should brokers be fiduciaries?

…my answer is Yes.

In his recent spate of initiatives, President Obama is proposing that retail brokers be legally declared to be fiduciaries, the way investment advisers already are.   I’ve written about this before, when the SEC carried out a study of the topic, ordered in the Dodd Frank Act, which it published in early 2011.  Nothing happened back then.  Probably the same result this time.

The issue?

As I see it the change would mean that, for example:

–unlike today, your broker would have to point out, when he gives you a computer-generated analysis of your financial needs and a resulting asset allocation, that the names suggested consist solely of funds that pay fees to be on the list–and that potentially better-performing, lower cost funds that don’t pay have been excluded.

–that his (about 90% of traditional brokers are men) favorite fund families, whose offerings he always touts to you, also treat big producers like him (and a companion, usually) to periodic educational seminars at a sunny resorts in return.

More than that, depending on how any new regulations are written, he might also have to tell you that the trade his firm is charging $300 for could be executed just as well at a discount broker for less than $10.

brokers say No!

Brokerage houses are strongly opposed to Mr. Obama.  They’ve apparently already raised enough of a lobbying fuss in a very short time to cause the President to weaken his proposal.

How so?  From a business perspective, wouldn’t it make sense for traditional brokers to hold themselves to a higher standard of conduct?   They might thereby improve their very low standing  in the public mind and possibly stem the continual loss of market share they’re suffered over the past decades.

Two practical problems:

loss of skills

–over the past twenty years, brokers have homogenized their sales forces, moving them away from having their own thoughts and opinions about stock and bond markets to being marketers of pre-packaged products and ideas developed at central headquarters.

The ascendancy of pure marketing over investment savvy may have had sound reasoning behind it (although I regard it as one more triumph for the former in the battle of jocks (traders) vs. nerds (researchers) that I’ve witnessed through my Wall Street career).  However, most of the experienced researchers who had the skills to shape an investment policy and retrain the sales force have been fired either before or during the recent recession.

It’s easier in the short run to lobby against change than to revamp operations–or rehire the newly laid-off nerds needed to accomplish the task.

red ink = loss of bonuses

–in almost any phase of economic (or any other kind of) life, the status quo is extremely powerful.

Traditional retail brokerage is extremely high cost.  Remember, the retail broker himself nets only about half the fees he generates.  The rest goes to support very elaborate–and now seriously outmoded–bricks-and-mortar infrastructure and central overhead.  Lowering fees to get closer to discount broker levels, spending to raise the quality of proprietary products sold or consolidating real estate would all diminish–or even temporarily erase–operating income.  In a culture that values short-term trading profits over all else, it’s hard to develop support for a move like this.


massive redemptions at PIMCO? …I don’t think so

Late last week, bond guru Bill Gross, founder and public face of PIMCO, resigned from that firm to go to work for a much smaller rival, Janus.  This has led to speculation that the departure of Gross, who crafted the superior long-term record of the PIMCO flagship Total Return bond fund, would cause the loss of as much as 30% of the $1.8 trillion PIMCO has under management.

I don’t think the outflows will be anywhere near this bad, for a number of reasons:

1.  PIMCO deals in load funds, meaning that retail investors must pay a fee to buy them.  Two consequences:

–owners find the fact of the fee, not necessarily the size of it, a psychological barrier to sale.

–the load-fund client typically places a sell order through his broker.  The fact he can’t just go online in the middle of the night and redeem is another barrier to sale.  When called, the financial adviser can make reasoned arguments that persuade the client to hold on.  The broker may also convince the client to move to another bond fund in the PIMCO family, so that money leaves the Total Return fund but stays in the group.

What’s to stop a broker from using the Gross departure to call all his clients and tell them to take their money from PIMCO and place it with a different family of load funds–thereby generating another commission for him/her?  Generally speaking, such churning is illegal.  The transactions might even be stopped by the broker’s own firm.  Worse yet for the broker, this kind of call is pretty transparent as a fee grab.  It might also invite questions about where the broker was when the Gross performance began to deteriorate.

2.  My experience in the equity area is that while no-load funds can lose a third of their assets to redemptions in a market downturn.  Under 5% losses have been the norm with the load funds I’ve run.  Even smaller for 401k or other retirement assets.

3.  Money has already been leaving PIMCO for some time.

–Bill Gross’s performance has been bad for an extended period.

–He’s been acting like a loose cannon.

–Mohamed El-Erian’s leaving PIMCO was particularly damaging.  I think most people recognize that Mr. El-Erian is a professional marketer, not an investor.  But he was being paid a fortune to replace Gross as the public face of PIMCO.  Why leave a sweet job like that  ..unless the inside view was frighteningly bad?

