paradox of thrift; paradox of indexing?

The paradox of thrift is the idea that the common sensical approach individuals take in bad economic times–that is, to save a lot more–actually reduces overall consumption and ends up making a bad situation worse.

 

People are beginning to talk about the same sort of situation happening with investing and index funds.

The idea of indexing was initially popularized by Charles Ellis, who argued that large numbers of well-trained, well-educated, highly motivated, highly compensated portfolio managers were battling it out with one another every day in the active management world.  Therefore, he argued, none would be able to maintain a clear competitive advantage over any of the others.  And they would all be running up costs in their (futile) attempts to do so.  Therefore, the wisest course for anyone would be to take the lowest-cost route–simply buying the index.

Of course, it took Vanguard to provide the means and many years for the idea to be accepted.

Today, in contrast, it’s accepted that the lowest risk course of action, and likely the highest return one as well, is to buy an index ETF or mutual fund.

Over recent years, there has been a steady flow of assets away from traditional active managers in the US and into index products–meaning less money from management fees to fund active manager research.  In addition, the recent recession has triggered the mass layoff of seasoned brokerage house equity analysts.  (This is due to the contraction in assets under active management, regulatory constraints on the use of “soft dollar” commissions and the dominance of trading over research in brokerage firm office politics.)

Are we at the point where indexing has culled the herd of active managers enough that the fierce competition which has made the US stock market super efficient over the past generation is no longer functioning?

No, not yet.  2014 was the worst year in a long time for active managers, as far as outperformance is concerned.  And we know that hedge funds have rarely been able to keep up with the S&P.

However, today’s Wall Street seems to me to be much more reactive than proactive when it comes to company news.  That is to say, the market seems to react more strongly to company announcements of good or bad news, rather to have anticipated them from leading indicators.  Take, for example, the shock Wall Street showed when firms had weak 4Q14 results because of euro weakness–even though the size of the firms’ EU business was well-known and the change in value of the euro is shown in currency trading every day.

So something has changed.  It may simply be that brokerage research departments were much more important to the smooth functioning of the equity market than has been commonly perceived.

My question:  will individual investors take the place of active managers in keeping markets efficient?

 

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.

 

 

 

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.

consequences

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.

Boring!!

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.

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.

 

 

security analysis in the 21st century: the former paradigm

One of my California brothers-in-law, a savvy investor and an Apple devotee, sent me an email the other day lamenting the parlous state of brokerage house analysis of AAPL.  He supplied this link from Apple Insider as evidence.

The article talks about Peter Misek, an analyst from Jefferies, who:

1.  had a price target of $900 for AAPL last year while the stock was going up and one of around $400 now that the stock has weakened

2.  made a series of (mostly negative) predictions about new products and current sales for AAPL, none of which have come true, and

3.  is blaming his misses on AAPL management failures and has used these occasions to downgrade the stock further.

 

In one sense, this is “normal” Wall Street behavior.   As an analyst trying to make a name for himself, Misek has been making out-of-consensus predictions.   He wants distinguish himself from the crowd and catch the attention of institutional clients who might direct trades (and therefore commissions) to his firm in exchange for access to his research.  In this, he’s following the time-honored dictum that customers will remember the home runs and quickly forget about the strike outs.

From what I’ve read on the internet–I haven’t seen Mr. Misek’s actual research, and have no desire to–what really sticks out in this case is the lack of skill he’s shown in the predictions he’s made.

Even that is not so surprising.

An illustration:

Early in my career (I’d been a buy-side oil industry analyst for maybe three years), I got a call to interview for a job as assistant to Charles Maxwell, then the dean of Wall Street sell-side oil analysts.  I went.

The interview was with the research director for Maxwell’s firm.  It was very short.

The hours were long.  The pay was poor.  I would be away from home visiting companies and clients about 60% of the time.  The payoff would come–if one did–three or four years hence.  Having made a reputation with clients, and with Charlie’s blessing, I’d be hired by a major brokerage firm as its oil analyst.  I’d do basically the same work as before but be paid the equivalent of several million dollars a year in today’s money.

The look of horror on my face at the prospect of a ton of boring travel–hadn’t they ever heard of the telephone?–was enough to tell both of us that I wasn’t the man for this job.

Two points:

–back in the day, securities analysts spent long apprenticeships learning their trade before they were allowed to take the reins as sell-side analysts covering major companies. and

–compensation was relatively high.

Both factors have changed a lot during the past decade.  Nevertheless,  I don’t think either the investing public or the companies being researched understand what’s happened.  Neither group appears to me to have adjusted to the new world we’re in.

More tomorrow.