Category Archives: Investment firms

the “dark pool” investigation

June 11, 2014 By in dark pools, Industry Analysis, Investment firms, the SEC Tags: , , , , Leave a comment

Someone with a Dungeons and Dragons background must have named them “dark pools.”  But they’re neither mysterious nor scary.  Dark pools are just off-exchange automated trading networks for stocks.

They exist for two reasons:

–the old school method of having a trader in a money management firm call up a broker and place a buy or sell order by phone is expensive.  And money managers have a legal obligation to obtain the lowest cost execution of their orders on behalf of clients.  So they have a positive obligation to seek out cheaper ways of doing business–which automated networks are.

–brokerage house traders won’t keep a money manager’s order secret unless the manager is exceptionally diligent.  This is a real hassle, and very time-consuming for the  money manager’s trading room.  But if you don’t pay extraordinary attention, your secret trading plans–which, after all, are your stock in trade–will be all over Wall Street in a nanosecond.

Automated trading networks have one–no, make that two–defects:

–they can be relatively illiquid, so that very large positions may not be able to be moved quickly, and

–many of the biggest of them are run by investment banks/brokerage houses.

This second characteristic is the reason for the current SEC investigation.

In a recent post, I wrote that Fidelity was exploring the possibility of forming its own automated trading network with other money managers, cutting out brokers altogether.  Its reason, I thought, was that computer=based high frequency traders were able to deduce Fidelity’s trading plans by analyzing dark pool data–and that Fidelity wanted to create a venue where they’d be banned.

It appears I may have been too high-tech in my approach.  The SEC investigation appears to focus on two possibilities, both of which are decidedly old-school brokerage behavior and both of which would violate the guarantees the automated network operators give to clients:

–the first is that the operators may have taken undisclosed fees from high-speed traders to allow their buys and sells to have priority over other order–essentially letting them front-run or scalp other participants

–the second is that operators may have taken the supposedly anonymous trading activity of high-profile participants and sold its details to others.  I say “sold” but in my experience, the compensation for such information would normally not be in cash but either in increased trading volume or higher per-trade fees.

Personally, I don’t think dark pools themselves are the issue.  I view them as part of the solution to a problem with how traditional brokerage/investment banks are run.  And the fact that the old system is breaking down makes these firms even less willing than normal to give clients an even shake.

It will be interesting to see how the SEC investigation progresses.

 

 

thinking (some more) about PIMCO

April 14, 2014 By in Current Market Thoughts, hedge funds, Industry Analysis, Investment firms, Recent Market Action, Trading Tags: , , , , , , , , 1 Comment

Pacific Investment Management Company (PIMCO) built itself into a bond market juggernaut over the past forty+ years, thanks to a soaring bond market, savvy marketing and the superior fixed income management skills of now-septuagenarian Bill Gross.

I’m an admirer of PIMCO’s organizational success.  But, at the same time, I can’t help thinking that the firm’s “New Normal” campaign of the past several years is mostly marketing hype–and wrongheaded, at that.  No matter what the economic or market conditions, the PIMCO conclusion is “Avoid stocks and buy more bonds!!!”  For all but the most risk-averse investors, that’s bad advice.  A first-rank firm should be better than that.

This is not what I want to write about, however.  I just want to declare that I have a vaguely anti-PIMCO point of view.

PIMCO has been having problems recently.  Mr. Gross has been underperforming.  Clients–even long-term clients–have begun to head for the door.  So, too, Mr. Gross’s putative successor, Mohamed El-Erian, who resigned from the firm citing irreconcilable differences between himself and Mr. Gross.  Press reports suggest Mr. Gross had been beating Mr. El-Erian over the head with his lack of actual portfolio management experience as a reason for dismissing his questions and concerns.

Great gossipy stuff   …but not what should concern us as investors.

Mr. El-Erian may not be an accomplished portfolio manager, but that doesn’t mean he isn’t a very shrewd individual.  What would make him a high-profile, high-prestige, high-paying job, instead of just hunkering down, busying himself with his considerable marketing responsibilities and waiting Mr. Gross out?

El-Erian’s decision to leave, I imagine, came when he realized that this strategy wouldn’t work.  Mr. Gross’s behavior wouldn’t change.  And it could well have consequences that would tarnish Mr. El-Erian’s image, as well.  After all, although apparently powerless, he was the co-Chief Investment Officer.

I imagine that because Mr. Gross has had such phenomenal success for so long with an aggressive strategy, he sees no reason to adopt a more conservative approach–even though, intellectually at least, he knows that the great bull market in bonds in the US that rewarded that behavior is over.  So he continues to take extra risk.  But that translates only into extra volatility in today’s world, not extra return.  Think:  Jon Corzine, or any number of prominent hedge fund managers.

Growth stock investors went through a similar existential crisis as the Internet bubble imploded in 2000, so it wouldn’t be surprising to me if this were the case with risk-oriented bond investors today.

