Category Archives: Investment firms

brokers and standards of care: the SEC study

January 30, 2011 By in Getting financial advice, How your broker gets paid, Industry Analysis, Investment firms, mutual fund holders and financial advisors, Portfolio management, Where are the customers' yachts? Tags: , , , , Leave a comment

the report

Last Wednesday the SEC published the results of a study on the differing legal obligations of brokers and investment advisers to their clients.

The SEC’s bottom line:

–while customers are generally satisfied with the investment advice they receive, they don’t really know what standards of conduct their brokers or investment advisers are legally held to.  In addition, they sometimes mistakenly think brokers are required to perform to the same high standard as investment advisers.

–the standard of conduct for brokers should be raised to match that for investment advisers, “when providing investment advice about securities to retail customers.”

why the study?

One might think that it was driven by the realization that millions of Baby Boomers will be retiring in the US over the next decade or so.  The vast majority–government workers are the biggest exception–will not have the security of defined benefit pension plans backed by their former employers. Instead, they have the money they’ve saved in IRAs or 401ks, for which they will have investment responsibility, to support them in retirement.

That’s not the reason, though.  The SEC did the study because it was ordered to in the recently-passed Dodd-Frank Act.

broker or investment adviser:  what’s the difference?

in law…

Investment advisers are regulated by the Investment Advisers Act of 1940.

Broker-dealers are regulated under the anti-fraud provisions of the Securities Act of 1933 and the Securities Act of 1934.

Broker-dealers are specifically excluded from regulation under the Investment Advisers Act.

…and in practice

Investment advisers are fiduciaries.  In practical terms, this means three things:

–the adviser must do what’s best for the client

–the adviser must put the client’s interests ahead of his own, and

–the adviser has to make extensive disclosure of possible conflicts of interest.

Broker-dealers are not fiduciaries.  As a result,

–although brokers aren’t permitted to act in a way that harms their clients,

–they can recommend an investment that is less good than another but which provides a higher profit to the broker.

I’m not sure what the technical requirements for disclosure of conflicts of interest are for a broker.  My experience is that such disclosures are, at best, buried in the middle of large amounts of fine print and couched in language that only a specialist would understand. Goldman’s trading “huddles,” exposed in an article in the Wall Street Journal in 2009, are a recent example of differential treatment of institutional clients, not retail, but it’s still a good illustration of the broker mindset.

The huddles are weekly meetings of analysts and traders that ended up generating ideas, some of which go against Goldman’s official stock recommendations.  These trading ideas are communicated only to a few of the firm’s highest revenue-generating clients.  The official recommendations aren’t changed, so most clients continue to be told the opposite story.  (I just looked at a recent Goldman research report.  This practice is described in paragraph 25 of 30 paragraphs of fine print, covering three pages of the report’s total length of seven.).

if brokers are required to become fiduciaries, what changes?

It may be an exaggeration to say that this would radically change the fundamentals of the retail brokerage industry…but, on second thought, that may not be so far from the truth.  For example,

quality of fund recommendations

1.  Some retail-oriented brokerage houses have their own in-house fund management groups.  In many cases, the records of such proprietary funds is mediocre at best.  Yet brokers are encouraged to sell these funds to clients.  In my view, the main factor–other than the underperformance clients experience–is their greater profitability of in-house funds to the firm. If brokers were fiduciaries, presumably they would have to point out that third-party funds have better track records, or to disclose their financial interest.

2.  Brokers might have to disclose that in general no-load funds sold by Vanguard or Fidelity are a better deal that the load funds brokers sell.

3.  When you go into a brokerage office to have an asset allocation analysis done, it may be that the mutual fund recommendations that the computer spits out come only from fund groups that have paid to have their names displayed to customers–or who have agreed to rebate to the brokerage a portion of the management fee earned on shares sold.  Fund groups that decline to pay get no exposure. In other words, the fund recommendations aren’t the objective assessment they appear to be.

A fiduciary couldn’t do this without clear disclosure.  Actually, I think a fiduciary who tried to do this would be run out of town.

4.  If an individual broker does enough business with a given fund group, he may qualify to bring himself and a guest to  an all expense-paid educational seminar (including nightly entertainment),  in, say, Las Vegas, or San Diego or Disneyworld.  Has any broker ever mentioned that possibility when recommending a fund to you?

quality of stock recommendations

5.  Institutional Investor magazine publishes a yearly ranking of brokerage house research and a list of All-American analysts in each industry.  If brokers were fiduciaries, I think they’d have to tell you if, as many have, they’ve laid off most of their experienced researchers during the recession.  So they have no ranked analysts anymore.  And the report you’ve just been handed recommending XYZ Corp as a “buy” was written by a replacement who only has six months experience, no formal training in securities analysis, and is learning to do research on the fly.

