Two aspects:

the over-allotment

In the case of FB, it was 63.2 million shares (the number is on the front cover of FB’s registration statement).   As noted in the sentence that gives the over-allotment number, this amount of stock is not included in the 421.3 million share figure listed in bold.

What is it, then?

The over-allotment is a kind of insurance or safety precaution that the company issuing stock and the underwriters build into the offering.  The company agrees to sell a specified amount of extra stock to the underwriters at the IPO price if the underwriters ask for it.  In the FB case, it was 62.3 million shares.

When the underwriters divide the stock up and sell it to clients, they distribute the larger amount.  So the FB stock sold to the public amounted to a total of 483.6 million shares (421.3 + 62.3).

If the issue goes well and the stock stays at a price higher than the IPO level, the underwriters purchase the extra stock from the company and deliver it to clients.  That’s the usual case.  For FB, that would have meant an additional $2.4 billion from the IPO.

If, on the other hand, the issue goes badly, the underwriters can buy stock in the open market at the IPO price up to the amount of the over-allotment, without taking any financial risk themselves.  Don’t ask me why, but underwriters are legally allowed to do this for a short period after the IPO is launched.

The underwriters did this kind of intervention with FB just before noon and again during the final hour of trading on its first day.

How do we know?

The underwriters make no attempt to hide their identity or their intentions.  They want other traders to know they have a huge amount of buying power and intend to defend the IPO price.

How did I find out?  I looked at a chart of FB on my cellphone.  I saw the stock stopped its normal minute-to-minute gyrations just after 11:30 and flatlined–just like when someone dies on a TV medical drama.  That’s not natural.  Someone was making a statement about the $38 level.

In listening to hundreds and hundreds of IPO roadshows, I’ve never heard the over-allotment mentioned–ever.  Professionals know it’s there.  For the underwriters, it would be like a restaurant saying it had a great food poisoning doctor on call.

underwriting group vs. sales syndicate

This is really arcane.  There’s no reason to read any further, except that this distinction may explain the bad treatment of some retail investors in the FB IPO.

The money that brokers charge in an IPO is for two slightly different functions.

–They have a percentage interest in an underwriting group.  Although I use underwriter and broker as synonyms in everything I write, that’s not precisely correct.  The underwriting group buys the stock from the company and then resells it. It’s paid a small amount for taking the “risk” the members will be unable to resell the stock.  Remember, though that the brokerage companies have firm–though not legally binding–commitments to buy the stock from clients who know they’ll never see another IPO allocation if they renege (legally, any client can return the stock and get his money back up until shortly after the final prospectus is issued.  Se my post on preliminary and final prospectuses).

–the underwriting group employs a selling syndicate to distribute the shares it buys from the company.  It’s made up of the same firms that comprise the underwriting group, but possibly in different proportions, based on the size and strength of institutional and retail distribution networks.  Normally, the selling commissions are much higher than the underwriting fees.

Why write about this?  The accounts I’ve read mention only Morgan Stanley as a broker whose retail clients received much larger allocations of FB stock than they anticipated.  My guess is that Morgan Stanley carved out for itself an especially large piece of the selling syndicate pie.

On Wednesday, the New York Times published the resignation letter of Greg Smith, a (former) derivatives salesman at Goldman Sachs.  Smith, a 12-year employee, says he’s leaving because the GS work environment has become “toxic and destructive.”

My first reaction:  plus ça change…

In 1989, Michael Lewis, of later Moneyball fame, wrote Liar’s Poker, an expose of the culture of cutthroat competition and macho banality of Salomon Brothers while he was a bond salesman there.  Salomon, you may recall, had to be rescued by Warren Buffett after top executives colluded to illegally manipulate prices in the US government bond market.  What’s left of the firm now resides inside Citigroup.

Yes, Moneyball shows that Lewis is sometimes reluctant to let facts stand in the way of a good read.  Nevertheless, I think Liar’s Poker is an important book.  In fact, I’ve asked all the securities analysts and portfolio managers I’ve trained since its publication to read it.