 

My point (finally!):  we know about Mr. Gross.  How many invisible clones does he have, however, running banks’ bond trading desks, fixed income hedge funds or private equity operations?  …what fallout will occur as/when underperformance forces all of them to change tack?  Will it be six months of really ugly bond returns?  How much will spill over into the equity markets?

 

 

 

 

 

 

 

 

 

Value Line: why mechanical systems stop working

January 7, 2014 By in Investment firms, Portfolio management, Value Line Tags: , , , , , , Leave a comment

Sam Eisenstadt of Value Line created a famous computer-driven stock ranking system that worked fabulously for about a quarter century.  Then it stopped working.  Why?

1.  Any economic system is dynamic, not static.  When an innovation happens, it spurs changes in all sorts of other systematic variables.  When a competitor introduces a new product into a market, rivals don’t simply watch their market share erode.  They launch new products themselves, ranging from simple knockoffs of the original innovation to genuinely new, but different, products of their own.

To the extent that “me too” products proliferate, the value/power of the initial innovation is eroded.  In the case of Value Line, post-ERISA, rival money managers poached Value Line IT people to create duplicate systems for themselves.  In fact, a number of very successful value-oriented money managers in the 1970s-1980s were driven, so far as I can see, almost exclusively by their VL ranking system knockoffs.

The fact that many professionals began to act on the system’s predictions–in large size and as soon as the predictions were made–began to blunt the effect of the system.  It tended to make subsequent outperformance smaller in degree and duration.

In short, the Value Line system changed the world  …and then the world began to catch up.

2.  The Value Line system is based on an extensive analysis of historical data.  That was okay when computing power was expensive and when (future-oriented) stock market derivatives were few and far between.   This was also before ERISA turned money management from a backwater into a gigantic business, that is, before brokerage houses and money managers built large staffs of securities analysts churning out predictions of future earnings.

The result of these changes was to reorient Wall Street away from historical earnings to studying–and buying and selling based on–future earnings estimates.  When the actual numbers came out, the market had already reacted.  Not always, but most of the time.

3.  The system has, in my view, a number of quirks, which I’ll just state without elaboration.

–It’s biased toward smaller stocks, which is one reason the VL system did so well in the 1970s.

–I think there’s a semi-permanent underclass of 5-ranked stocks, which makes the 1 vs. 5 comparison less relevant than, say, 1s vs. the S&P 500.

–The system is bad at turning points in the economy, activity either decelerates or accelerates sharply.  In today’s world, investors react to macroeconomic news far in advance of when corporate earnings reflect such changes.

–It works better in down markets, where investors cling closer to reported earnings, than in up.

could the VL system start to work again?

Maybe.  Sam Eisenstadt is a shrewd guy, after all.  Much of the Wall Street information gathering apparatus has been dismantled during Great Recession-induced cost cutting.  We’re unlikely, I think, to experience another decade of macroeconomic and stock market disruption on the scale of the past ten years (at least, I hope we won’t).  So conditions for a system like VL’s to work look to be better than they’ve been in a long time.

The biggest issue I can see is that computing power is no longer expensive.  Most of us could do something like what VL does on our home computers.  I doubt many of us are going to take the trouble, though.

Sam Eisenstadt and Value Line

January 6, 2014 By in Academic Theories, Analyzing performance, Current Market Thoughts, Portfolio management, Value Line Tags: , , , , , , Leave a comment

About a week ago, the Wall Street Journal ran an article about the Value Line ranking system for stocks and its inventor, statistician Sam Eisenstadt.

I knew Sam in the late 1970s – early 1980s, during the heyday of Value Line.  At that time, the company was an incubator that launched the careers of a large number of successful investors.  The ranking system was also a formula for consistent outperformance.

Then the music began to stop.

What I find most interesting about the WSJ article is Sam’s belief that the Value Line ranking system will begin to work again.

how the VL ranking system works

The method, which was revolutionary when it was introduced in the middle of the last century, is taken straight out of a finance textbook.

It evaluates stocks by analyzing two main variables, cheapness and growth:

Cheapness is measured by taking the current price-earnings ratio for each stock and seeing where it stands relative to its PE over the prior ten years.  If the current PE is the lowest, the stock receives the highest score.  If the current PE is the highest, the stock gets the lowest score.

Growth is measured by taking the current per-share earnings growth rate and comparing it with the company’s earnings growth rate in each of the past ten years.  If the rate of growth is currently the highest, the stock gets the highest score.  If the growth rate is the currently the lowest, the stock gets the lowest score.

After scores for each stock are tallied, the totals are compared with those of all the other stocks in the VL universe of about 1,800 stocks–in the early days, this required a mainframe.  A couple of technical variables are mixed in.  The factors are weighted (this is the system’s secret sauce).  The end result is a ranking of the universe in order from 1 to 1,800.