All of this would be a little like watching your meal being prepared in the kitchen of a restaurant that probably won’t pass health inspection.  Certainly, brokers don’t want to be forced to allow you this peek under the covers.

are any changes likely, based on the SEC findings?

I doubt it.  Opposition from “full service” brokerage houses would be too great.  It’s also interesting to note that, while the study was done by the staff of the SEC as Dodd-Frank mandated, its conclusions weren’t endorsed by the SEC.

But this did give me another chance to write about some of the less obvious practices of the retail brokerage industry.  So at least that’s something.

is retail money coming back to the stock market? …yes and no

January 21, 2011 By in Current Market Thoughts, Industry Analysis, Investment firms, securities markets, stock market, Trading Tags: , , , , , , 2 Comments

the news

There have been numerous reports in the financial press over the past month or so that, after two+ years on the sidelines, retail investors are beginning to return to the stock market.  The latest of these appeared in the Financial Times yesterday.  The FT article is a bit selective.  It points out that Charles Schwab added $26.2 billion in new assets in the December quarter, the largest amount in one quarter for the past two years.  It reports that competitor TD Ameritrade added $9.7 billion to its books for the period, but doesn’t mention that this is about average for the firm over the past year and that it added more than $10 billion to its books in the June 2010 quarter.

The latest ICI figures–the Investment Company Institute, the money management trade association, which seem to have been a lagging indicator, are finally starting to confirm the trend that newspapers have been reporting.  The weekly figures for January 12th show $3.78 billion flowing into domestic-oriented equity funds, continuing flows into international/global stock funds, and moderation in the (still positive) flow of money into taxable bond funds.

One significant point is beginning to emerge.  According to the FT, the money flows to the discount brokers are primarily day traders, not buy-and-hold investors.  This latter, much larger, group remains firmly in the highly defensive posture it adopted over two years ago.  The speculative orientation of the recent assets opening brokerage accounts is confirmed by TD Ameritrade’s comment that the use of margin loans by its clients is up 31% year over year.

consequences

The new inflow of retail money likely gives Wall Street a further gentle upward bias.

The fact that there is still considerable private investor money on the sidelines suggests there is more positive news to come on funds flow front.  In other words, the new money doesn’t appear to be a harbinger of the end of the bull market.

The day trader character of the new money suggests that short-term volatility in the market will increase.  To the extent that day traders concentrate on mid- and small-cap names, the volatility in this area should be most affected.  For a long-term investor, this is good news, since it means better buying and selling opportunities for anyone willing to exercise patience.

The use of margin suggests inevitable corrections in the market will be swifter and deeper than they would be otherwise, as high leverage works against traders.

 

Blackrock’s new trading platform (ll)

December 31, 2010 By in Industry Analysis, Investment firms, Stock ideas, Trading Tags: , , , , , 1 Comment

Blackrock is the largest money manager in the world, with $3.5 trillion under management.  It manages stock, bonds and alternative investments, packaged as either separate accounts, ETFs or mutual funds.  It was built by former brokerage house employees who come from a deeply trading-oriented culture.  So it’s not surprising that the firm has a keen awareness of the value of the trading it does with the rest of the financial world.

Blackrock first announced its intention to create an internal trading platform in 2009.  Recently the Financial Times reports that the firm has begun to hire IT people to have the network up and running sometime in 2011.

the platform

How will the trading platform work?

If I understand Blackrock’s plans correctly, it will be something like this:

1. All buy and sell orders for publicly traded securities anywhere in Blackrock will be  entered into the internal trading system.  Buys and sells that match one another will automatically be executed inside Blackrock, saving the majority of the commission that would otherwise be paid to a third party.  In this respect, the platform will work like an electronic crossing network.

2. Small orders can be aggregated and placed externally at a more favorable commission rate.

3. Minimum levels of order flow can be directed to brokers who will give a better rate in order to get higher volume.  Factors 1-3 would mimic the behavior of discount brokers.

4.  Unlike the case with third parties, portfolio managers will presumably give a true indication of the total intended size of any transaction, rather than feeding orders piecemeal to try to disguise their intentions.  This may allow managers to negotiate more frankly through internal Blackrock traders, and thereby buy and sell in large size much more quickly than they would be able to do otherwise.

Where will the trades come from?