Three points from the Lewis account still stand out to me:

–the strong internal pressure for salesmen to get unattractive, illiquid bonds off the company’s books by persuading some gullible customer to buy them

–a sketch of the growing dismay of a certain client as the realization dawns that he has been sold a toxic security that he can’t resell and which will get him fired when his bosses figure out what he’s done (why they don’t already know is beyond me)

–the feverish rush to unload dud bonds on a client the brokerage community figures is so unskilled that he’ll soon be fired.  Like blood in the water to sharks.

Welcome to Wall Street.

an adversarial relationship

What the Michael Lewis book and the Greg Smith letter bring out most strongly, to my mind, is the simple truth that the relationship between broker and client is a commercial one where the interests of the two sides are not aligned.

Two senses:

–Every time you trade, you think you know more than the other party.  You think any security you buy is undervalued and that the other side of the trade will give up future profits by selling it to you at today’s price.  You expect anyone you sell to to lose money by taking your offer.  You also expect the broker to act as the counterparty if he can;t find someone else.  It’s like baseball.  You take the field expecting to beat the other side.  You’ll win; they’ll lose.

–Investment managers earn higher fees by having superior performance, which helps attract new assets; brokers get paid in direct relationship with the amount of trading the client does.  Experience shows, however, that for most managers superior performance and the amount of trading are inversely related.  So, what’s good for the manager isn’t particularly good for the broker, and vice versa.

In addition, each side markets itself to the other.  That is, each tries to replace the cold commercial structure of the relationship with a warmer “like me, trust me” one.  That’s partly because we’re all decent people.  It’s partly so the other side will continue to do business with you after you’ve traded them into the dust.  And it’s also partly because it’s a way of gaining a competitive advantage, of tilting the ratio of compensation to services in your favor.  In my experience, brokers are much more successful in getting clients to deliver excess compensation than clients are in getting excess services without payment.

the business has changed

A generation ago, the principal business of investment banks was providing comprehensive financial services and advice to companies of all sizes–everything from working capital finance to strategy to mergers and acquisitions.  For small- and medium-sized firms, its investment banker may well have held a seat on the board of directors.

Not any more.  In today’s world, however, most firms have an in-house staff of financial professionals who do most of this.

At the same time as businesses based on building long-term relationships of trust have eroded, the trading business, which focuses on rapid-fire, reflex-action, individual transactions, has exploded in size and scope.

As the composition of company profits for brokers has changed, so too has the character of those who rise to positions of control.  The traditional investment bankers, whose temperament is to focus on long-term relationships, are out.  High skilled traders, who focus on short-term profits, are in.

playing hardball vs. cheating

Where to from here?

The huge profits that trading businesses have generated during the past decade are already spurring changes.  Institutions are already shifting to electronic crossing networks, where fees are much smaller and where the activity won’t be seen by a broker’s proprietary trading desk.  Retail investors are doing more business with discount brokers.  They’re increasingly shifting, I think, to passive products like ETFs as well.

Institutions have long memories.  In cases where they believe a broker has crossed the line between aggressively competing and cheating, they simply won’t do business with them anymore.

there’s something about Europe, too

Did it really take Greg Smith 12 years to figure out what brokers do for a living?   …or was it his final year, in Europe, that changed his mind?  Why is it that the losing end in all the toxic credit default swaps was a European bank?

business has changed away from long term repationships—now cos do for selves, change of control toward traders in brokerage firms

what Apple is

Just to be clear,

–Apple is a US-based company.

–It’s incorporated in California, where its headquarters is located.

–Primary trading is on NASDAQ.

–AAPL doesn’t pay a dividend.

–AAPL isn’t just a large-cap stock.  It’s a MEGA-cap stock.

The median market cap for members of the S&P 500, the large-cap index, is a touch under $12 billion.  AAPL, in contrast, has a market cap of close to $550 billion, or 45x the median.  The company has no debt and over $100 billion in cash on its balance sheet.

what funds hold AAPL shares

Despite this description, according to the WSJ the following kinds of funds hold AAPL shares:

–40 funds that focus on dividends in selecting stocks

–50 funds that specialize in small- or mid-cap stocks

–3 Fidelity funds that specialize in Europe

–international funds, including the Ivy International Growth and the Waddell & Reed Advisors International Growth

–the BlackRock High Yield Bond Fund, a $5.9 billion junk bond fund that held $8.3 million in AAPL shares at 12/31/11.

how can these funds do this?

