Category Archives: Where are the customers' yachts?

brokers and standards of care: the SEC study

January 30, 2011 By in Getting financial advice, How your broker gets paid, Industry Analysis, Investment firms, mutual fund holders and financial advisors, Portfolio management, Where are the customers' yachts? Tags: , , , , Leave a comment

the report

Last Wednesday the SEC published the results of a study on the differing legal obligations of brokers and investment advisers to their clients.

The SEC’s bottom line:

–while customers are generally satisfied with the investment advice they receive, they don’t really know what standards of conduct their brokers or investment advisers are legally held to.  In addition, they sometimes mistakenly think brokers are required to perform to the same high standard as investment advisers.

–the standard of conduct for brokers should be raised to match that for investment advisers, “when providing investment advice about securities to retail customers.”

why the study?

One might think that it was driven by the realization that millions of Baby Boomers will be retiring in the US over the next decade or so.  The vast majority–government workers are the biggest exception–will not have the security of defined benefit pension plans backed by their former employers. Instead, they have the money they’ve saved in IRAs or 401ks, for which they will have investment responsibility, to support them in retirement.

That’s not the reason, though.  The SEC did the study because it was ordered to in the recently-passed Dodd-Frank Act.

broker or investment adviser:  what’s the difference?

in law…

Investment advisers are regulated by the Investment Advisers Act of 1940. 

Broker-dealers are regulated under the anti-fraud provisions of the Securities Act of 1933 and the Securities Act of 1934.

Broker-dealers are specifically excluded from regulation under the Investment Advisers Act.

…and in practice

Investment advisers are fiduciaries.  In practical terms, this means three things:

–the adviser must do what’s best for the client

–the adviser must put the client’s interests ahead of his own, and

–the adviser has to make extensive disclosure of possible conflicts of interest.

Broker-dealers are not fiduciaries.  As a result,

–although brokers aren’t permitted to act in a way that harms their clients,

–they can recommend an investment that is less good than another but which provides a higher profit to the broker.

I’m not sure what the technical requirements for disclosure of conflicts of interest are for a broker.  My experience is that they are, at best, buried in the middle of large amounts of fine print and couched in language that only a specialist would understand. Goldman’s trading “huddles,” exposed in an article in the Wall Street Journal in 2009, are a recent example of differential treatment of institutional clients, not retail, but it’s still a good illustration of the broker mindset.

The huddles are weekly meetings of analysts and traders that ended up generating ideas, some of which go against Goldman’s official stock recommendations.  These trading ideas are communicated only to a few of the firm’s highest revenue-generating clients.  The official recommendations aren’t changed, so most clients continue to be told the opposite story.  (I just looked at a recent Goldman research report.  This practice is described in paragraph 25 of 30 paragraphs of fine print, covering three pages of the report’s total length of seven.).

if brokers are required to become fiduciaries, what changes?

It may be an exaggeration to say that this would radically change the fundamentals of the retail brokerage industry…but, on second thought, that may not be so far from the truth.  For example,

quality of fund recommendations

1.  Some retail-oriented brokerage houses have their own in-house fund management groups.  In many cases, the records of such proprietary funds is mediocre at best.  Yet brokers are encouraged to sell these funds to clients.  In my view, the main factor–other than the underperformance clients experience–is their greater profitability of in-house funds to the firm. If brokers were fiduciaries, presumably they would have to point out that third-party funds have better track records, or to disclose their financial interest.

2.  Brokers might have to disclose that in general no-load funds sold by Vanguard or Fidelity are a better deal that the load funds brokers sell.

3.  When you go into a brokerage office to have an asset allocation analysis done, it may be that the mutual fund recommendations that the computer spits out come only from fund groups that have paid to have their names displayed to customers–or who have agreed to rebate to the brokerage a portion of the management fee earned on shares sold.  Fund groups that decline to pay get no exposure. In other words, the fund recommendations aren’t the objective assessment they appear to be.

A fiduciary couldn’t do this without clear disclosure.  Actually, I think a fiduciary who tried to do this would be run out of town.

4.  If an individual broker does enough business with a given fund group, he may qualify to bring himself and a guest to  an all expense-paid educational seminar (including nightly entertainment),  in, say, Las Vegas, or San Diego or Disneyworld.  Has any broker ever mentioned that possibility when recommending a fund to you?

quality of stock recommendations

5.  Institutional Investor magazine publishes a yearly ranking of brokerage house research and a list of All-American analysts in each industry.  If brokers were fiduciaries, I think they’d have to tell you if, as many have, they’ve laid off most of their experienced researchers during the recession.  So they have no ranked analysts anymore.  And the report you’ve just been handed recommending XYZ Corp as a “buy” was written by a replacement who only has six months experience, no formal training in securities analysis, and is learning to do research on the fly.

