Category Archives: Investment firms

what will a soft dollar-less world look like

February 12, 2015 By in economics, Industry Analysis, Investment firms, Portfolio management, securities markets, Securities regulation, sell-side analysts, soft dollars, stock market, Trading Tags: , , , , , , , 3 Comments

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

February 11, 2015 By in Investment firms, Portfolio management, securities markets, Securities regulation, soft dollars, stock market Tags: , , , , , , Leave a comment

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

 

 

 

 

 

 

why more equity managers don’t outperform

January 14, 2015 By in Getting financial advice, index funds, Industry Analysis, Investment firms, Where are the customers' yachts? Tags: , , , , 1 Comment

1.  Most US equity managers, prompted by personal inclination and the wishes of their employers and their institutional clients, adopt either a value (buying undervalued assets) or a growth(buying accelerating profit growth) investment style.  In a typical business cycle, the first two years favor value stocks, the latter two growth issues.  Over that cycle, a manager is likely to have two good years, one so-so year and one bad year.  A skilled manager, however, will outperform over the cycle sc s whole, no matter what his style is.

This is another way of saying that the criterion of outperforming every year is unreasonable.

2.  a truism:  the pain of underperformance lasts long after the glow of outperformance has faded.  A manager who builds a riskier portfolio expecting fame and fortune from significant outperformance risks exploding on liftoff and outperforming badly–thereby losing both his clients and his job. He also gives his firm a significant black eye. No one, however, gets fired for underperforming slightly and being in the middle of the pack of competitors.

As a result, many long-lived investment organizations are constructed on the idea of strong marketing and so-so performance.  I’ve always regarded Merrill as the poster child of this approach in the mutual fund arena.

In other words, outperformance isn’t the most important attribute of a successful investment product.

3.  Most investment organizations find that a running a research department of their own is difficult and expensive.  Many, especially (in my view) the majority which are run by professional marketers, have long since eliminated proprietary research and have been depending heavily on brokerage houses to supply this service.   Doing so has the additional advantage that in-house analysts are no longer a drain on management fees received (brokerage house research is paid for with clients’ commissions).  That “solved” a problem and enhanced profits at the same time.

However, brokerage houses gutted their research departments during the market downturn in 2008-09.  The sharp decline has also accelerated an ongoing trend away from traditional investment managers and toward a diy approach using index funds.

So there’s no longer a plethora of high-quality brokerage reports and no “extra” management fee money to reconstitute proprietary research departments. Where are the good new ideas going to come from?  I think this new client preference for investment performance over salesmanship will create severe difficulties for traditional investment organizations.

 

actively managed ETFs?

November 5, 2014 By in ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, securities markets Tags: , , , , , Leave a comment

ETFs vs mutual funds

ETFs are just like mutual funds, with two exceptions:

–investors buy and sell mutual fund shares directly with the fund itself.  All transactions take place at net asset value, without commission, once a day, after the close of trading. (Load mutual funds will be subject to a bid-asked spread, as well.)  The (high) costs of maintaining this sales and record keeping organization are borne by fund shareholders.

–ETFs, on the other hand, use the (much cheaper) already existing sales and record keeping system maintained by the brokerage community to record transactions in individual securities.  This allows ETFs to trade continuously throughout the market day.  Buyers and sellers pay a commission when they trade ETFs, and they also pay a bid-asked spread.  (I know of no reliable source that calculates these spreads.  The only information that ETF managers provide is a comparison of the last trade of the day with NAV calculated after the close.  This, of course, tells us nothing about what happens during the day.)  For a buy-and-hold investor, though, I think there’s no question but that ETFs are cheaper than mutual funds.

One other feature of ETFs:  brokers authorized by the ETF actually assemble themselves the securities that are in an ETF.  They only transact with the ETF manager when their holding reach a certain size, say, 50,000 shares.  This is another way to keep costs down.  But it also means that the broker has to know, every day, what’s inside a given ETF.  So the SEC requires ETFs to disclose their portfolio holdings and structure once daily.  This contrasts with mutual funds, which disclose holdings once every three months, shortly after the end of their quarter.

active ETFs

The daily disclosure requirement poses a huge problem for active management firms controlling large amounts of assets.  Their ability to outperform their peers depends (in their minds–and marketing materials, anyway) on having different (and better) portfolio composition than their rivals.  This can mean having different weightings in stocks everyone holds.  But it more often means identifying and buying a securities with favorable characteristics before anyone else, or getting rid of dog that the consensus thinks are stars.