In one sense, it’s crazy.  How can you trust a manager who says he’s going to buy small, fast-growing stocks with market caps below the S&P 500 median for you, after you see his outperformance is coming from a half-trillion dollar stock?  In this regard, the BlackRock High Yield position that the Journal reports is extremely hard for me to understand.  Ignore the fact that it’s a bond fund owning stocks.  The AAPL position size is so small, at 0.14% of assets, that it’s immaterial to fund performance.  There has to be more to that story.  One guess is that the position is much larger today.

In another, narrowly technical, sense–even though the fund name, and presumably its marketing materials, don’t give the slightest hint that this may be going on–fund rules doubtless permit the purchases.

If you read the prospectus carefully, it will surely say something like the fund will achieve its objective (of buying small-cap, or foreign stocks…) by having at least, say, 65% of the fund assets invested in the specified kind of securities.  It will go on to state that the fund reserves the right to invest the rest of the fund in other stuff.  (By the way, the prospectus may also say that for temporary defensive purposes, the fund has the right to redeploy its assets entirely to cash or to Treasury bonds, or some other presumably safer form.)

why do they do this?

I think the obvious answer is the correct one.  The portfolios in question want to achieve a performance advantage, either over the other funds in the same category or against their benchmark index, by buying securities that are outside their normal investment universe.

Is this illegal?  No, because of the prospectus disclosure.

Is it unethical?  In my view, yes.  An international manager might try to argue that because APPL manufactures and sell products abroad, it’s actually a foreign stock.  Someone might buy that explanation.  It certainly wouldn’t fly in the institutional pension management world, however.  And small-cap managers, who typically charge higher fees to compensate for the extra work involved in small-cap, don’t have an ethical leg to stand on.

what to do

Figure out how much AAPL you actually own and ask yourself if you’re comfortable.

Remember that any S&P 500 index vehicle you hold is about 4.5% AAPL.  AAPL may also be 20+% of any tech fund you own.  And, as the WSJ article suggests to me, it might be wise to take a quick look at all your mutual funds or ETFs to see how much AAPL is in them.  You can get the information from the management company website, the SEC Edgar site, or to the latest report you’ve gotten from the fund itself.

To my mind, the ETF phenomenon is not just a story about price advantage.  I think the popularity of ETFs is an indicator of a fundamental sea change in sentiment on the part of individual investors.  For me,ETFs mark the end of the almost twenty-year love affair of individuals with actively managed mutual funds–and maybe with mutual funds, period–that began after the stock market crash in 1987.

Just as individuals shifted from relying on retail brokers to puting their faith in mutual fund portfolio managers after Black Monday, the trigger for the change in direction has been the Great Recession.  Its cause is the continuing failure of even the most highly publicized active managers to beat their benchmark indices-or, even if they did, to preserve during the downturn of 2007-2009 what their clients thought of as enough of their wealth.

The new trend is for individuals to take responsibility for themselves and to allocate their portfolios by sector through narrowly focused passive vehicles, that is, ETFs.

price war?  yes and no

Exchange traded funds, which now control over $1trillion in assets in the US, appear to be entering a new phase of competition, one marked by sharp reductions in their management fees.  The media are calling this a “price war.”

It’s not a price war in the most dramatic sense–where firms with excess production capacity slash selling prices in a desperate bid to keep their heads above water, or to generate cash flow needed to repay debt.  But it still is one, in the sense of a widespread fall in fee levels.

What do the fee reductions mean? 

Two aspects:

a maturing industry

1.  At one time, ETFs were competing for investor dollars primarily against their cousins, index mutual funds.

During this period, simply having an expense ratio lower that that of an index fund was all an ETF needed to succeed.  Today, despite the fact that their per share expenses are already far below those of index funds, ETF companies are beginning to slash their fees further.

(An aside:  to some extent, the ETF fee advantage is offset by the commission charges that ETF transactions bring with them.  More important, buyers pay more than net asset value at the time of purchase, sellers collect a bit less.  There isn’t enough data available for third parties to determine what this bid-asked spread typically amounts to.  Comparisons of ETFs vs. index funds usually deal with this issue by ignoring it, making ETFs look somewhat more attractive on a cost basis that then actually are.)