All of this would be a little like watching your meal being prepared in the kitchen of a restaurant that probably won’t pass health inspection.  Certainly, brokers don’t want to be forced to allow you this peek under the covers.

are any changes likely, based on the SEC findings?

I doubt it.  Opposition from “full service” brokerage houses would be too great.  It’s also interesting to note that, while the study was done by the staff of the SEC as Dodd-Frank mandated, its conclusions weren’t endorsed by the SEC.

But this did give me another chance to write about some of the less obvious practices of the retail brokerage industry.  So at least that’s something.

State Street’s Limited Duration Bond Fund: an ironic name for a cascade of poor judgments

February 9, 2010 By in Banks, Getting financial advice, hedge funds, Industry Analysis, Where are the customers' yachts? Tags: , , , , , , Leave a comment

The demise of hedge fund investment pools

I’ve been watching the demise of hedge funds over the past few years with what one might call a morbid mix of horror and fascination at the potent mix of marketing savvy, personal arrogance, snake oil and stunning technical incompetence the principals involved have displayed.

…and then there’s State Street

The case of State Street and its Limited Duration Bond Fund is an odd one.   The fund was sold as the equivalent of a money market fund, but ended up making speculative investments (which it misled investors about) using large amounts of leverage. It lost 80% of its value in the last twelve months it was in operation.

State Street recently settled SEC and State of Massachusetts charges by paying fines and reimbursing investors.

It’s rare in today’s world to see a large company, particularly one that projects an image of all-American values and stodgy reliability, to show itself to have no internal moral/ethical compass–nor, it would seem, either a compliance department or any deep knowledge of securities laws.  Also, no one seems to care.

The New York Times article

I first read about State Street’s settlement with the SEC and the state of Massachusetts in an article in the New York Times, titled “State Street Gave Some of Its Clients Better Data.” Huh?  Maybe its reporter/reader fatigue.  Maybe the blowup of a sub-prime mortgage investment pool isn’t news any more.  Maybe a disaster has to be big enough to bankrupt a company–which this wasn’t–to get any attention.

I find three things surprising:

–top management either had no clue about what was going on in the investment management business, or turned a blind eye;

–no one involved in the affair–no portfolio managers, compliance people, supervisors, marketers…stood up at any point and said “What we’re doing is wrong.” (you’ll see what I mean if you read the details below); and

–State Street got a slap on the wrist, and nothing more, from the regulators.

Here’s the story:

..or at least my summary version of it.  (You can get the full details from the State of Massachusetts consent order or the SEC “cease and desist” order.)

1. In 2002 State Street began offering the Limited Duration Bond Fund to institutional investors as an “enhanced cash fund.”  The marketing pitch was that it had all the safety of a money market fund, but with higher returns.  It could do this because it was investing in short-term asset-backed securities and some derivative instruments.  The fund might have some day-to-day volatility.  But it would remain widely diversified, more so than the typical money market fund, would restrict itself to high-quality credits and would use only “modest” leverage, if any, to achieve its goals.

(The idea of a “free lunch” is probably as old as investing itself.  People love it.  Invariably, I think, the investment strategy is based on a market anomaly that gradually disappears.  Then the concept blows up.)

As time passed, the fund increased its exposure to sub-prime mortgages, apparently figuring this was the only way it could generate yield. By the end of 2006, sub-prime had become the majority of the fund’s investments.

Shareholders, however, continued to be informed that the fund was widely diversified and involved only with high-quality credits.

(Where were the compliance people, the internal regulators who are supposed to make sure something like this can’t happen?  How could any responsible person sign the letters to shareholders?)

2. In 2005, State Street changed the way it disclosed portfolio contents to clients.  Previously it had shown the amount of leverage employed by having the portfolio contents add up to a number higher than 100%.  So if the portfolio was 115% invested, for example, that would mean that its market exposure was equal to 115% of the assets under management.  The extra 15% would be achieved through option-like derivatives.

From that point on, however, it showed the funds weightings only as a percent of the total market exposure, without reporting the amount of leverage in the fund.  All investors saw was market exposures adding to 100%.

According to the SEC, by 2007 the fund was no longer using “modest” leverage.  Routinely, 150%+ of assets were invested in sub-prime mortgages.  The new reporting format meant investors couldn’t see this change.

(Compliance?  Management?  who doesn’t see the red flag? could the change to less disclosure have merely been a coincidence?)

3. At some point, State Street decided to allow other internal finds to invest up to 25% of their assets in Limited Duration.  Through contact with the common trading room, membership on the firm’s investment committee and special detailed in-house reports not made available to outside clients, these internal customers learned the true situation with Limited Duration.  As a result, a number withdrew their funds during the summer of 2007.

