you got a big capital gains tax bill and you were surprised by it because

Speaker 12 it's not in any sort of proportion to your actual gains. It's like all these people cashed out, so there was a big bill.
Yeah.

Speaker 14 So mutual funds.

Speaker 12 Mutual funds. You were like, I wrote about this and I was like, let me guess.

Speaker 12 They should have done an ETF.

Speaker 14 Well, I mean, ETS, with ETFs, this wouldn't have happened. Do you think about the creation redemption mechanism of ETF shares?

Speaker 14 People love ETFs because you don't get capital gains bills in the same way that you would with a mutual fund when other holders redeem.

Speaker 12 Right. It's like you have to sort of think about what is the right treatment.
You know, so I wrote a few years ago, like Bloomberg Zach Meiter had a...

Speaker 12 series of stories about the ETF heartbeat trade where basically like if you run an ETF, broadly speaking, you can avoid realizing any taxable gains because you're doing in-kind creations and redemptions.

Speaker 12 But every so often, you need to like adjust the holdings of your fund. And if you traded for cash, you would have taxable gains.
If you run an ETF, the number one goal is never have taxable gains.

Speaker 12 And so people have developed all of these like complicated mechanisms to take advantage of what a lot of people call the ETF tax loophole, right?

Speaker 12 Like it's a loophole that you can have this fund that never buys or sells stocks and never has taxable gains. Yeah.

Speaker 12 yeah at their heart it's kind of a tax dodge yeah it's kind of a tax dodge it is so intuitively appealing to say i've put my money in a fund in a year or 10 years or 35 years i'll take my money out of the fund if i have gains over those 35 years i'll pay taxes on the gains but in between i shouldn't pay any taxes because i haven't sold anything like what's the taxable event where i just hold the mutual fund and every year i get a tax bill and the tax bill is not really related to my actual gains in the fund it's just weird yeah and like that's how the tax law works for mutual funds.

Speaker 12 It's not how the tax law works for ETFs, in part because there is this ETF loophole and in part because people have built the industry around exploiting the loophole.

Speaker 12 But like the ETF treatment is just more intuitive than the mutual fund treatment. And a lot of people are genuinely surprised that they get a tax bill for their mutual fund trading activity.

Speaker 12 And the SEC is like, they should have been surprised. Like, it's not fair.
They shouldn't get the tax bill. You know, because that is the tax law.
But

Speaker 12 no one finds it intuitive or appealing.

Speaker 14 I mean, so mutual funds, when they're in 401ks, what we're talking about sort of goes away. Yes.
401ks, you don't have that capital gains thing.

Speaker 14 In this specific instance with these Vanguard target date funds, so it was the investors that held these funds in their taxable accounts that we're talking about.

Speaker 12 So Vanguard sort of assumed that most of these people were 401k investors. Theoretically.
In part because

Speaker 12 a lot of people hold these funds through Vanguard's own platform, like their website and their brokerage.

Speaker 12 And so Vanguard could look at those people and say, almost all of these are 401k plans, so they won't have to pay the taxes, so it's not a big deal.

Speaker 12 But also, like, people hold billions of dollars of these funds away, like in other brokerage accounts, and Vanguard didn't have transparency on them and sort of assumed, yeah, it's all 401k plans, it's fine.

Speaker 12 But in fact, a lot of retail taxable investors had money in these funds and then got a big tax bill. Yeah.
Because they were outside of the 401k.

Speaker 14 Trevor Burrus, Jr.: So we've talked a lot about products and wrappers so far.

Speaker 14 I want to talk, though, about why this is like the spiritual inverse of the Capital One example, because you had a lot of sympathy for Capital One last week.

Speaker 14 And if that's the case, you must have a ton of sympathy for Vanguard here, kind of trying to do this out of the goodness of their hearts for these investors.

Speaker 12 I do. Yeah.

Speaker 12 Talk about that. The thing they did here was they wanted to lower fees.
Yeah.

Speaker 12 Vanguard is an interesting company because it's sort of not a company, right? It's like owned by the funds. So it's a mutual in the sort of classic sense.
Like the funds ultimately own Vanguard.