That’s because competition between ETFs and index funds is over.  Index funds have been defeated.  The new contest for customers is between one ETF and another.

closing the door to newcomers

2.  Investment products like mutual funds and ETFs have substantial up-front fixed costs, mostly computers and professionals to manage the money and safeguard it.  So they initially run at a loss.  Once a fund gets to the point where fees cover these costs, however, new assets bring almost pure profit.  Margins expand fast.

At some point high margins become a negative, not a positive.  They act as a lure for new competition.  And they allow new entrants to become profitable quickly.

Therefore, lowering fees has a second purpose.  It lengthens, possibly by an enormous amount, the time a potential new entrant must operate at a loss–and increases proportionally the amount of assets he must gather in order to reach profitability.  Naturally, this decreases the attractiveness of the industry to newcomers.  So, as counter-intuitive as it may seem, the fee reductions also serve to preserve the long-term profit profile of at least today’s very largest players.  It makes no economic sense for anyone else to enter the fray.

It’s interesting to note that of the three largest sellers of ETFs in the US, BlackRock, Vanguard and State Street, only Vanguard has a significant actively managed mutual fund complex.  All the other last-generation investment companies have had their heads in the sand.  Internal forces of the status quo have preferred to let assets leave rather than create an ETF divisions that might be headed by a political rival.

The diminutive Depression-era bank robber, Willie Sutton, was reportedly once asked why he chose banks to hold up.  His alleged reply:  “because that’s where the money is.”

Whether Mr. Sutton actually said that or not, the answer contains the essence of this post.  Hedge funds have more money to spend.  Until recently, they’ve been very far from the focus of regulatory and client attention to how investors spend client money;  even now, it seems to me they’re subject to far fewer restrictions on their trading activity than traditional long-only investors.

Finally–and this may just be my personal axe to grind–many hedge funds are the creations of professional traders, not researchers.  To me, this means they don’t have the experience or mindset to develop useful research conclusions by themselves.  Yet their own marketing claims put them under great pressure to produce superior results.  And they don’t have the compliance awareness that’s repeatedly pounded into every US-trained analyst’s head to make it clear what’s legally permissible and what isn’t.

Details:

“soft dollars”

Clients compensate money managers in two ways.  One is clear–they pay management fees.  The second is less obvious–they give their managers the power and influence with brokers that comes from controlling large trading commissions.  In my last job, for instance, in round numbers the firm spent $100 million a year in trading fees.

Managers who manage pension plans (subject to ERISA regulations) or or vehicles like mutual funds catering to ordinary individuals (subject to SEC oversight) have a fiduciary obligation to minimize the commissions and fees they pay for trading.

One exception:  they can pay extra-high amounts as compensation for research services brokers provide.  These services can come from the brokerage house itself.  Or, like Bloomberg terminals or copies of the Wall Street Journal, they can be paid for by the broker but provided to clients.  The commissions (or bid-asked spreads for OTC stocks) that pay for research services are called “research commissions” or “soft dollar” commissions.

clients’ money

The key benefit to the money manager is, of course, that the “extra” amount involved in a research commission comes out of the client’s pocket.  One might argue that the manager should pay for his own Bloomberg.  But that’s not industry practice.

Research commissions are a potential area (and, in the past, an actual area) of abuse.  So they are under increasing scrutiny.  A common rule when I was managing institutional and mutual fund money was that the percentage of research commissions for the overall asset management effort should be no higher than the average of all major money managers.  Five years ago, that was about 15%.

Trading frequency is also monitored carefully.  Managers who have above-average turnover rates risk losing their customers–and their jobs.

restrictions on use by traditional money managers…

Anyway, today’s traditional money managers have severe restrictions on the way they can use commissions to buy information.

…but not for hedge funds

On the other hand, to the degree that hedge funds manage money for wealthy individuals or non-pension institutions, they’re subject to neither asset turnover nor research commission limitations.

Hedge funds are Fort Knox to the traditional money managers’ kids’ piggy banks.

management fees

Yes, the famous ” two and twenty,” that is, a management fee of 2% of the assets per year + 20% of any investment gains, that hedge funds charge may well be fading out.  Nowadays, some may “only” collect 1.5% and 15%.  Compare that with the long-only manager charging, say, .75% of the assets annually with no profit participation.  I’m not saying we should feel sorry for traditional money managers.  But the comparison is Fort Knox vs. maybe a small-town savings and loan.