The stocks are then grouped on a bell curve:

–the top 100 are ranked 1

–the next 300 are ranked 2

–the middle thousand are ranked 3

–the next 300 are ranked 4

–the bottom 100 are ranked 5.

Fresh rankings are published each week.

results

For over twenty years, the system worked like a charm.  1s consistently outperformed the market; 5s underperformed (in fact, academic research showed that 5s underperformed more deeply and for longer periods than 1s outperformed).  In most years, stocks performed precisely in line with their ranks.  That is, 1 outperformed 2s, which outperformed 3s, which outperformed 4s, which outperformed 5s.

Academics were flummoxed.  The system was statistically sound.  It used only publicly available historical data.  And yet, contrary to the “efficient markets hypothesis” (the academic assumption that, in simple terms, all publicly available information is immediately factored into stock prices), favorably ranked Value Line stocks outperformed as a group year after year after year.

Then, suddenly, the system didn’t work so well.  The WSJ article has a chart that shows the ten-year annualized performance of the VL 1s minus the performance of the 5s.  That outperformance figure peaks during the first half of the 1980s at a staggering 40% difference per year over the prior decade.  It then begins to fall pretty steadily through 2006, when the performance difference for the prior decade is close to zero.

(An aside:  one might question whether a 10-year time frame isn’t a bit too long or whether having the top 5% or so do better than the absolute bottom of the barrel is a high enough bar–but the author of the article, Mark Hulbert, didn’t go there and I won’t either.)

 

What happened?  Are the bad times over?  That’s for tomorrow’s post.

 

 

high yield (junk) bonds (ii)

December 2, 2013 By in bond market, Getting financial advice, Industry Analysis, Investment firms, junk bonds, junk bonds, Portfolio management, securities markets Tags: , , , , , , , , Leave a comment

what went wrong

1.  Junk bonds began to be used as a substitute for bank financing–but to a large degree by takeover specialists targeting either mediocre industrial companies or consumer staples firms of any stripe.  In both cases, more efficient management would boost cash flow enough to service the massive debt incurred in the acquisition.  Fear of the required debt service would act as a powerful motivator toward greater profitability.

Arguably, the substantial change of control among underperforming companies during the 1980s that junk bonds made possible laid the groundwork for the industrial renaissance the US experienced in the early 1990s.

Nothing wrong with that.

But in some cases, rapacious acquirers went further.  They targeted well-funded employee pension plans, replacing a conservative investment menu with a diet of exclusively junk bonds.  Others, particularly in the natural resources area, forced the acquired firms to operate for maximum near-term cash generation.  Timber companies, for example, harvested 3x-4x the usual number of trees every twelve months–leaving no time for replacement trees to grow.  As a result, companies went out of business; employees found their pension plans, after the junk bond collapse, unable to meet obligations.  The acquirers just walked away with the cash they’d drained from the firms.

Drexel also pleaded no contest to SEC charges that it illegally supported acquirers through stock manipulation and by helping them avoid 13-D reporting requirements.

2.  By the end of 1986–maybe a little later–Drexel and Milken had done all the junk bond/leveraged buyout deals in the US that made any economic sense.  What to do then  …close up shop or continue to do junk bond deals, even though they made no sense and might ultimately fail.  Drexel/Milken chose curtain #2.

By early 1989, the consequences were becoming evident.  Junk bond default rates were rising sharply, depressing junk bond prices.  To my mind, October 13th of that year marked a tipping point.  That’s when the media reported the failure of a proposed $6.75 billion leveraged buyout of United Airlines.  This was the first big junk bond deal not to get done.  Psychology changed decisively for the worse.

That’s when retail investors, who had been sold junk bonds on the idea that they had all the return potential of stocks plus all the safety of bonds, found out their dark side   ..if nothing else, how illiquid they are.  Junk bonds fell, on average, by about 30% in the following months.  Some investors also found out, to their sorrow, that up until that time their mutual funds had been pricing their holdings at what proved to be unrealistically high levels.

3.  We can all understand, though not condone, why Drexel/Milken would want to continue to sell dud junk bonds.  It’s what they did.  But why would any professional buy them (I know I characterized bond fund managers as not being among the best and brightest in my Friday post, but you;;d think they’d catch on eventually)?

The Federal government had an answer.  It was that Milken and Drexel bribed prominent junk bond fund managers to look the other way and take part in bad deals for their clients.  The Wall Street Journal had an in-depth investigative series on this issue in 1990.  I’ve been unable to find in the the WSJ online archives, however.

The government was unable to prove its case.  A New York Times article and one from the LA Times that describe the charges are the best documentation I can find.

Personally, it feels to me that the government was right, but that it had no way of getting any of the small number of people who would have been involved in a scheme like this to testify against themselves.

still, a revolutionary idea

By the early 1990s, the junk bond market had revived, though on a firmer footing as a result of the government action.