…from ETF share creation/redemption and related hedging, mutual fund inflows and outflows, and the buy/sell decisions of active managers working for Blackrock.

only scratching the surface

When the trading platform is up and running and some record of savings from internal matching is available, Blackrock will likely begin to use the data as a marketing tool for its products.  I presume the marketing pitch will be that part or all of the savings will be returned to clients–producing better performance.  Maybe this will be enough to tilt a hiring decision in favor of Blackrock, maybe not.  But I think this is only the first use Blackrock will make of the platform.  For instance:

–understanding the aggregate patterns of the movement of Blackrock’s $3.5 trillion under management is a powerful source of market intelligence

–it can be a tool for evaluating the decision-making skills of the firm’s managers

–Blackrock can seek other sources of trading flow.

—–it could easily open its trading platform to others as a “dark pool.”

—–it could offer the platform to discount brokers.

—–it could create a discount brokerage operation itself.

What I think is most interesting about Blackrock’s plans is that the firm doesn’t need to make money from its trading operations.  It can even take a loss on trading, if it thought that would enhance the attractiveness of its fee-generating money management business.  This possibility should be very scary to financial firms whose chief/sole business is based on trading, especially for any with Blackrock as a big customer.  But the possibility has wider import.  The canyons of Wall Street are littered with the bones of one-product companies where someone else decided to make that product a loss leader.

 

 

Blackrock’s new trading platform as attack on traditional money managers (l): background

December 30, 2010 By in Industry Analysis, Investment firms, Trading, trading: how valuable? Tags: , , , , , Leave a comment

I’m going to write two posts about the internal trade order-matching network that Blackrock intends to have up and running next year.  This one will provide background, some of which I’ve written about before.  Tomorrow’s will deal with how the Blackrock network fits as a strategic weapon in the money manager’s arsenal.

three types of commission

For a conventional money manager, commissions paid for trades–or bid-asked spreads, which amount to the same thing–break out into three types, from most expensive to least:

–research commissions, aka “soft dollar” commissions.  These commissions consist of a payment to a broker for executing and recording a trade plus an amount to compensate for research services.  Ten years ago the research service payment was predominantly in return for information from the broker’s own in-house research.  Today, most brokerage house analysts have been laid off and work in independent research boutiques that their former employers act as middlemen for.

The amount paid per trade will depend on the size and trading habits of a given institutional client, by may amount to, say, $.05 per share.

–commissions for execution.  These are paid strictly in accord with the SEC mandate for registered money managers to obtain “best price” and “best execution” when they trade for clients. They might amount to $.03 per share, of which $.015 might be the broker’s cost and the remainder a profit element.

–trades through electronic crossing networks, aka “dark pools” (for fantasy or vampire fans, I guess).  These have become increasingly popular.  One advantage of such networks is their low cost–maybe $.001 over the expense of executing a trade.  The second is their anonymity–you don’t run the risk that your intentions are not only broadcast to your broker’s proprietary trading desk, as they surely are, but also to all the broker’s best customers as well.

attacks on the conventional model

Blackrock’s new trading platform is the latest one.  That’s tomorrow’s story.

A second attack, blunted for a while by the financial crisis, is coming from Fidelity and concerns soft dollars.

When I entered the industry, conventional money management firms typically had large cadres of in-house research analysts who serviced the firm’s portfolio managers and reported to a research director.  This was expensive.  Also, in many cases the firms didn’t have strong enough general management to ensure the in-house research was any good.

As time went on, firms gradually shrank their in-house research efforts.  Instead, they began to increasingly depend on analysis generated by the brokerage houses they traded with–paid for with higher-than-normal commissions.  This “solved” the management problem.  And it had the added benefit of increasing profits by shifting the cost of research away from salaries paid out of the money manager’s fee income to commission expense paid by the client!

How do you justify this, either to the SEC (assuming the agency weren’t clueless) or to clients?  The standard response was that this was normal industry practice.  How so?  …because that’s what the industry giant, Fidelity, does.  The mantra has been that if Fidelity allocates 15% of its commission volume to pay for research, it’s ok for everyone else to do that, too.

Just before the onset of the financial crisis, however, Fidelity, which has a large in-house research staff, decided to change its practice.  It proposed to the major brokers that it pay them a set cash fee for research each year, say, $8 million.

Brokers balked, for two reasons.  The money was been less than they were getting paid before.  It would have forced an internal reallocation of compensation away from the traders who run the firms to the researchers who were specifically identified with the fee income.

For other money managers–to my mind, the true target of the Fidelity initiative–this was a nightmare.  They could no longer use Fidelity as justification for their soft dollar spending.  In addition, their profits would plunge as they either paid out large portions of their management fee income to newly rehired research analysts or to brokers for their research output.  Smaller managers might be forced to close up shop.