Speaker 12 So it doesn't like charge as much as it can to like provide returns to the shareholders. It like has a mandate to kind of keep fees low.
And so it offered these funds.

Speaker 12 It set some expense ratios and the funds gathered a lot of assets, including from like mid-sized 401k plans. And they're like, we're making so much money off these plans that we don't need.
Yeah.

Speaker 12 Like let's give it back. And they thought of different ways to give it back.
And the way they came up with was lower the minimums on the institutional fund, which there are a lot of other options.

Speaker 12 And they chose this one

Speaker 12 for reasons that are not entirely clear to me, but basically the SEC sort of implies that they didn't fully appreciate the tax problem. Yeah.
In part because they thought everyone was in 401k plans.

Speaker 12 And in part because when they were considering this, it was like March of 2020. And so stocks were all the way down.
And so they're like, yeah, nobody has capital gains. It's fine.

Speaker 12 It's not a big deal. But then by the time they actually did it, people had capital gains.
Yeah. So I sympathize with all of that.

Speaker 12 The only thing I'll say, like, you know, I have a soft spot for Vanguard. A lot of my money is in Vanguard funds.
But like,

Speaker 12 Vanguard feels like a historic innovator in index funds that is like a little

Speaker 12 timey. Okay, old-fashioned.

Speaker 14 Like, you know, out in the woods of Pennsylvania.

Speaker 12 Yeah. And like, you know, they sort of resisted ETFization a little bit more than the other places.

Speaker 14 Jack Bogle had a lot to say about ETFs.

Speaker 12 Some of that about what we'll get to, like weird, weird product ETFs, but like some of the, they just didn't like the ETF structure because it felt trader-y and they want like a sort of long-term buy-on-hold investors.

Speaker 12 And

Speaker 12 the way they've structured this,

Speaker 12 you could have done this in a lot of other ways. You could have started from the beginning with we have one fund

Speaker 12 and we can have two classes of shares of the fund, and we can lower the fees on one class without lowering, you know, like the problem here is that they had two separate funds, and so when they lowered the fees on some of the investors, those investors had to sell one fund and buy another one, which is like kind of crazy.

Speaker 12 It shouldn't work that way. So, like, I have a lot of sympathy here for Vanguard because really all they were trying to do was lower fees out of the goodness of their heart.

Speaker 12 But I also like, yeah, this is kind of sloppy, you know? Yeah, a couple things.

Speaker 14 Vanguard turns 50 years old on May 1st. May 1st, 1975 was when Vanguard was born.
Vanguard does this all the time in terms of lowering fees.

Speaker 14 Like you talked about their ownership structure a little bit. Like any time that they have extra cash or assets generated by their products, that is just...

Speaker 14 funneled into lowering fees, which has put a crunch on the entire industry because of the way that they're owned.

Speaker 14 Other people, like BlackRock, doesn't operate like Vanguard does, but BlackRock still has to compete with Vanguard and just lower fees to

Speaker 14 dirt cheap levels, which is interesting. And in the ETFIQ newsletter, you know, after you've read money stuff, if you read the ETFIQ newsletter, the $106 million,

Speaker 14 I saw some reaction that was like, oh, that's nothing for Vanguard. They manage how many, like $10 trillion in assets.

Speaker 14 But because their fees are so low, assuming that they charge an average of 10 basis points, $106 million for Vanguard is like napkin math 1% of their total revenue.

Speaker 14 So this is actually pretty painful for Vanguard. Maybe it was sloppy, you know, but it was painful.

Speaker 12 A thing that I read about a lot, I read about cases where either the SEC or like a shareholder class action sues a company for doing a bad thing and the company agrees to pay a big fine or pay a big recovery to shareholders.

Speaker 12 And people always ask, like, isn't that circular? Like, where does the money come from?

Speaker 12 And part of the answer is like, the money sometimes comes from TNO insurance, but like, sometimes, yeah, like the company writes a check to compensate shareholders who lost money on something.

Speaker 12 And you're like, well, like, how did that help the shareholders? Like, the lawyer's got a fee, but like, the shareholders are writing a check to the shareholders.

