Category Archives: Vocabulary

dealing with high daily volatility

February 4, 2016 By in Technical Analysis, technical bounce, Uncategorized Tags: , , , 1 Comment

To state the obvious, we’re in a period of high daily volatility in the trading of stocks around the world.  What I find particularly striking is that we’ve had two days recently–January 20th and yesterday–where stocks in the US made dramatic intraday shifts in direction.  In both cases, heavy early selling that pushed indices down sharply was followed by a late reversal that wiped out most, or all, of the previous losses.  In my experience, this rarely happens once–to say nothing of twice, and within a couple of weeks of each other.

I’ve got little clue as to why the going is so choppy.  I imagine that algorithmic trading has something to do with it.  Sovereign wealth fund selling may be playing a role.  Investment banks reining in proprietary trading, thereby removing liquidity from the market, could be a factor, too.  I don’t believe that either oil or China are much more than straws the financial media are clutching to.

Still, I find it very strange.  The closest analog I can think of is the period following the collapse of the internet bubble in early 2000.  But even that wasn’t that much like the present.

My thoughts:

  1. The intraday reversals may be significant technical events.  Sometimes, they signal market bottoms.  In both recent cases, the market did bounce up off important support lines.  Time will tell, especially since markets have a habit of returning to prior lows after a month or so before resuming a new direction.
  2. Blackrock, the largest investment manager in the US, seems to be calling into question whether daily volatility really has any significance for ordinary investors.  Presumably, we all have equity investment horizons of three to five years.  So what do daily ups and downs matter? This is just common sense, in my view, and harks back to traditional Wall Street beliefs.  It is, however, heresy to devotees of the (wacky) academic theory of finance taught to in MBA schools.
  3. As a practical matter, you and I will never be able to outtrade high speed computers, or even low speed ones–or professional human traders, for that matter.  We don’t have–or want–the mindset.  We have lives; we aren’t interested in watching stock price feeds all day.  Our main advantage over traders is that we are willing and able to take a longer investment horizon.  We try to be aware of the shape of the forest, not the height and width of each individual tree.
  4. We can look for anomolies, though.  Yesterday is a case in point.  We can look for stocks that didn’t follow the herd.  Issues that went down less than the market in the panicky morning selling and rose more the the average during the afternoon rebound are probably worth looking at more closely as buy candidates.  The reverse is also true.  Stocks we own that sold off more heavily than the average in the morning and rebounded less have got to be reexamined for whether we still want to hold them.
  5. It’s conceivable that high daily volatility is the new normal.  Who knows.  But if so, we should consider what else we can to to turn this to our advantage.  More limit orders when we trade?  More aggressive limits?

 

market leadership and relative market share

June 16, 2015 By in relative market share Tags: , , , Leave a comment

In looking for companies to invest in, market leaders are very often a good place to start.  They have the advantage of their large size, high visibility to existing and potential customers, and likely scale economies.

Of course, there are some common sense caveats to this.  We have to ask ourselves, for instance, whether the market a company claims to be addressing actually exists or is worth the effort to dominate.  If, say, a restaurant chain says it rules the market for left-handed diners in Cleveland, we might scratch our heads on either count.

Once we get past silliness, though, there is an important market attribute to consider–market concentration.  A useful way to approach this issue is through relative market share..  Relative share can be calculated in a number of ways, the simplest (and therefore my favorite) is to calculate the market share of a given competitor–usually either the firm you’re interested in or the number two in the market–as a percentage of the market leader’s.

In a market where the leader controls 60% of the market, #2 has 30% and #3, 10%, the relative market shares are 1, .5 and .17.  This is usually a very favorable situation for the leader.  Unless the overall market is growing at warp speed–in which case every firm is staking out territory as fast as it can and not worrying about what competitors are doing, #3 had better had a good niche strategy or else it’s toast.  #2 may be in a better position than #3 but may also be vulnerable to market share loss from #1.

A market where #1 has 35%, #2 has 33% and #3 has the rest is far different.  The relative market shares are 1, .94 and .91.  This is most likely an incredibly competitive market, where #1’s “leadership” may only be a function of its greater willingness to cut prices.  While the dynamics of such a market may be theoretically interesting, for investors–except, again, in the unusual situation of hyper-growth, it’s usually one to watch from the sidelines.

 

 

 

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

 

 

 

 

 

 

making it clearer who pays for investment research

September 3, 2014 By in How your broker gets paid, Investment firms, Portfolio management, sell-side analysts, soft dollars, Trading Tags: , , , , , , Leave a comment

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.