The soft dollar issue hasn’t gone away.  Brokers, however, have “solved” their internal profit allocation problem in the short term by firing most of their veteran researchers during the downturn.  And Fidelity seems to have lost interest for the moment in pushing the issue.  …or at least publicizing it.  It may well be striking cash deals with small research boutiques.

I think Blackrock’s trading platform idea has similar elements of using large market size to damage smaller competitors while at the same time making a profit for itself.




marketing bonds when interest rates are rising

December 10, 2010 By in Current Market Thoughts, Investment firms, securities markets, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

US Treasury yields rising from a cyclical low…

In early October, the 10-year Treasury bond yields reached as close to zero in this cycle as they are going to get, at 2.4%.  I think this figure will prove to be a low that will hold for a very long time.  Since then, yields have bounced back to the current–and still low–3.2%.

What has changed in the past two months?  Three things:

1.  The US economy is showing clearer signs of life.  These are evident in macroeconomic indicators like the money aggregates and in bank lending, as well as in announcements by individual company managements and by retail and other trade associations.

2.  Washington–or at least Mr. Obama + the GOP–is saying it’s willing to use fiscal policy to help the US economy along, meaning that the Fed would not have to strain so hard to keep interest rates ultra-low so that the economy doesn’t stumble.

3.  Bond buyers may be beginning to realize just how expensive bonds are.  If you figure that a ten-year bond should give you, say, a 2.5% real yield + protection from inflation, the 2.4% nominal yield implies no inflation–basically a dormant economy–for the next decade.

...means capital losses for bond holders

Roll the clock back to October 7th.  Suppose you bought a 10-year bond from the government on that day.  For your payment of $1,000 to the Treasury, you would have gotten the promise of interest payments of $24 a year, or $240 in total,  plus return of your $1,000 ten years hence.

Today, if you did the same thing you’d get the promise of $320 in interest plus your principal back, or about 6.5% more.

If today’s bond is worth $1,000, then October’s must be worth less–maybe 5% less.  In other words, if you sold the October bond in the secondary market today, you’d only get about $950.  You’d have a capital loss of $50.

the response to the prospect of losses varies…

…by product.

In all cases, the seller of bond products probably stresses that we don’t know for sure what will happen in the future.

For the holder of individual bonds, there may be no getting around the fact that the holder has a minimum requirement for current income, which may require keeping longer dated bonds despite the prospect of capital loss.  In this case, a financial advisor probably stresses this fact, and also tries to point out that “you haven’t lost money, you’ve just lost time.”  In other words, the advisor will point out that–unlike the case with stocks– the stream of interest payments will gradually offset any capital loss.  Also, if you hold the bond to maturity, you’ll get your principal back.  These words may give some psychological comfort.

In the case of bond mutual funds, the marketing departments of the major bond managements companies have been working overtime during the past couple of years spreading the story of the “new normal.”  That’s the idea that the damage done to the world by the financial crisis was so severe that global economic growth will be close to zero for many years.  Therefore, bond yields will remain at emergency-low levels for a very long time.  It’s hard to know if the bond management companies actually believed this, but it never made any sense.  And, other than for Europe, we have clear evidence that it’s wrong.

As a result, the bond fund marketing pitch has changed.  The fund managers are constantly trading their holdings–and have, to my (equity-oriented mind) surprisingly small accumulated unrealized gains to show for this–so there’s no equivalent of holding to maturity and getting your principal back.  What bond managers are saying now is that the global bond market is so wide and deep and has so many different products that there are opportunities to ride through the upcoming rise in rates with minimal or no losses.

Of course, if you listen carefully, the companies aren’t saying that they can do so–like equity managers, most bond managers serially underperform their benchmarks–just that it’s theoretically possible.  Egos buoyed by close to three decades of rising markets, they may believe they can do so and are being held back in their public statements by their legal departments.  But if so, I diagnose this as a case of the ultimate Wall Street sin–confusing brains with a bull market.

ETFs fall into two categories, actively managed and index.  Index funds have no scope to change their composition.  ETFs focused on longer-dated bonds will feel the brunt of higher rates.  Management companies will, as usual, say nothing.  For actively managed ETFs, the marketing pitch will be the same as for mutual funds.

what they won’t say

During times of rising interest rates, stocks have typically been flat to up, while bonds have made losses.  (Stocks are negatively affected by higher rates, but rising rates of profit growth have had a counterbalancing effect.)