Two implications:  there’s much more at stake for hedge funds if they generate outsized returns, and here’s much more money potentially sloshing around inside the partnerships and in the partners’ pockets.

separation of research and trading

In the US, there’s a strict separation between the research and planning a portfolio manager does, and the execution of that plan through the trading room.

Typically, the PM designates the brokers he wants to receive research commissions over, say, a three-month period of time. He submits his trading orders to the trading room.  But he cannot direct a given order to a specific broker.

The idea is to prevent the PM from directing business to his friends or from taking a bribe to buy some dud stock a broker is trying to unload from his inventory.  This isn’t a cure-all.  The rules don’t end wrongdoing.  They shift the locus of possible wrongdoing to the traders, where there’s arguably less room for monkey business.  But, for good or ill, that’s the way the system works in the US.

In contrast, hedge funds haven’t typically had these safeguards.  In fact, it may well be that the chief PM is also the head trader–or sits on the trading desk right next to the head trader.  So there’s the opportunity for all sorts of under-the-table activity that would be impossible in a traditional money management firm.

PM as researcher

Scratch a successful equity portfolio manager in the US and you’ll uncover an exceptionally good securities analyst, who may have spent a decade or more polishing his craft.

In my view, the last thing a good analyst wants is inside information.  If you’re in a meeting where a company executive accidentally blurts out some piece of confidential information that you’ve already figured out for yourself, you’re stuck.  The information is suddenly transformed from the product of your creative mind to a company secret revealed.  It’s now forbidden fruit; you trade on it at your regulatory peril.

Though some hedge funds are headed by experienced analysts, others are run by professional traders or marketers.  The latter have their own strengths, but in my experience they don’t have the nerdy turn of mind a true analyst needs.  Yet they’re under tremendous pressure to come up with novel ideas to justify their high fees.  I’d imagine that this creates a big temptation to either accept–or even solicit–inside information.

compliance

Over the past twenty years or so, traditional money managers have all built sophisticated departments to supervise regulatory compliance.  Compliance rules visible every day.  Periodic training sessions are mandatory.  In my experience, emphasis is on avoiding any action that could possibly be (mis)interpreted as being intended to violate the laws.  Better safe than the subject of an SEC inquiry.

Pluck a couple of proprietary traders or a sell-side analyst out of their brokerage firms and set them up as hedge funds, and there isn’t the same awareness.  They may not know what the laws are.  They may not even see the necessity of setting up safeguards.  So the whole corporate culture may evolve into one where principals are encouraged to push the legal envelope in seeking proprietary information from third-parties about potential investments, rather than to safeguard the firm against the negative consequences of using inside information.

Two brokerage areas routinely call on corporations.  They are:

–investment bankers.  They’re somewhat like bank lending officers, in that they visits company to try to sell services.  In the investment banking case, that’s typically the possibility of stock or bond offerings, mergers and acquisitions advice or general consulting.

–securities analysts specializing in the company’s industry.  Analysts are members of the firm’s research department.  For smaller and privately held firms, the analyst will want to gather information that may be useful in his reports on publicly traded companies.  He’ll also want to set the stage for possible investment banking business with his firm as/when the company goes public.  For already publicly traded companies in the analyst’s coverage universe, the visit will be for updates–usually right before the analysts issues one of his periodic reports to clients.

Prior to 2000, securities analysts usually reported to the head of investment banking.  After the Internet Bubble-related scandals, where analysts were seen to have written inaccurate reports solely to stimulate demand for the stocks of companies their firms had brought public, that supervisory relationship has been broken.  I’m not sure there is a general rule about who supervises the research department today.

securities analysts

calling on clients

Securities analysts also spend a lot of time interacting with the firm’s brokerage clients, in the expectation that the client will trade with the firm–thus generating commission/spread profits–in return for the information provided.  This interaction may either be with the client’s own securities analysts, their buy-side counterparts, or with the client’s portfolio managers.  Communication may be by phone or e-mail or in person.

Like any other brokerage service, the appropriate institutional salesman will control/advise the analyst about the quality (phone or in person) and quantity of time he spends with a given client.  This will depend on the importance of the client to the firm, measured by the profitability of the relationship.

spreadsheets

Analysts or their assistants create spreadsheets to forecast company earnings.  They also write research reports that either analyze the company’s operations in detail, or highlight recent developments and their significance.  As well, they make buy, hold and sell recommendations for the company’s stock.

technical background?