State Street did not tell outsiders that insiders were selling.   Instead, it continued to assure them that nothing was wrong.  At no time, however, did it reveal the extent of the fund’s sub-prime holdings or its high leverage.  In fact, some external client contact agents told regulators that they were unaware there was any sub-prime exposure.

In one case where an external client withdrew money and then sued, State Street blamed the client for creating the losses by panicking out of the fund at the wrong time!

(Being a fiduciary means taking care of your client before you take care of yourself.  New concept for State Street.)

4. To add insult to injury, when State Street withdrew its internal money, Limited Duration portfolio managers used the most liquid securities to pay them–leaving the least liquid assets for the trusting outside customers.

(Maybe they had no choice, although the SEC says the investment committee discussed how to raise cash to meet anticipated redemptions.  Normally, a portfolio manager works first on selling the least attractive, less liquid assets.  This is partly because selling may take longer, but it’s mostly to avoid the outcome of being stuck with only unsaleable assets in the portfolio.)

Will Wall Street stop providing research from “independent” sources?

December 8, 2009 By in Getting financial advice, Industry Analysis, Investment firms, Where are the customers' yachts? Tags: , , , , , Leave a comment

Background

Remember the aftermath of the collapse of the Internet?  Customers who bought once high-flying tech IPOs that had no fundamental merit and became worthless when the bubble burst filed lawsuits.  So did the then New York Attorney General, Eliot Spitzer. The SEC investigated, as well.

The basis for the uproar was not so much that buyers were caught up in the frenzy and made crazy purchases (although I doubt anyone would have complained if they had made money).  It was instead that the brokerage houses themselves had encouraged their customers by providing research reports from in-house analysts, who wrote that clients should buy the stocks–even though they firmly believed the securities had little value and that the proper course of action would be not to touch them with a ten-foot pole.

The poster child for duplicitous analysts was Henry Blodget, a relatively unseasoned researcher who became an overnight sensation  in 1998 with a prediction that Amazon would double in price, which it promptly did.  That report rocketed him into a job with Merrill Lynch and eventual recognition by Institutional Investor as the #1 expert on the Internet on Wall Street.

Mr. Blodget’s emails to colleagues, in which he derided companies he was touting in his official research, became a key feature of Mr. Spitzer’s case against the big brokerage houses.   Blodget was charged with securities fraud by the SEC, and settled with the agency by agreeing to be banned for life from the securities industry and to pay $4 million in fines and return of investment gains.

The overall brokerage industry settled with Mr. Spitzer.  Among other things, it agreed to provide customers, from late-2004 until mid-2009, not only with in-house research reports on stocks but also with research produced by independent third parties.  According to the Financial Times, brokers paid independents $430 million for their efforts.  (Incidentally, the FT article I cite strings together a number of aspects of the Wall Street research business that are individually correct but make up a picture that I don’t think is particularly accurate–maybe the topic of another post.  But the factual information is interesting.)

Where to from here?

There are lots of cross currents, but my guess is that brokers will return to providing only in-house research as soon as the independents’ contracts run out.  Why?

1.  For one thing, the samples of independent research I looked at in 2004 and 2005 (after that I stopped looking) were pretty awful.  The reports tended, for my tastes anyway, to be long on historical information, technical indicators and computer-driven, trend-following “recommendations”–and short on well-reasoned conclusions.

Why should this be?  I don’t know.  Maybe Mr. Spitzer only said the reports should be independent, not that they had to be good.  Maybe these were the best services out there, so the brokers had to make do.  On the other hand (what follows is just Wall Street humor on my part), you’d have to be crazy to point clients to outside research that’s better than your in-house product.

2.  Wall Street believes that providing research is a money-losing proposition.  The brokerage houses are run by traders, not researchers, so it’s natural that they would think this.  But they’re probably correct.

Over the years, many investment managers–firms, incidentally, that are typically run by marketers, not researchers–have shaped their businesses to rely heavily on brokerage research instead of in-house efforts.  The advantage to doing this?  Research is paid for by clients’ trading commissions rather than taken out of the manager’s fee income.  (Try to get that to change!!)  The brokers argue that they would doubtless get those commissions anyway, even if they provided no services in return.

(An aside:  Just before the financial meltdown, Fidelity, which has an extensive in-house research staff and which is also an industry benchmark for investment management firms trying to justify their research commission payments to brokers, was attempting to curtail such payments severely.  This would have created a real dilemma for rivals that depend mostly on brokerage research for their investment ideas.  Something to watch carefully.)

3.  Many research boutiques are/were staffed by analysts laid off by brokers in their efforts to control costs.  Rehiring them, even as consultants, might have been seen as awkward.

4.  My guess is that brokers’ website monitoring systems show clients never access the independent reports.  So the industry won’t upset anyone and will save $90 million a year by eliminating them.