Speaker 12 Similarly with Vanguard, it's owned by its funds, right? So if you find Vanguard $100 million,

Speaker 12 in some sense, are you taking that money from the Vanguard investors who like lost money because of this tax problem? Wow. Like, they're the shareholders.
They're the owners. That's true.

Speaker 12 They're the ones paying the fine. Those are good points.
And when I say they, I mean me.

Speaker 14 Yeah. So it's technically not a fine.
And I learned that the hard way.

Speaker 12 Because

Speaker 12 I had to. So you said it was a fine?

Speaker 14 I said it was a fine, and I had to correct my newsletter. It's technically not a fine because the $106 million

Speaker 14 will be distributed to those impacted.

Speaker 12 Yeah, it's true. So

Speaker 14 you should still subscribe to ETFIQ.

Speaker 14 90% of the time is correct.

Speaker 12 Carol has for more than that. Oh, come on.

Speaker 14 I'm doing my best.

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Speaker 3 Just one.

Speaker 5 EasyCater, the workplace food platform that lets teams order from a huge variety of restaurants, over a hundred thousand nationwide, all through a single vendor.

Speaker 9 In addition to all that variety, Easy Cater also gives you full visibility of your organization's food spend with invoicing, centralized reporting, and seamless integration with expense management systems, all on one platform, EasyCater, your business tool for food.

Speaker 10 To learn more, visit easycater.com slash podcast.

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Speaker 14 Let's talk about something that Jack Bogle would absolutely hate. They're called buffered Bitcoin ETFs.
Buffered ETFs, they're really popular. They've just ballooned over the past several years.

Speaker 14 Can you tell me why? Oh, I don't know. I actually, so I mean, it's a great pitch.

Speaker 12 Yeah, I've written this. Like, it is so close to my heart because it's like a pitch that I learned as a young derivative structure at an investment bank.
Yeah. You'd be like, there's no downside.

Speaker 12 Exactly. Get all your money back.
It's great.

Speaker 14 Like, what a great pitch. Yeah.
And it sort of evolved evolved to be no downside at all. Of course, 100% protected downside buffered ETFs have launched in the past year or so.

Speaker 14 But buffered ETFs came into existence. I'm sure they existed in other iterations, but they came into existence in 2020, I believe.
I was pretty new to the ETF beat.

Speaker 14 And in that time, they've ballooned to this like $60 billion asset class. And it's because the pitch is really good.
We're going to shield you against these losses.

Speaker 12 Yeah, we're going to give you the upside in something, the SDG, whatever, micro strategy, whatever. And if like it goes down, it doesn't go down.
Like you get all your money back. Yeah.
It's amazing.

Speaker 14 What a great pitch. It makes sense in stocks, the 100% downside.
To me, I can kind of see it.

Speaker 14 In Bitcoin, I don't super understand it because volatility is the selling point of Bitcoin for a lot of people. People have fun trading extremely volatile cryptocurrencies.

Speaker 14 If you are buying a 100% Bitcoin buffer ETF with like an upside cap of 12% or 11%,

Speaker 14 what is the GD point?

Speaker 12 What is that point?

Speaker 12 Yes. Right.
So Calios is launching these buffered Bitcoin ETFs, right? Where like these things are all like defined periods, right?

Speaker 12 So you get like a one year, like you buy it at the beginning, and at the end, you get some amount of the return on Bitcoin, but like fluoride at some level, right?

Speaker 12 So like they have a 100 by like 111, something like that. Not exactly sure on what the cap levels are.
But so basically you buy it. And if Bitcoin goes down, you get your money back in a year.

Speaker 12 And if Bitcoin goes up, you get the return on Bitcoin unless it goes up by more than 11%, in which case you only get 11%, right?

Speaker 12 So if you're sure that Bitcoin will go up, this is like a way to get an 11% return on your money.

Speaker 12 But if you're sure that Bitcoin will go up, you just buy Bitcoin and it'll go up like, you know, 1,000%.

Speaker 12 So why would you buy it? I continue to ask you, why do people buy buffered ETFs, right? I mean, like, it's such a good pitch. When I was doing this, they didn't exist in ETF form.