In many cases, analysts will have worked in the industry they cover before moving to Wall Street.  They may also have relevant advanced technical degrees, such as in petroleum engineering for oil and gas analysts, or in electrical engineering for analysts covering technology hardware firms. (In my experience, such technical training can be a mild positive.  But it can also be a major hindrance, if the analyst mistakenly thinks this exempts him from having to do actual financial analysis of a company’s profit prospects.)

reliant on companies for information

No matter what their background, however, analysts remain very reliant on the companies they cover for industry and firm-specific information.  They’re also dependent on the continuing attractiveness of their industries to investors, whose commission business with the broker influences the analyst’s compensation.

In my experience, therefore, analysts tend to be a bit like home town sports announcers.  They’re highly reluctant to make negative assessments about their industries.  After all, that puts them out of work.  They also can be subject to considerable pressure from holders of large positions in a stock not to write anything negative about it.  Also, some companies may demand that analysts not only make positive statements but also adhere closely to company-issued earnings guidance.  Non-compliance can mean that the offending analyst is denied access to company management that’s routinely given to others.

Sounds crazy, doesn’t it?  But stuff like this happens.  The case of bank analyst Mike Mayo is perhaps the most famous recent case of this type.

A possible response to this pressure is for an analyst to give a “base case” in print, but to supplement this with a “whisper” number that’s noticeably different.  This will be disseminated to clients orally, with or without attribution to the analyst, but never put down on paper.

To be successful, analysts have to be good either at marketing themselves and their research to clients or at analyzing the companies they follow.  Of course, it would be better to excel at both, but in my experience that’s not necessary.  At one end of the spectrum there are (only a few) analysts who have completely pedestrian information, but are witty and know where a client likes to be taken to lunch.  For the majority who provide analytical insights, they come in several varieties:

–able to forecast earnings very accurately

–able to give a good qualitative appraisal of the industry and where all the companies stand within it

–able to say whether the stocks will go up or down.

These are all separate skills, and each worth paying for, I think.

A little less than two weeks ago, the media heralded the opening of another in a long line of investigations by the SEC of insider trading involving hedge funds.  This time, those reportedly targeted include an institutional salesman from Goldman Sachs and the former head of GS’s research in Taiwan, as well as hedge funds who allegedly traded on inside information passed by the GS pair.

what do these people do for a living?

The press reports made me start to think that I should write on three associated topics:

–what does an institutional salesman do?

–what does a sell-side securities analyst do?

–why the focus on hedge funds?

three posts, starting today

I’ll answer these questions–from my perspective as a former client, never myself having been a hedge fund principal, an institutional salesperson or a sell-side analyst–over the next three days.

Before I start, though, I should say that the brokerage landscape has been changing, with increasing speed, over the past decade, and to the detriment of many institutional salesmen and industry analysts.

Two reasons:

–pension fund clients and mutual fund boards of directors are paying increasing attention to the amounts paid by traditional long-only investment managers to brokers.  This is only natural, since this money comes out of the pockets of the clients, not the managers (more about research commissions in Wednesday’s post), and

–increasingly, successful traders (think: Jon Corzine) have become the heads of major brokerage firms.  They’ve been reshaping the firms in their own image, and shifting emphasis away from areas like research and institutional sales.

what does an institutional salesperson do?

An institutional salesperson is a marketer.   He’s is in charge of the overall relationship between the broker and a specific set of money manager clients.  The job is to ensure that the broker makes a profit on each client relationship.

The institutional salesperson is a gatekeeper, in two senses:

–he regulates access to brokerage services, depending on the level of client payments.  “Access” includes things like: phone calls or private visits from industry analysts; private meetings with companies on road shows hosted by the broker; one-on-one company meetings at broker-hosted industry conferences; favorable allocations of initial public offerings (the salesman is only one of several parties in this discussion, though).