Brokers: where are the customers’ yachts? Goldman’s trading “huddles”

August 28, 2009 By in Getting financial advice, Where are the customers' yachts? Tags: , , , , Leave a comment

I happened to see an article in the WSJ the other day that both disappointed me and conveyed in a few words how brokers and clients can have diverging interests.  Here’s the link.

Goldman’s weekly trading “huddles”…

The article describes the Goldman practice of having short weekly meetings between its research staff and the firm’s proprietary traders–the ones who operate with Goldman’s own money.  I assume the article is factually accurate.  I haven’t seen a correction or retraction, and the WSJ has subsequently reported that several regulators have begun investigations of the meetings, called “huddles.”

In the “huddles” the analysts and traders discuss stock ideas, including their opinions about near-term prospects for names under Goldman coverage.  The Goldman traders obviously have the conclusions the meetings generate, because they take part.  From the article, it sounds like the institutional salespeople assigned to Goldman’s most profitable fifty or so accounts relay this information over the phone later the same day.

But nothing is published and most clients don’t even know the meetings exist.

Apparently, Goldman written reports all say someplace on them that “salespeople, traders and other professionals” may act against the firm’s recommendations.  I must have read thousands of Goldman reports over the years and never noticed this warning, though.

…are not a big surprise

It shouldn’t come as much of a surprise that Goldman, or any other broker, gives more service to itself and to its best clients.

Nor should it be a shock that the firm isn’t at pains to point this fact of life out.  After all, it’s part of a good salesman’s job to try to turn a commercial relationship into an emotional one, where the client ends up paying more than he should.

[An aside:  Years ago a friend of mine told me about a portfolio management colleague who fancied himself an expert billiards (actually, snooker) player.  He frequently met the brokers he dealt with after work for drinks and a few friendly games of snooker.  He routinely trounced his institutional salesmen, until...he left his portfolio management job and became a broker himself.  As of the time my friend told me about this, the colleague had yet to win another match.]

…but it’s disappointing

Some things I find disconcerting in the article’s description of the meetings, however.  They are:

1.  The meetings were attended by compliance people, the in-house experts on adherence to securities laws.  There’s no mention that the compliance people were any more than passive witnesses, but the mere fact that they were there indicates to me that Goldman knew it was treading in a delicate area.  Notes could easily have been disclosed by posting them on the GS website, but that wasn’t done, either.

2.  Someone (the compliance people?) coached (“guided” is what the article says) analysts to use euphemisms to avoid uttering the words “buy” or “sell” in the meetings.  Apparently, an analyst who had issued a written opinion of “buy” on a stock would say to a trader it was “overbought” or could “go down,” to suggest the trader should sell it.  Although hard to believe, the WSJ makes it sound like Goldman figured that this word trick would get around the necessity of disclosing to ordinary clients the analyst’s most current thoughts.  Coincidentally, but luckily for Goldman, these uninformed investors might well end up being the other side of the trader’s sell order.

More worrying, one might easily think that the idea behind the doublespeak is to ensure that the letter of the law was being upheld, although the spirit might well be being broken.  Or Goldman might have been thinking that the ambiguity of the language used would make it harder for any third party to figure out what Goldman really intended to do.

3.  How did the WSJ find out about the meetings?  My guess is that one of the participants, unable to decide how legal/ethical they might actually be, spilled the beans.

Conclusions:

1.  The regulators will figure out if Goldman has broken any laws.  It could easily be that the answer is none.  For an investor, the bigger issue is the apparent breach of trust.  A client placing a buy order with Goldman for a stock on the recommended list now has to consider that the analyst who wrote the “buy” report may be telling the trading desk the opposite story.  Goldman’s rejoinder to a client protest?–read the fine print in the research report.

In a technical sense, that’s right–caveat emptor. I would have anticipated this kind of treatment in a used car lot.  But I thought better of Goldman.  Small and mid-sized clients probably also thought they had a relationship of reciprocity and fairness with the firm–the “invisible handshake” that Arthur Okun talked about, the idea of “let’s grow rich together.”.  Now they may conclude otherwise.  Even clients in the inner circle may question what information they are not privy to, or whether they will be able to retain their privileged status for any length of time.

2.  The “huddles” also make the Goldman business strategy clear:  concentrate on proprietary trading, hedge funds, a few big clients. GS won’t usher everyone else to the door, but they’ll have to be satisfied with the crumbs that fall from the table.

Does Goldman think it may someday need these other clients?  –say, as distribution capability in case the IPO market revives?  If the WSJ article is accurate, apparently not.

Does it need a retail presence?  other than its bank, no.

Will this strategy work?  It remains to be seen.  It will be easier to judge if the regulators’ probes shed more light on Goldman’s actual conduct and as client reaction is heard.  I think that the biggest risk in an aggressive strategy to find the line between behavior clients will accept and what they won’t is that in the search a firm steps over the line without knowing–and damages its business reputation severely as a result.

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