I’ve just updated my Current Market Tactics page. How the 2015 market for US stocks is shaping up.
Monthly Archives: February 2015
what will a soft dollar-less world look like
Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.
Today, the effects of a ban…
hedge funds?
I think the most crucial issue is whether new rules will include hedge funds as well. The WSJ says “Yes.” Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.
Looking at traditional money managers,
$10 billion under management
in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services. This is the equivalent of about $1.6 million in “hard,” or real dollars.
My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars. The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).
That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.
How will a firm pay the $1.6 million in expenses once soft dollars are gone?
–I think its first move will be to pare back that figure. The infrastructure and hardware are probably must-haves. So all the chopping will be in purchased research. The first to go will be “just in case” or “nice to have” services. I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.
–Professional compensation will decline. Lots of internal arguing between marketing and research as to where the cuts will be most severe.
smaller managers
There’s a considerable amount of overhead in a money management operation. Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst. At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.
Maybe managers will be more likely to stick with big firms.
brokers
If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.
publicly traded companies
Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts. As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.
I think smart companies will come up with better strategies–and be rewarded with premium PEs. Or it may turn out that backward-looking firms will begin to trade at discounts.
you and me
It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient. That should make it easier for you and me to find bargains.
the demise of soft dollars
This is the first of two posts. Today’s lays out the issue, tomorrow’s the implications for the investment management industry.
so long, soft dollars
“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.
Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client. In a sense, soft dollars are a semi-hidden charge on top of the management fee.
In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice. This is another way of saying: whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.
In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research. As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan. Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.
theWall Street Journal
Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.
not just the EU, however
Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.
Why?
Other jurisdictions are likely to follow the EU’s lead. Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.
soft dollars in perspective
in the US
Let’s say an investment management firm has $10 billion in US equities under management. If it charges a 50 basis point management fee, the firm collects $50 million a year. Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)
If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells. Plucking a figure out of the air, let’s assume that the price of the average share traded is $35. The $15 billion in transactions amounts to about 425 million shares traded. If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.
foreign trades
Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are …well, softer. So the soft dollar issue is much more crucial abroad.
hedge funds
Then there are hedge funds, which are not subject to the best price/best execution regulations. I have no practical experience here. I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.
We know that hedge funds are brokers’ best customers. Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.
translating soft dollars to hard
When I was working, the accepted ratio was that $1.75 soft = $1.00 hard. I presume it’s still the same. In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000 = $70,000 to (the clients’) commission tab.
Tomorrow, implications of eliminating soft dollars
a report card for smart beta
Purveyors of “smart beta” equity portfolio strategies have been very popular over the past few years, both with individual investors and with institutions.
The source of the attraction is clear:
smart beta claim to provide better performance than an index fund without engaging in active portfolio management. Actually, it claims to outperform because it doesn’t employ value-subtracting human portfolio managers to muck up the works. Rather, smart beta operates by reshaping the weightings of stocks in the index according to predetermined computer-managed rules. (I’ve written about smart beta in more detail in other posts.)
In other words, it’s free lunch.
My observation is that smart beta is a marketing gimmick …one that has been very successful in bringing in new money, but a gimmick nonetheless. Basically what it does is to create a portfolio that contains the index constituents, but in different proportions from their index weightings. The rules for determining the smart beta weightings are set in advance and the portfolio is periodically rebalanced to restore the “correct” proportions. For my money, the preceding sentence describes active management. The portfolio managers are just hidden behind a computer curtain.
A simple example of smart beta: maintain a portfolio of S&P 500 names but have .2% of the money in each stock–rather than having it loaded up with lots of Apple, ExxonMobil, Microsoft, Johnson&Johnson and Berkshire Hathaway. Historically, this is a strategy that had its best run in the late 1970s – early 1980s, but which followed with a very extended period of sub-par performance.
Anyway,
I was catching up on my reading of the Financial Times over the weekend and came across an article from the FTfm of February 2nd titled,“Smart beta is no guarantee you will beat the market.”
It turns out that of the 10 biggest smart beta ETFs in the US, seven have underperformed over the past three years and five over the past five years.
That’s not that different from what active managers have done.
However, unlike the case for active managers, assets under smart beta management have grown fivefold since 2009.
sorting out oil-related stocks
The very large drop in oil prices over the past eight months has had negative effects on all oil-related firms. The amount of suffering varies considerably, however, based on how a given firm is involved in the hydrocarbon business. Here’s my take on the various sub-industries:
1. oilfield services companies. It’s a general rule in business that when a manufacturer slows down, its suppliers feel more pain than the manufacturer itself. This is true in the oilfields, as well.
–Lower output prices mean some new drilling projects are cancelled. This is bad for the contract drillers who supply and operate the rigs that do the actual drilling. Offshore, where projects are typically larger and more expensive–therefore riskier, is a worse place to be than onshore. Worst hit of all are the suppliers of the oilfield services firms, like the companies that manufacture new drilling rigs.
–Suppliers of goods and services, from seismic analyses of prospective acreage to drilling mud, are hurt as well. Being in support for development of existing projects is better than being involved in new exploration.
2. high-cost alternatives …like liquefied natural gas (LNG) or tar sands. Projects may no longer be economically viable. I think LNG is more at risk. Transporting natural gas from, say, the US to the EU or from Australia to Japan requires a multi-billion dollar investment in plant and equipment to liquefy and ship the gas to market (the alternative would be an underwater pipeline). Because of this, I think new projects are non-starters in today’s world. As for projects already up and running, we have no way of knowing how contracts are structured–that is, how the selling price of the gas is affected by the oil price drop. This determines whether the pain of the oil price decline is borne by the LLNG project or by the utility customers who ultimately use the gas.
The situation for green alternatives, like solar and wind, is less clear.
3. reserve valuations The asset value of any oil exploration/production company depends heavily on the size and value of its oil reserves. The lower oil price clearly hurts the value of reserves. What’s less obvious is that reserves are defined as barrels of oil that can be brought to the surface and sold at a profit at the current price. Some barrels that are economically viable at $100 a barrel may not be at $50. If so, the size of reserves will also shrink. In an extreme case, a company with a million barrels of reserves worth $50 million at an oil price of $100 might have 0 barrels worth $0 at a $50 oil price.
4. US-based exploration companies Smaller firms have been the leaders in shale oil production. Generally speaking, they are hurt worse by shrinkage in cash flow and downward revisions in reserve value than the big international firms. To the extent they’ve borrowed to finance drilling, their problems may be magnified. As a practical matter, however, there’s probably less scope for creditors to take action against a firm if it has issued junk bonds than if it has bank loans.
5. international majors The profits of these firms are more insulated against the price drop than their smaller rivals. How so?
–They have petrochemicals and refining/marketing businesses that benefit from the lower price because they’re users of crude oil.
–They have fields they own that may have been operating for decades, and which therefore are still profitable at today’s prices.
–Also, in their deals to develop fields with national oil companies in foreign countries, they typically are paid a return on invested capital. In other words, they don’t gain or lose much (if anything) as the oil price rises and falls.
No, they don’t escape unscathed. They do lose from the lower price they get from production they own in the US and Europe, but their losses are much less than the pure domestic exploration and production companies.
6. I haven’t looked at refining and marketing companies. I assume that they aren’t fully passing along to their customers the benefits of lower crude oil costs, but I haven’t checked.
Of course, if/when the oil price begins to rise again (I don’t expect that to be any time soon), the most responsive stocks will likely be those of the oilfield services firms, with those of the international majors moving the least.