–he also regulates the timing of access.  Does a requested analyst drop everything he’s doing and rush to the client’s offices?  …or does he make a phone call the following day?  Is a company meeting for an hour at 10:00am?  …or twenty minutes at 5:30pm?  …or a conference call, instead of face to face?  …or a canned presentation at a group lunch?  If the salesman makes personal calls to relay information from the broker’s morning meeting (in addition to internet dissemination) about companies he knows the client is interested in, who is the first call and who is the tenth?

relationship:  commercial to emotional…

As is the case with any effort to sell recurring services, part of the job is to try to turn a commercial relationship with the client into a personal one.  To that end, institutional salespeople study and cultivate their clients very carefully.

In my experience, salespeople know much more about the client and what makes him tick than he would ever dream.  If the client likes to be taken to lunch or to sporting events, fine.  If the client likes to gossip about rivals, okay.  If he likes flattery, so be it.  If the client responds better to salespeople who are tall/short, young/old, male/female, slim/portly, sports nut/nerd–even if the client is unaware he does so–assignments will be altered to suit. (I’ve even seen one brokerage house–long since merged away–that wanted to establish a certain image.  It had only salespeople who were young, slim, good-looking and very tall.)

…or maybe not

An intelligent salesperson (and that’s just about every one I’ve come into contact with) also makes judgments about the client’s overall business.  Is it on the rise, or has a former hot hand turned permanently cold?  Adjustments are made, accordingly.  One of my friends used to classify clients explicitly in terms of the BCS matrix.  I never asked where I stood.

information collection

The salesperson also has an information gathering function.  Particularly in the US, money managers take pains to separate research decisions made by portfolio managers and their implementation through the trading desk.  One reason is to disguise their investment strategy from their trading partners (another is to guard against bribery).  However, experienced institutional salespeople can often ferret out information by reading between the lines in their conversations with clients–data which is immediately relayed to the broker’s trading desk.  Salespeople also usually know their clients’ analytic strengths and weaknesses very well.  If they believe a key client is buying a stock in an area where he’s an expert, the salesperson may give other clients an extra nudge–after alerting the trading desk, of course.

In a good year, an experienced institutional salesperson in the US can make millions of dollars.  And a strong working relationship with a client who becomes a super-star manager can make an institutional salesperson’s career.  On the other hand, high compensation also makes someone like this an obvious target for downsizing during a period of brokerage retrenchment like the one we’ve been going through over the past few years.

Back to the media reports on the SEC investigation:  can an institutional salesperson develop inside information on his own?  Maybe, but that would be very unusual, in my view.  I think a more likely accusation would be that a salesman either traded on inside information himself or passed it on to a client who did.

Tomorrow:  the sell-side securities analyst.

One of the most useful tips on company analysis I’ve ever gotten came from a former P&G marketing executive who was working for a hotel company when I heard him speak.

He said that if you run an ice cream stand that sells vanilla ice cream, you don’t start to sell strawberry (my favorite, by the way) until the market for vanilla stops growing.  In other words, once you see a company begin to segment the market for a product (by offering several varieties), you know that sales of the “plain vanilla” version are tapping out.

the new Pimco Total Return ETF

That’s my take on the Pimco announcement that it’s launching an ETF version of its total Return bond fund, the largest actively managed bond mutual fund on the planet, two days from now.  It means investors have stopped buying bond mutual funds from Pimco.  Since Pimco is the biggest bond manager and has the best long-term record, I think this also means investors have stopped buying bond mutual funds, period.

Remember, too, that Pimco–a unit of Deutsche Bank–is a marketing monster.  It’s executives are constantly pounding home their message, often packaged as “economic” commentary, that now is the best time to buy more bonds.  During the two decade+ period of secular long-term interest rate decline that ran from the early 1980s until recently, that stance was 100% correct.  Not anymore, though.

True, Pimco had a year to forget vs. peers in 2011.  But I don’t think that’s the issue.  Pimco’s long-term record is strong.  And the company had begun laying the groundwork for the new ETF before its performance weakness unfolded.  Despite Pimco’s relentless sales efforts, I think investors are finally catching on that bonds may not be the one-way street that they’ve come to expect.  Even if the light bulb hasn’t gone on, investors are at least signalling that they don’t think they need any more bonds.

ETFs aren’t a walk in the park

performance differences

Many bonds are surprisingly illiquid.  Pimco won’t be able to use the much more easy-to-trade derivatives market to change the shape of its ETF holdings in the way it does in its mutual fund portfolio, however.  So it’s possible that the ETF won’t track the mutual fund very closely.