Speaker 12 They existed in structured notes at banks, right? And like, this is a, this is like a classic structured note product, right?

Speaker 12 This is like your wealth manager goes to a rich conservative person who's like, oh, I like this stock. And you're like, well, I can give you that stock, but no downside, right?

Speaker 12 Like, to be clear, like, you're always trading up upside, right? Like, the trade is that the advisor goes and buys treasuries for,

Speaker 12 you know, 96%.

Speaker 12 of the investment, right? And like that provides the downside protection because at $96, a treasury bill matures at $100 in a year.

Speaker 12 And then he takes the other $4 and buys a call spread that gives you some of the upside on the asset.

Speaker 12 This is a medium to high interest rates product.

Speaker 12 If interest rates are really low, you have to spend like $99 on the treasuries to mature at $100. And so you have only $1 to spend on a call spread.

Speaker 12 But if interest rates are really high, you can spend like $10 on a call spread. And then you're in business.
Yeah.

Speaker 14 So a story I actually started reporting in autumn of last year, right before the Fed started cutting rates, was what happens to these 100% downside ETFs once rates start going lower.

Speaker 14 And it seems like.

Speaker 14 Yeah, well, that's the thing. Well, no, some issuers, there's a choice you have to make.

Speaker 14 Yeah, do you keep the 100% downside protection or do you lower the cap? And some issuers were thinking about, you know, maybe it's not 100% protection. It's 85%.

Speaker 14 So there's a choice that has to be made. But then interest rates went up like 100 basis points.
So it's less relevant right now. But it will become relevant at some point.

Speaker 12 My crude assumption is that you can get a buffer ETF that has 100 floors. So you always get your money back.
And it has a cap of like crudely twice the treasury bill rate. Right.

Speaker 12 Because like, you know, like your option is like put $100 in today and get back the treasury rate or put $100 in today and get back, you know, with equal probability between zero and twice the treasury rate.

Speaker 12 Yeah. So it's like, that's sort of like the right expected value.
Yeah. It's not exactly right, but it's like, it's like kind of close.

Speaker 12 And so like you see caps that are under like 110 with like a foreign change treasury bill rate.

Speaker 12 The other thing I'll say is the Bitcoin buffer ETF that we're talking about from Calamus, they actually have three options. One is like 100 by like 111 or whatever.

Speaker 12 And then the others are like a 90 by 130 and a 80 by 150.

Speaker 14 So like those haven't launched yet, though, right?

Speaker 12 Yeah, but they're like, they're talking about them like by 80 by 150. I mean like if Bitcoin goes down by more than 20%,

Speaker 12 you only go down by 20%, right? So like if Bitcoin loses half its value, you only lose 20% of your investment. But But then, if Bitcoin goes up, you get up to 50%

Speaker 12 returns on your investment. So, it's like a much wider collar, which is maybe more appealing.

Speaker 12 Still, it's like a weird trade.

Speaker 14 It is. Before we talk about Trump coin, which is coming, one more point that I just remembered on buffer ETFs broadly.

Speaker 14 I remember talking to Aliance about this and basically asking the same question that we are: who and why would you buy this?

Speaker 14 And the point that they made, which I found found somewhat compelling, was this is a better version of bonds.

Speaker 14 Like if you're putting together a portfolio, don't take from your equity bucket to put into these buffered products. Take from your fixed income allocation.

Speaker 14 This is a better version of bonds because bonds have been an unreliable hedge since the pandemic anyway. This makes more sense as a fixed income alternative.

Speaker 14 That was their pitch, which, you know, if you're getting 100% downside protection, but, you know, twice what treasury treasury builds are yielding, that makes a little bit more sense.

Speaker 12 Yeah. And like just in general, like you have some exciting sounding thing stamped on some bond-like product, right? Like you have like, ooh, it's Bitcoin, but in bond form, right?

Speaker 12 Like it's appealing, right? Yeah. I've written a lot about microstrategies, convertibles, right, which are Bitcoin in bond form, right?

