Category Archives: Vocabulary

taking a “barbell” approach

August 8, 2014 By in barbell Tags: , , , Leave a comment

creating a barbell

This is a metaphor that investors and their advisers use to describe the following strategy:

–sort the things you’re going to invest in  from, say, left to right in order of riskiness

–put the least risky on the extreme left, the most risky on the extreme right and fill in the rest in risk order

–if you were indexing, you’d have some of everything and your holdings would look kind of like a solid line along your riskiness scale.  Don’t do that.  Take a bunch of money from the center and put, say, half of it in the least risky assets and the other half in the most risky.

Now your portfolio looks like a barbell.

a persuasive–though bad–metaphor

The idea sounds good.  The picture of being a weightlifter instead of a wimp is appealing.  It also has tones of stability, familiarity and prudence.

why it’s a bad image

In general, the biggest problem with creating a barbell isn’t the idea itself, but the way risk is defined.  The metric that’s commonly used is day-to-day price variability.  Why?  …because that’s what finance professors use.  As far as I can see, the only thing short-term volatility has going for it is that the data are readily available.  But investors like you and me will find it hard to swallow that stocks that have wide daily trading ranges but are up 25% at the end of the year are somehow worse than stocks that seldom fluctuate in price and end the year 15% (or less) higher.

In particular, for today’s circumstances the issue is that models alike this almost always end up with bonds on the far left and emerging market stocks on the far right.  I’m not sure I’d get much sleep at night if I were loaded up with a barbell of Treasury bonds and frontier market stocks right now.  Symmetrical, yes, as safe as an index, probably not.

an S&P barbell forming?

What makes me write about this today is that during the current stock market turbulence, I’m noticing distinct barbelling in my own stock portfolio.

I own ZEN and SCTY, for example, not stocks I would recommend to anyone else.  I also continue to watch TSLA, although I no longer own it.  All three are pretty far to the right on the risk spectrum.  But all three are doing fine.

On the other hand, I’ve recently been looking for low PE industrial stocks.  I don’t care so much about dividend yield; I just want low relative and absolute PEs–relative meaning vs. both the market and the stock’s own history.  The couple I own (I’m still doing my homework, so no names) doing fine, too.

So it appears to me the stock market is now doing its own form of barbelling.

My conclusion, however, is not that stock market participants are stretching for extra risk and offsetting it with ultra-conservative names.  I think investors just want to get away from the center, at least for the moment, because they think it’s overvalued.

 

missing the boat on dark pools

July 2, 2014 By in dark pools Tags: , , , 1 Comment

Maybe it’s the name, as some have suggested, but for whatever reason electronic crossing networks for stock trading are being portrayed in the press as insidious devices that need a large dose of sunlight shone on them.

That’s not right.  Electronic crossing networks exist for a good reason  …two, actually.

why use a dark pool?

Suppose you’re the manager of the Fidelity Magellan Fund and want to sell your entire holding in Bank of America (BAC).  As of its end of May disclosure, that amounted to 25.2 million shares.

Here’s the plan:

–average daily trading volume for BAC on the exchanges is 60.6 million shares.  Let’s say you don’t want to be more than 10% of daily volume, so that your selling doesn’t disturb the market too much.  That means it will take you four days to trade out of the position.

That’s pretty straightforward.  The real trick is to keep your identity and intentions secret for as long as possible, so that news of your selling doesn’t reach potential buyers and cause them to lower their bids.  This may be doubly important if you have a reputation as a shrewd investor.  Worse still if you bought BAC at the bottom when others thought you were crazy: your selling may be taken as a strong sign that the party is over for that stock.  So the exit door may get pretty crowded if others find out what you’re doing.

call a broker?

In my experience, if you’re Fidelity, calling one of the big brokerage houses and placing a sell order, even for a small amount of stock, is not the best idea.  Within minutes, that broker’s proprietary trading desk will likely know about your order.  Shortly after that, so too will other brokers.  Everyone’s sales desks will then begin to call the trading arms of institutional clients, spreading the information.  After all, these guys make their money by generating lots of trading commissions, not by taking the best care of you.

…and lose outperformance?

In my view, good trading + the ability to keep your actions below Wall Street’s radar, can be worth 100 basis points in annual performance.  This is like gold in keeping your money management clients happy …and getting new ones.

try a crossing network

Preserving this treasure is why crossing networks were invented and why professional money managers want to do business through them.

the second reason

The SEC mandates that managers it supervises obtain the lowest possible trading cost.  That’s crossing networks.  In other words, all other things being equal, professional money managers (ex hedge funds) have a positive obligation to use them.

the Barclays case

Most investors don’t want high-speed traders in their crossing networks.  The latter’s computers can quickly detect unusual trading activity, which allows them to trade against this movement, both in and out of the dark pool.  Put another way, the element of secrecy, the key feature of the crossing network, is lost.

Barclays is accused, among other things, of running a dark pool whose largest participant was a high-speed trader while telling other participants no such damaging influence was present.

 

The big brokers are now saying the solution to the Barclays problem is to abolish dark pools.  Of course, I’m sure they’d also like to get rid of discount brokers and no-load funds as well.  But the real issue is alleged deceptive business practices by one of the big brokers themselves.  Eliminating alternatives to their trading desks is no solution.  If you’re not a borker, it’s crazy.

 

 

 

 

 

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.