At some point, however, PIMCO will have lost all the customers who are prone to quick flight.

PIMCO will try hard to get clients to stay.  It will presumably concede that it waited much too long to rein Mr. Gross.    But, it will argue, a seasoned portfolio manager at PIMCO, Dan Ivascyn, has now taken over the Total Return fund.  Supported by the firm’s broad deep research and investment staff of more than 700 professionals, Ivascyn will stabilize performance.  So the worst is now over.  In fact, Gross’s departure may have been a blessing in disguise.

4.  Arithmetic.  About $500 million of PIMCO’s assets come from its parent, Allianz.  Presumably, none of that will leave.  Third-party assets total about $1.3 trillion.  A loss of 30% of total assets would mean a loss of over 40% of third-party assets.  That would be beyond anything I’ve ever seen in the load world/

5.  Although individuals are prone to panic, institutions act at a more measured pace.  It would certainly be difficult to persuade institutional clients to add more money now, but it should be easier to persuade them to allow the assets they now have at PIMCO to remain, while keeping the firm on a short leash.

In sum, I can see that in the wake of the Gross departure, PIMCO could easily lose 10% of the third-party assets it has today.  I think, however, that the high-end figures are being put out for shock value and without much thought.

making it clearer who pays for investment research

paying for research information

Who pays for the investment research that professionals use in managing our money?

We do, of course.

But this happens in two ways, one of them not transparent at all.

management fees

–We pay management fees, out of which the management company pays for its portfolio managers and securities analysts.  That’s straightforward enough.

research commissions aka soft dollars

–We also permit, whether we know it or not, our managers to pay higher commissions, or to allow higher bid-asked spreads, on trades they do with our money.  They are so-called “research commissions” or “soft dollars.”  These are not so transparent.  It’s our money, and it does to pay for  the manager’s newspaper subscriptions, Bloomberg machines, brokerage research reports…

In 2007, there was a movement afoot in the US, spearheaded by Fidelity, to eliminate soft dollars and have management companies pay for all its research out of the management fee income paid by customers.  This effort fell victim to the recession.

EU financial authorities have now revived the idea.  They’re proposing to ban research commissions completely–that is, they will demand that investment managers obtain the lowest price and best execution on all trades–that is, they won’t permit a certain portion to be paid for at, say, double the going rate in return for access to the work of the brokerage house security analysts.


According to the Financial Times, smaller investment management firms could have their operating income cut in half if they had to pay for all the research they get out of their own pockets.

But that won’t happen.  Every investment manager, big or small, will go over the list of research providers with a fine tooth comb and eliminate sources whose value is unclear but who are being paid anyway because it’s “just” a soft dollar payment.

I think there will be three main consequences of European action:

1.  Pressure for the US to follow suit will be enormous.  Balking by US managers will open the door for UK-based specialists on the US market to gain business from domestic managers.

2.  Analysts who produce original research will be much more highly prized;  those who do more prosaic “maintenance” research will be replaced by robots (not a joke, more a question of how quickly).

3.  The overall size of sell-side research will continue to shrink, not just boutique firms but at the big brokers as well.


institutional vs. individual investment decisions

This is a follow-up to my post from yesterday on perils of relying on an analyst’s investment recommendations.

The FINRA article I mentioned in that post comments that institutional investment decisions can be motivated by considerations that differ markedly from those we as individuals face.

What does this mean?  Here are some examples:

1.  for almost two decades, endowments (like those for universities) have made large investments in highly illiquid “alternative” assets.  They argue that their financial circumstances allow them to take liquidity risk in search of extra-high returns because they won’t need the money for, say, 25 years.

Such investments present several problems for you and me:

generally speaking, endowments haven’t cashed out of many of these investments, so it’s not clear how well they’ve done

we probably don’t have a 20-year+ investment time frame, and

we definitely will only be able to participate in alternatives on much less favorable terms than big institutions.  In retail-oriented projects, the organizers reap most of the rewards.

2.  An institution may try to offset the risk of “roll-the-dice” investments by being very conservative in other areas.  Without knowing its overall investment strategy, it’s hard to know how to evaluate any one part.  So when an institutional portfolio manager says he has a huge weighting in Treasury securities, it may be that he’s acting on instructions from his client, or it may be to offset the risk of holding a ton of risky emerging markets debt.

3.  Portfolio management is a craft skill that sometimes operates on less-than-obvious rules.  The IT sector, for instance, is the largest component of the S&P 500, making up almost 20% of the index.  The largest constituents are Apple, Microsoft, IBM, Google,  and Intel.