That’s potentially a big concern.  Holders of the vehicle that’s doing less well will always be unhappy.

filling a need nobody has

So far, actively managed ETFs haven’t been very popular with investors, who have preferred low-cost passive products.

cannibalization

Cannibalization of the Total Return mutual fund by the lower-cost ETF might seem to be an issue, but I don’t think it is.  Two reasons:

–taxable investors with unrealized gains on their mutual fund holdings won’t switch to the ETF because they’d trigger capital gains tax

–it’s always better to cannibalize an existing product with a new one of your own rather than have a rival do it to you with one of his.

conclusion

The new ETF will be interesting to watch, if nothing else to see how successful it is in gathering assets.   Still, I think it’s probably as close as we’ll get to a bell ringing to signal the top of the market.

That’s basically what happens in investment-related businesses during downturns–people find other, unrelated industries to work in.

Looking at the situation a little more systematically,

finance has two main branches–three if you count the often bizarre area of financial “theory” that prospective finance teachers must master.

–commercial finance, commercial banking and corporate finance.  It deals with areas like lending, capital structure, budgeting, financial management controls, investing/raising cash for corporations, communicating with investors and regulators.  It’s generally insulated from the violent ups and downs of securities markets.

–investments, which deals with the structure and practices of securities markets.  People who focus on this branch of finance are generally much higher paid and much more highly specialized.

While it’s common for a commercial finance professional to move among different areas during a career, however, there’s virtually no carryover in skills, other than at the most basic level, from the investment specialty to the broader world of commercial finance.  In fact, other than early in one’s career, there’s very little movement possible among various areas–like stocks, bonds, trading, investment banking–within investments.  Career paths are that highly specialized.

This is a recipe for big career trouble for investment people if your sub-specialty suddenly has too many workers.

buy side vs sell side; professional investors vs. investment professionals

The industry commonly splits jobs into buy-side (investment management) and sell side (investment banking and brokerage).  There’s also typically very little movement between these two.  You can also distinguish between professional investors (the people who actually make investment decisions) and investment professionals (trading, sales/marketing and recordkeeping functions that provide services to portfolio managers).

professional investor issues.  The main industry problem over the past several years has been the decline in the value of assets under management.  This is the key problem for profits, since professional investors typically charge a percentage of assets under management as a fee.  Investment firms are also highly operationally leveraged–meaning they have roughly the same costs, no matter what the level of assets is–so the loss of assets under management results in a disproportionately large fall in operating income before compensation of portfolio managers.

The moves to index products and from equity to fixed income, both of which generate lower fees, haven’t helped, either.

What do investment management firms do?  They prune the least profitable products, eliminate staff and lower the level of compensation for almost everyone who survives.  There isn’t much else they can do.  Laid-off money managers either go into business for themselves (massive layoffs of value-oriented PMs in the late 1990s formed the basis for much of today’s hedge fund industry) or find smaller, often regional or local, firms to work at.

investment professional issues.  On the buy side, firms trim their trading and marketing staffs and lower compensation for those who remain.  The investment industry is mature, however, meaning there are few new customers.  So firms gain business mostly by taking it away from other firms.  So marketing is a vital function–more important than the investment management itself.

On the sell side, it’s important to distinguish between high-value employees, who are masters of their trading or investment banking trades, and low-value workers, whose main function is to act in a sense as “overflow” capacity.  That is, they answer the phone and process orders, or visit clients and make presentations, during cyclical peaks in business.  They may not add much value, but the firm avoids losing potential profits by being unable to respond, even badly, customers’ requests.

Such second-tier workers are paid a lot, both in absolute terms and relative to the value they add.  But when business slows down, they’re the first to be laid off.

First-tier investment professionals typically earn (much) less in lean times.  They also risk being laid off, as well.  Like their portfolio manager counterparts, they may end up at regional or local firms.  Boom times give second-tier workers an inflated sense of their own abilities.  Typically, though, they’re unable to remain employed in the investment industry during downturns and eventually end up working in other professions.

where are we now?

My sense is that the investment industry is at a cyclical bottom for employment.  But the industry still has enormous idle capacity available with the staff it now has.  We won’t see the boom times of 2004-2007 again soon.

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.