Speaker 12 And the appeal of that is a lot of that is to convertible arbitrageurs, but a lot of it is actually to like just boring fundamental like institutional investors who are like,

Speaker 12 I'll take some Bitcoin upside and some, you know, 100% downside protection. So, yeah.

Speaker 14 I feel like there's still work to be done, though, when it comes to the pitch for a buffered Trump coin ETF.

Speaker 12 Yeah.

Speaker 12 God, that's going to happen, isn't it? Yeah.

Speaker 12 Like, someone announced the filing for a Trump coin ETF, not a buffered one, just like

Speaker 12 your Trump coin in a stock wrapper. Yeah.

Speaker 12 Yeah. No, it's interesting because you think about what's like the Trump coin audience, right?

Speaker 14 Like a lot of it is like Trump has a huge crypto native following who are like going on Solana and buying Trump coin but he also has like a you know yeah less tech native following who would love to buy Trump coin but aren't going to like mess around with the blockchain yeah and so selling them Trump coin in ETF form is like you know has an obvious appeal we had Kathy Wood of Arc Investment on ETFIQ the television show this week and of course we asked her about Trump coin and she stays away from meme coins she likes the big three as she called it and she said something to the effect of I'm not sure what the utility of Trump coin what it it is.

Speaker 14 And it seems like the utility is just funneling money to the Trump family, hopefully.

Speaker 12 I've along aside on utility.

Speaker 12 I don't know if this is relevant.

Speaker 14 Let's find out.

Speaker 12 So, and this gets back to the SEC.

Speaker 12 Five years ago,

Speaker 12 if you talk to crypto people, there's a lot of talk about like, we're building the future of the internet. We're building like these useful tools that will affect people's lives.

Speaker 12 We're building new ways of gaming and new ways to store files and decentralized everything. Right.

Speaker 12 And you don't hear that anymore. And now you hear fartcoin and dogecoin and trump coin, right?

Speaker 12 Why? Well,

Speaker 12 one

Speaker 12 very obvious possibility is that like all of those promises of utility, many of them, were kind of vaporware and they didn't work out. And people are like, yeah, it's fun gambling, right?

Speaker 12 Another possibility is that the people who were either building or hyping new technologies in crypto saw a new shiny object in AI and now we're all building and hyping large language models.

Speaker 12 But I think a really important explanation for all of this is that the SEC had a huge crackdown on crypto, and it was specifically addressed to like people who were building stuff.

Speaker 12 If you were offering an investment in some project that you thought would like build utility for the world,

Speaker 12 the SEC said, well, that was a securities offering and you couldn't do it. And if you got it listed on an exchange, the exchange would get in trouble.
The crypto exchange would get in trouble.

Speaker 12 And so there was a SEC crackdown on crypto generally, but specifically on like useful crypto. Whereas meme coins, everyone agrees, basically, are not securities because they don't promise anything.

Speaker 12 They're just like, yeah, it's a meme. It has no utility.
As long as you don't have utility, you can sell it to your heart's content. It's like a collectible.
It's not an investment.

Speaker 12 And so the SEC can't regulate it. I feel like if the SEC went back, it would find that to be like a bad strategic decision because like it didn't stop crypto.
It just made crypto more useless.

Speaker 12 And so one question is like with a much more accommodating SEC, will crypto become more useful or is the meme coin gambling stuff too good and that's all anyone wants anymore and it'll just be a lot of no utility meme coins.

Speaker 12 Yeah. And we'll find out what we want.

Speaker 1 How many vendors does it take to meet all your organization's food needs?

Speaker 3 Just one.

Speaker 5 EasyCater, the workplace food platform that lets teams order from a huge variety of restaurants, over 100,000 nationwide, all through a single vendor.

Speaker 9 In addition to all that variety, EasyCater also gives you full visibility of your organization's food spend with invoicing, centralized reporting, and seamless integration with expense management systems, all on one platform, EasyCater, your business tool for food.

Speaker 10 To learn more, visit easycater.com slash podcast.

Speaker 11 Every business has an ambition. PayPal Open is the platform designed to help you grow into yours with business loans so you can expand and access to hundreds of millions of PayPal customers worldwide.