Let’s say I’m a PM and I don’t like the IT sector right now.  I probably won’t express my opinion by having no technology stocks.  To make up a number, I may elect to have 15% of my portfolio in IT.  If I’m right, I’ll make gains by having the “missing” 5% invested in a better=performing sector.  I may also decide that, because I want to be defensive in this area, I’ll shift my emphasis toward the biggest, lowest-multiple, most mature companies.


But that’s the point.  These will probably go down the least in a bad market.

As a result, I may end up having 3% of my portfolio in AAPL and another 3% in MSFT.  They may also be the largest holdings in my portfolio.  A cursory glance at my holding may give the impression that I like AAPL and MSFT.  I do, but only in the sense that I expect that they’d go down–they’ll lose less than smaller IT stocks, gaining me outperformance.   They’re my hedging alternative to making an all-or-nothing bet against IT.

Another situation:  let’s say I have no clue how AAPL will perform.  I may decide that I should concentrate my attention elsewhere in the portfolio, where (I hope) I can add value.  The easiest–and safest–thing I can do with AAPL is to neutralize it.  That is, I hold the market weight in the stock.  Yes, I won’t gain any outperformance this way, but I won’t lose any, either.  Because AAPL is the largest stock in the S&P 500, AAPL may end up being my largest position.  But, again, this doesn’t mean I like it.  It means I don’t want the stock to hurt me.

Will I explain any of this in an interview?  Yes, I’ll try.  But reporters’ eyes will glaze over.  What they’ll come away with is the idea they came in with–that my largest positions must be my favorites, and they’re AAPL and MSFT.




the FINRA Guide to Understanding Analysts’ Recommendations

Yesterday someone sent me a link to Understanding Securities Analyst Recommendations, written by the Financial Industry Regulatory Authority (FINRA), the brokerage industry trade organization.

The short article is surprisingly candid and contains important information, although couched in very abstract language.

The highlights (paraphrased by me):

–brokerage house analysts, and the brokerage houses themselves, are subject to enormous potential conflicts of interest when it come s to saying what they think the future performance of a given stock may be.  For instance, –a company may select a brokerage house for lucrative investment banking business based on how favorably the firm rates its stock

–conversely, it may refuse to give corporate information to analysts who rate the stock unfavorably.  The company may “forget” to return phone calls, avoid appearing at conferences sponsored by the analyst, refuse to appear with the analyst at public or private investor meetings, or not acknowledge requests for information from institutional investors that are directed through the offending analyst.  The company may even more overtly try to get the analyst fired.

–very large money management companies may build up gigantic positions in the stock of a given company.  Powerful portfolio managers may have large stakes riding on the stock’s performance–and the positions may well be too big to sell quickly, in any event.  So they may pressure brokers and their analysts to maintain a favorable opinion on the stock.  Their threat–to withhold trading commissions from a firm that downgrades the stock.  Same thing about firing the analyst, too.

–as a result, the terms brokers use to rate stocks may not be self-evident.  “Buy,” for example. may not be a particularly good rating.  “Strong Buy” or “Conviction Buy” may be what we’d ordinarily understand as”buy.”  “Buy” may be closer to “Eh” or “Hold.”  Of course, analysts may also have one official opinion in writing and another that it expresses verbally to clients.

Two other worthwhile points the article makes:

–some analysts may not be highly skilled, so their recommendation may not be worth much.  Rookies may not have enough experience, for instance, and they may be more susceptible to outside pressure than others.  Analysts may not know a spreadsheet from a hole in the ground but have the ear of management.  (Oddly, old-fashioned managements continue to give information to favored analysts that they deny to shareholders.)

–the fact that a portfolio manager owns a stocks, even if it’s a large position and if his analyst appears on TV saying positive things about it, the manager may hold the stock for completely different reasons (more on this tomorrow). Anyway, the FINRA page is well worth reading.

Wall Street firms are running out of retail brokers

In the post-recession world, traditional brokerage/investment banking firms have become much more interested in the steady income that can come from providing financial advice to individuals.  This is partly due to the demise of proprietary trading, partly a new respect for recurring income.   But Wall Street is finding it hard to maintain its retail sales forces.

One would think that with the Baby Boom beginning to retire, and having 401ks and IRAs rather than traditional pensions to support them in their “golden” years, there would be a lot of demand from this quarter for professional investment advice.  Yet, brokerage firms are finding it hard to recruit salesmen.  The demographics of the big (or “full service,” as they’re called) brokerage forces themselves are also telling:  lots of over-fifties, few under-thirties.  Why is this?

