Category Archives: Trading

taking out a fresh sheet of paper

March 27, 2012 By in Constructing a Portfolio, Portfolio management, taking out a clean sheet of paper, Trading Tags: , , , , , , , Leave a comment

the tyranny of what we own

The current structure of our equity holdings exerts an influence on our investment thinking in a number of ways.  Most are normally invisible.  Usually it’s only when performance begins to get ugly that we turn a totally objective eye on what we own.

For one thing, there’s a powerful psychological tendency for our gaze to jump over positions that are losing us money (because we need to be right).  As a result, the dogs of the portfolio stay hidden longer than any of us would like to admit.  That’s why regular performance attribution analysis is so important.  (I’m not saying that we should jettison a holding if it doesn’t live up to our expectations right away.  We should give those expectations a sanity check, though, if the stock takes a nose-dive shortly after day one.)

For another, in a taxable account, we all are tempted to let the IRS tail wag the dog.  That is to say, we all weigh, at least semi-legitimately, the capital gains tax due on profitable holdings as a cost of making any change.  Because the tax is a concrete here-and-now expense, as opposed to the maybe-it-will-happen, maybe-it-won’t potential of future capital gains, it tends to have much more influence than it should in the decision to sell or not.

In a wider sense, there’s always a certain inertia associated with any portfolio, even while it’s still meeting our general performance expectations.  It is our intellectual child, after all.  We’ve done a lot of work in bringing it into being.  We know that more trading and more portfolio turnover, however emotionally satisfying, are almost always associated with worse investment results.  So why rock the boat.

taking out a fresh piece of paper

Periodically, though, it’s useful to ask ourselves what we would buy if we were creating a new portfolio from scratch.

Try it.

Don’t work from a list of existing holdings.  Sit down instead with a blank piece of paper (or document or spreadsheet).   Use whatever research materials you have at hand–a copy of Value Line, a discount broker’s screening services, a list of S&P 500 sector weightings and major constituents.  Read the company annual reports and 10-Ks.  Figure out what a portfolio–built today–should look like.  While you’re doing this, don’t look at what you already own.

When you’re done, compare this list–names and weightings–with what you actually hold.

You may be surprised at the differences.

why write about this now?

When I was managing money for others, I’d do the “clean sheet” exercise every six months or so.  I asked the portfolio managers working for me to do the same.

As it turns out, I’m currently investing in an IRA a lump sum pension distribution I recently received.  I want the money to be in more mature, income oriented stocks than I’d normally be attracted to.  This is compelling me to create a new portfolio from scratch, one with somewhat different objectives than I’m used to.  Hence this post.

I decided to read through a three-month cycle of Value Line reports as a way of generating new ideas.  I’ve been looking at the safety rankings and historical data on dividends and earnings growth.

I’ve been surprised at how many potentially interesting stocks I’ve found.  (Some of the prose reports in VL are quite good;  in others, the main virtue seems to me to be that they have a specific word count rather than any information.  Be careful about the performance rankings:  as I read the aggregate data, they no longer have the predictive power they once did.)

What also strikes me is how few of the stocks I already hold I’m eager to put into the new account.  Part of this, I’m sure, is simply a difference in investment objectives.  But part may also be an indication that some of my holdings are beginning to show their age.

Greg Smith’s resignation letter from GS

March 16, 2012 By in Industry Analysis, institutional salesperson, Investment firms, Trading Tags: , , , , , , , Leave a comment

the letter

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

collective action clauses: Greece’s deus ex machina

March 8, 2012 By in Banks, Derivative instruments, Industry Analysis, Trading Tags: , , , , , , , , , 1 Comment

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.

why do so many insider trading investigations involve hedge funds?

March 7, 2012 By in hedge funds, Industry Analysis, Investment firms, Trading Tags: , , , , , Leave a comment

where the money is

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.

developing competence as an equity investor

December 18, 2011 By in buying and selling, Constructing a Portfolio, developing competence as an investor, Trading Tags: , , , , , , , Leave a comment

Zen…

The teachers of many sports or craft skills use a Zen-like scale to rate students on their progress toward mastery of their specialty.  The scale typically has four levels, that are often expressed as:

–unconscious incompetence

–conscious incompetence

–conscious competence

–unconscious competence.