Speaker 11 And your customers can pay all the ways they want with PayPal, Venmo, Pay Later, and all major cards so you can focus on scaling up.

Speaker 11 When it's time to get growing, there's one platform for all business, PayPal Open.

Speaker 12 Grow today at PayPalOpen.com.

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Speaker 12 Two Sigma.

Speaker 14 This was also, you know, in the rush to the finish. for the SEC under the Biden administration.
Yes.

Speaker 12 Got that right.

Speaker 12 Two

Speaker 14 Tell me about it.

Speaker 12 So Chooseigma announced in like 2023 that it had found someone messing with its models.

Speaker 12 One of its employees was messing with its models in a way that caused some funds to make an extra $450 million and other funds to lose $170 million.

Speaker 12 And when the stories came out, it was like he was messing with the models to try to improve his bonus, which is like the only reason anyone does anything, right?

Speaker 12 And it's like a little bit of a funny story because he succeeded in the aggregate

Speaker 12 in improving the performance of Two Sigma's funds, right? Like he made more money on the good funds than he lost on the bad funds. And like you could imagine

Speaker 12 ex-ante, if you knew that that was going to happen, you'd be like, okay, we'll just like take $170 million from the funds that win, give it to the funds that lose, then they haven't lost.

Speaker 12 They're fine. And the funds that win have an extra like, you know...
$280 million. Like, great work.
Here's your big bonus.

Speaker 14 This seems like a happy story.

Speaker 12 Right. But neither Two Sigma nor the SEC saw it that way.
The guy was fired, and Tucson ended up paying like $90 million in penalties to the SEC.

Speaker 12 And so, like, yeah, so he improved the overall performance of the funds. And instead of a round of applause, he got fired and Tucson got fined.
And it's a little unclear why. Yeah.

Speaker 12 I mean, like, part of it is like he did it without authorization, right? And you're supposed to run your hedge fund. in a properly supervised way.

Speaker 12 So one reason they got in trouble was for like failure to supervise.

Speaker 12 Because basically like there is a long list of parameters that you're not supposed supposed to change without running it through a review process and he would just change them without running it through that process like he just yeah went into the computer and changed the parameters he was not supposed to do that but he did it anyway and so that's like a failure to supervise thing but the other thing that probably happened is that probably like you know a quantitative hedge fund is basically aiming for high

Speaker 12 risk adjusted returns. It's aiming for some level of risk and the highest possible returns within that level of risk.

Speaker 12 And it seems like what happened is that he changed these parameters to dial up the risk that the fund was taking on his strategies.

Speaker 12 Like he built a bunch of strategies for the fund, for the funds for Two Sigma. And

Speaker 12 Two Sigma's overall model was like, we're going to put this much risk into these strategies in order to achieve good risk-adjusted returns.

Speaker 12 And he kind of turned the dial to put more risk into those strategies, which did in fact, over the time period, mostly lead to higher returns, which was good for his bonus, but which was not what Two Sigma was looking for.

Speaker 12 And like, you know, if you ran the simulation 100 times, it might not have made as much money.

Speaker 12 And they're aiming for sort of long-term risk management framework, but like it happened to make more money in the time they needed.

Speaker 14 Yeah. So that one fund overperformed, but one of the funds underperformed, correct? So investors did lose money.
Sure, sure, sure. Some investors.
Right.

Speaker 12 But like, again, like the overperforming fund overperformed more than the underperforming fund underperformed. So like, you know, you could, you could reallocate that to make everyone happy.

Speaker 12 happy i mean in theory you can't really because like there's they have specific mandates right and if they're not following their mandates then like that's bad does the fact that one fund overperformed lessen the blow to two sigma at all like this 90 million dollar penalty would it have been 180 dollars if everyone lost money i think i mean who knows but like i think that there's always a range of rogue trader behavior right like this guy's not quite a rogue trader are you supposed to ask for forgiveness later right like

Speaker 12 you know, it's an interesting question of like, what would happen if he had just made money? Yeah. Everything had gone better.

Speaker 12 I think that a lot of these quant funds are like really quite rigorous about risk management. And like if they caught him just making $900 million for clients, they might have fired him.