In general:

1.  The internet has replaced financial services as the destination of choice for ambitious college graduates.

2.  Brokerage firms have traditionally been hostile toward women, thereby eliminating half the possible job candidates.

3.  Being a financial adviser is–something I kind of get, but kind of don’t–a relatively low status position, down there with used car salesman.


4.  People under the age of, say, fifty (maybe it’s sixty, though) would prefer to deal with a discount broker over the internet than face-to-face with a traditional brokerage salesman.  I have no short answer as to why, but they do–even when introduced to an honest, competent broker by their parents.  Of course, maybe that in itself is the kiss of death.

5.  Traditional brokerage firms have decimated their research departments as cost-cutting measures during the recession.  This eliminates the only reason I personally would consider a traditional broker.

6.  A broker typically gets a little less than half of the commission revenue he generates (see my post on how your broker gets paid for more detail).  The rest goes to the firm, which uses part of that to pay for offices, recordkeeping, and marketing…   For many years, however, firms like Fidelity, Charles Schwab or other, more low-profile companies have been willing to provide established brokers with back-office support for a small fraction of that amount.  I’m not current on today’s arrangements, but while I was working a broker could easily increase his “net” commission from 45% to 80% by switching to one of these firms.  Yes, he might have to provide his own office, but the headline is that he could increase his income by 78% with the move.


What’s new about this situation isn’t that it’s happening–this has been going on for well over a decade–but that traditional brokers are finally concerned.   Their retail business model is broken, however, and I don’t see it getting fixed any time soon.  My question is how Baby Boomers are going to get the financial advice they need to manager their money during retirement.








Ray Dirks, Kevin Chang and other stuff

a $30 million fine

According to the Wall Street JournalCiti technology analyst Kevin Chang was fired last month.  Citi was fined $30 million by state regulators in Massachusetts for his leaking the contents of a research report to influential clients the day before it was published.  Other investigations are ongoing.

What happened?

The Journal, whose account appears to be taken from the Massachusetts consent order, says Mr. Chang found out from an Apple component supplier, Hon Hai Precision, that Apple had cut back orders–meaning, presumably, that sales of iPhones were running considerably below expectations. Chang wrote up his findings in a report that he submitted to Citi’s compliance/legal departments for review.

While his report was being processed, Chang was contacted by at least one hedge fund, SAC, which was looking for corroboration of similar conclusions drawn in an already released research report by Australian broker Macquarie.  Chang promptly emailed the guts of his report to four clients, SAC, T Rowe Price, Citadel and GLG.

The legal issue?   …selective disclosure of the research conclusions.

not the first time:  the Ray Dirks/Equity Funding case

Mr. Dirks was a famous sell-side insurance analyst back in the early 1970s.  In researching Equity Funding, a then-high flying stock, he discovered that the company’s apparently stellar growth was a fiction.  The firm had a bunch of employees whose job was to churn out phony insurance applications for made-up people, which EF then processed and showed “profits” for, just as if they were real.

When he found the fraud out, Dirks immediately called all his important clients and told them.  They sold.  Only then did Dirks inform the SEC.

Rather than being grateful for his news, the SEC found Dirks guilty of trading on inside information and barred him from the securities industry–a verdict that was reversed years later by the Supreme Court.

two observations

1.  Why put important clients first, even at the risk of career-ending regulatory action?  After all, many sell-side analysts take home multi-million dollar paychecks.

Their actions show who the analysts perceive their real employers are.  Ultimately, they collect the big bucks because powerful clients continue to send large amounts of trading commissions to pay for access to their research.  If that commission flow begins to shrink, so too does the size of the analyst’s pay.

Also, an analyst’s ability to move to another firm rests in large measure on whether these same clients will vouch for him–and will increase their commission business with the new employer.

2.  What happens to people like Dirks and Chang?

Dirks was eventually exonerated.  While he was appealing the SEC judgment, his thoughts on insurance companies continued to be circulated in the investment community.  Only they appeared under the byline of a rookie apprentice to Dirks–Jim Chanos.

Dirks eventually established his own research firm.  Interestingly, when I Googled him this morning, I found that the top search results were all basically rehashes of the favorable information put out by Ray Dirks Research itself.  No one remembers the real story.

Chang?  I don’t know.  He lives in Taiwan, where I suspect he will catch on with a local brokerage firm or investment manager.  As far as Americans are concerned, disgraced analysts or portfolio managers tend to end up in the media.  For example, Henry Blodget, who wrote all those laudatory “research” reports for Merrill touting internet stocks he actually believed were clunkers, now works for Yahoo Finance.  You can watch similar characters every day on finance TV.  Crooked, maybe.  But they’re articulate and look presentable.  And that’s all that matters.