…and investing

I think these classifications have some relevance for us as individual investors.  Here’s my take on each–

1.  unconscious incompetence.  This is where everyone starts out.  You know you’re smart–certainly smarter than most of the people you see on stock market cable shows.  You’re successful at your career.  You’re informed about economics.  You read the financial press.  You look at stock prices every day.  You think that’s enough.

People at this stage misunderstand two related things (at the very least I did):

–investing is a craft skill.  Almost every concept is easy to understand.  Complexity comes from the way simple ideas are repeated and combined into intricate and less-than-obvious structures.  Here, experience is more important than having a stratospheric IQ.

–the person on the other side of the trade knows much more than you suspect.  Typically, it’s someone who has served a five-year apprenticeship under an experienced professional investor and has maybe ten years of experience working on this own.  That translates into 50 hours a week gathering information about stocks.  More than that, the person probably spends most of that time focusing on a single stock market sector–or even a single industry, or a subsection of that industry.  Yes, some of these professionals actually have two years experience 7.5 times (meaning they’ve been spinning their wheels for most of their careers–thank goodness for that).  But even so, that’s 5000 hours studying the stocks they tend to buy and sell.  How good is the hot tip from your buddy Charlie in comparison?

2.  conscious incompetence.   Some people remain in stage one forever.  They either don’t evaluate their investment performance vs. their objectives or a benchmark, or their underperformace doesn’t register because it doesn’t square with their self-image.

Others–here I’m much more familiar with what starting-out professionals do that with ordinary individuals–begin to understand that this activity, like almost any other where professionals are involved, is harder than it seems.  They react to the situation in two ways:

–they stop doing the things that lose them the most money, and

–they begin to work harder at learning the ropes.  If they can, they find a successful investor who is willing to teach and who will take them as an apprentice.

3.  conscious competence. At this stage, an investor knows:

–enough accounting to read company financial statements with ease and understands the important financial variables in a company’s success

–enough microeconomics (which is mostly common sense, in my view) to evaluate a firm’s competitive strengths and weaknesses

–how to create a detailed spreadsheet to estimate future earnings (or to forecast other relevant metrics)

–from reading 10-Ks or elsewhere, the financial history of the companies and industries he’s interested in

–that his research process, and his plan for monitoring the key variables his research has uncovered, generally lead to success.

4.  unconscious competence.  This is the Zen stuff.  In sports, it’s the idea that after you’ve done enough conscious practicing, you’ve engrained knowledge deeply enough that you can/should cultivate “the zone.”  You try to stop thinking out what you intend to do and let your unconscious run the show.

In the most literal sense, I don’t think there’s a place for this in investing.  The reason?  –the activity is much more complex than any sport, so accumulated experience isn’t enough to rely on.

Nevertheless, there is something analogous.  For example:  you may encounter a new investment idea.  You know it will easily take a month or more to do the research you need to make an informed decision to buy or not (for me, it usually takes me over a year to become completely comfortable with a stock).  On the other hand, you see that the stock is already beginning to outperform as others become aware of it.  What do you do?

At some point I think every seasoned professional develops a sense of what research tasks are crucial and which amount to crossing the ts and dotting the is, and can be done after buying a small position in the stock.  In effect, you develop a feeling of confidence that a stock has a chance to be an outstanding performer that’s based in part on unconscious processing of information that you aren’t yet able to articulate consciously.

Some veteran investors (me among them) consider this a competitive advantage.  They rarely, if ever, talk about this.  On the other hand, some use “hunches” as a substitute for doing basic research work.  That’s very bad.  If investors like this are not “managed” by their subordinates–analysts or portfolio managers–they threaten to bring down whole investing operations.  Still others shy away from the idea of unconscious thought completely, and remain at stage 3.  I think it’s foolish not to use all the tools at your disposal, but such investors may simply be recognizing their limitations and acting accordingly.

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