The most attractive actively managed ETFs for most investors, I think, would be clones of existing mutual funds that have favorable long-term records.  For portfolios like these, however, it can take at least several days–and maybe weeks–to add or subtract a holding.  So secrecy is very important.  Once the name is known, brokers will frontrun the asset manager’s trading; rivals can quickly imitate its actions.  Therefore, any competitive advantage an asset manager may have from proprietary research is lost.

According to the Financial Times, large asset management firms have been inundating the SEC recently with requests to form “opaque” actively managed ETFs, where the daily holdings disclosure requirement would be waived.  The SEC has refused them all, on the grounds that brokers would hesitate to support what would be in a sense a pig in a poke.

This doesn’t mean there won’t be actively managed ETFs.  There are already a number.  But they’ve either got to be created by small asset management firms which don’t have the size problem, or (less likely) completely novel ETFs from larger firms.

 

ARK Investment Management and its ETFs

October 13, 2014 By in Autos, cloud services, ETFs Vs. Mutual Funds, growth vs value, Industry Analysis, internet, Investment firms, robots, semiconductor manufacturing, software, Technology, Wireless Tags: , , , , , , , , Leave a comment

ARK

I was listening to Bloomberg Radio (again!?!) earlier this month and heard an interview of Cathie Wood, the CEO/CIO of recently formed ARK Investment Management.  I don’t know Ms. Wood, although we both worked at Jennison Associates, a growth-oriented equity manager with a very strong record, during different time periods.  Just before ARK, she had been CIO of Global Thematic Strategies for twelve years at value investor AllianceBernstein.  (As a portfolio manager I was a big fan of Bernstein’s equity research but I’m not familiar with her Bernstein output.)  She’s been  endorsed by Arthur Laffer of Laffer Curve fame, who sits on her board.

ARK is all about finding and benefiting from “disruptive innovation that will change the world.”

Ms. Wood was promoting two actively managed ETFs that ARK launched at the beginning of the month, one focused on industrial innovation (ARKQ) and another the internet (ARKW).  Two more are in the works, one for genomics (ARKG) and the last (ARKK) an umbrella innovation portfolio which will apparently hold what it considers the best of the other three portfolios.

What really caught my ear in the interview was Ms. Wood’s discussion of the domestic automobile market (summary research available on the ARK website).  Most cars lie around doing nothing during the day.  What happens if either ride-sharing services like Uber or the Google self-driven car, which make more constant use of autos, catch on as substitutes?  According to Ms. Wood, until these innovations reach 2.5% of total miles driven (based on the idea that on a per mile basis ride-sharing costs half what owning a car does), there’s little effect.  But at 5% penetration, the bottom falls out of the new car market.  New car sales get cut in half!

Who knows whether this is correct or whether it will happen or not   …but I find this a very interesting idea.

about the ETFs

The top holdings of ARKW are:  athenahealth, Apple, Facebook, Salesforce.com and Twitter.  These comprise just under 25% of the portfolio.

For ARKQ, the top five are:  Google, Autodesk, Tesla, Monsanto and Fanuc.  They make up just over 24% of the portfolio.

Both will likely be high β portfolios.  Both have performed roughly in line with the NASDAQ Composite since their debut.

The perennial question about thematic investors (I consider myself one) is whether the high-level concepts are backed up by meticulous company by company financial research.  This is essential.  In addition, it’s important, to me anyway, that the holdings be arranged so that they’re not all dependent on a single theme–the continuing success of the Apple ecosystem, for instance.

I’m not familiar with Ms. Wood’s work, so I can’t say one way or another (Fanuc and ABB strike me as kind of weird holding for ARKQ, though).  But I think her research is worth reading and her ETFs worth at least monitoring.  For us as investors, the ultimate question will be whether Ms. Wood can outperform an appropriate index.  The NASDAQ Composite would be my initial choice.