Speaker 12 They might have been like, nope, you messed with our risk management. Like that is really important.
And you're fired, even though you only made $900 million for clients. They might not have.

Speaker 12 I don't know. And I think Two Sigma is interesting because it's truly a quant fund, right?

Speaker 12 Like I think a lot of like less rigorous banks, like kind of famously, like, don't fire rogue traders who make money. This is like changing a little bit, but that's the stereotype.

Speaker 12 But yeah, I think, you know, if he had only lost money, then it looks like malice or incompetence. Or just like, it looks really bad.

Speaker 12 If he makes money, then it's like he was genuinely trying to make money for the firm and thus for his bonus. That's a little bit less, a little bit less bad conduct.

Speaker 14 Well, maybe he got hired by a bank, you know, maybe has an illustrious new chapter

Speaker 12 yeah i mean like you know like he could start his own fund being like

Speaker 12 we're like two sigma but we take more risk yeah

Speaker 14 two sigma full octane we do have a listener question on this oh yeah the listener asked like why is this an sec case yeah

Speaker 12 you know it's a good question like the answer is like if you read it it's like they violated the anti-fraud provisions of the investment advisors act

Speaker 12 and say why like it's not like two Sigma was doing a fraud on its investors in any obvious way, right? Like, they weren't lying to them.

Speaker 12 But I don't actually know what their market material said, but they probably didn't describe in detail the information security around the parameters for the, you know, like,

Speaker 12 they probably didn't lie to the investors at all. But the SEC is like, ah, you did this thing that just seems kind of bad.
And so it's probably operated as a fraud on your investors.

Speaker 12 And, you know, in this environment, you settle that case.

Speaker 12 Is that a case that the next SEC brings? I don't know. I will say there is one other reason that Tier Sigma got in trouble with the SEC, which is that they have NDAs.

Speaker 12 And I've written this, like, it is sort of illegal for financial firms to have NDAs.

Speaker 12 If you have an NDA that says you won't tell anyone about the secret stuff you learned at this firm, the SEC says, well, but what about whistleblowers?

Speaker 12 What if a whistleblower wanted to come to the SEC and tell us that you were doing securities law violations? Fair question. That NDA would prevent them from doing that.

Speaker 12 That's a violation of our whistleblower protection rule. And so the SEC goes after all these firms for having NDAs that don't specifically say, but you can tell the SEC.

Speaker 12 And in fact, Two Sigma had NDAs that did say you can go tell the SEC.

Speaker 12 But the SEC said, well, but they didn't say that you were, they said, you know, you had to represent that you hadn't already disclosed any confidential information.

Speaker 12 And that part didn't say you can have already told the SEC. And so the SEC fined Two Sigma for having this NDA that sort of said you could tell the SEC, but didn't say it in the right way.

Speaker 12 That was the last one. Never see that case again.
That's it.

Speaker 14 Enjoy it.

Speaker 12 That's not legal advice, but you'll never see that one again. Man.

Speaker 14 Paul Atkins, over to you.

Speaker 14 Is he confirmed yet? No. No.

Speaker 14 Paul Atkins, potentially over to you soon.

Speaker 12 And that was the Money Stuff Podcast. I'm Matt Levine.

Speaker 14 And I'm Katie Greifel.

Speaker 12 You can find my work by subscribing to the Money Stuff newsletter on Bloomberg.com.

Speaker 14 And you can find me on Bloomberg TV every day on Open Interest between 9 to 11 a.m. Eastern.

Speaker 12 We'd love to hear from you. You can send an email to moneypod at bloomberg.net.
Ask us a question and we might answer it on air.

Speaker 14 You can also subscribe to our show wherever you're listening right now and leave us a review. It helps more people find the show.

Speaker 12 The Money Stuff Podcast is produced by Anna Mazarakis and Moses Andam.

Speaker 14 Our theme music was composed by Blake Maples.

Speaker 12 Brendan Francis Newnham is our executive producer.

Speaker 14 And Sage Bauman is Bloomberg's head of podcasts.

Speaker 12 Thanks for listening to the Money Stuff Podcast. We'll be back next week with more stuff.

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