 

 

financial inversions are proliferating

May 28, 2014 By in Current Market Thoughts, financial inversion, Stock ideas, Strategy Tags: , , , , , , , Leave a comment

A while ago, I wrote about the financial or tax, “inversions” that have been sweeping the US pharmaceuticals industry.  Basically, a US company that pays a full 35% Federal corporate tax bill can reincorporate in a low-tax foreign jurisdiction–purely on paper–by taking over a foreign firm already set up there.  This is financial engineering at its finest/worst.  No one has to move; offices and plants remain untouched.  Certain conditions do have to be met, however.  The US acquirer must fold itself into the foreign acquiree so that the foreign entity is the survivor.  And foreigners must own 20% of the shares of the merged company.  Otherwise, it’s pure financial gravy.

Consider a US company that has $1,000,000,000 in pre-tax income.  After Federal tax, that’s $650,000,000.  If the firm can “invert” itself and end up with a 20% tax rate on that income, the after-Federal-tax number becomes $800,000,00.  That’s an annual savings of $150,000,000–a 23% jump in the funds that can be used for capital investment or paying dividends.

IHG

It’s no longer just drug companies, though.  Last weekend, media reports that Intercontinental Hotels Group, PLC (IHG) had been approached by a US hotelier, speculated to be Starwood (HOT), about a combination of this type.  IHG supposedly rejected a $10 billion takeover offer.  (IHG’s stock price indicates we may not have heard the last chapter of this story, since the quote rose to just about the reputed offer price after the news came out.

investment implications

1.  Back in the Stone Age (the late 1970s), when I entered the investment business, investors were very sensitive to the rate at which a company’s profits were taxed.  At that time, the prevailing view has that the higher the tax rate, the better quality the earnings were.  The rationale was that in order to be used for dividend payments, cash generated in low-tax jurisdictions would need to be repatriated and local corporate tax paid.  Therefore, the apparent profits generated in low tax areas were illusory and not to be trusted.

Now, that view seems very Austin Power-ish.  As I see it, for good or ill, over the past decade or more investors have been indifferent to the rate at which profits are tax.  It’s solely profit growth that counts.  Whether it’s achieved through selling more products or by astute tax planning doesn’t matter.

But the “modern” view has to be changing again, I think, as inversions become more popular.  It’s now a distinct investment plus to be a foreign company in a low-tax jurisdiction.  This means that, sooner or later, a US firm in the same industry will make a takeover bid.

2.  As the US corporate tax base begins to erode through financial inversions, there should be a response from Washington.  The rational one, in my view, would be to simplify the tax code and lower the levy on corporations to what’s normal in the rest of the world.

But no.  So far the only movement in Congress is to retroactively make inversions illegal.  This is the kind of thing that has helped give India its current reputation as a high risk area to do business in.

Still, reform of corporate taxes would potentially create a whole raft of winners and losers.  So it’s something to keep an eye out for.

 

Fidelity’s dark pool proposal–why?

April 28, 2014 By in dark pools, the SEC, Trading Tags: , , , , , Leave a comment

Recently, Fidelity, one of the largest money managers in the world, has been sending feelers out to its peers to form a private “dark pool” in which they could all trade anonymously.

What’s this all about?

I’m not sure who made up the name “dark pool.”  But it glamorizes a pretty mundane operation.  A dark pool is a computer-driven trading network where professional investors buy and sell securities with each other in a low-cost anonymous way.

They’re meant to solve two problems that every large investor like Fidelity who’s subject to SEC regulation in the US has:

–in trading securities for their clients,money managers are required to obtain the lowest cost in making any trade as well as the best execution of the order.  Best execution, which I take to mean the most favorable price, given the circumstances at the time of the trade, is a rather vague and contentious concept.  But lowest cost, meaning the lowest commission or bid/ask spread paid to get the trade accomplished, is relatively clear.

It’s also very clear that dealing with a third-party broker isn’t the lowest cost way of doing business.  Dealing directly with another institution through a computer trading network may cut commission/spread costs in half.  As a result, increasing amounts of trade is being done through dark pools so institutions can establish that they’re working to fulfil the lowest-cost legal mandate.

–any money manager wants to keep his trading activity as secret as possible.  After all, no one wants others to be freeriding on investment ideas that a manager has developed after long and expensive research efforts.

This is a particularly pressing issue for managers with large amounts of money under management, since such a manager will often have orders that are so big they can take, say, a month to execute–sometimes longer.  The trickiest part of such trading is keeping the manager’s activity secret for as long as possible.

Again, brokerage house trading operations for third parties are not a great way to go.  They tend to leak like sieves.  Part of this is a function of order size.  The broker may approach potentially interested parties.  As/when the size of the order becomes apparent, the other party may be able to guess the identity of the institution the broker represents.

There’s mre than that, however.  Information is also a valuable resource.  In my experience, most important clients of a broker–and the broker’s own proprietary trading desk–would know the general outlines of a Fidelity order within minutes of its being placed.  The broker might not use the Fidelity name, but the description ” a large institution in Boston” would leave little to the imagination.  The idea is that smaller clients will regard this as valuable information and will compensate the broker with increased trading commissions in return for continuing access.  (My tendency would be to do less business with a broker who acts this way, but apparently I’m in the minority.)

Dark pools, though sometimes illiquid, are one solution to this problem.

It turns out, though, that the dark pools also have their issues.  One that I find interesting is that to obtain liquidity dark pools may allow high frequency traders to participate.  And, it turns out, they have found “big data” ways to figure out which orders are Fidelity’s–and to use this information to trade against them.

Fidelity’s response is to try to form a dark pool that will consist only of institutional investors, without high frequency traders.  Such a setup might have issues of its own.  If there are only, say, four major members it may be that the trading intentions of the others will be obvious to all.  But, in Fidelity’s view at least, that would be better than the current situation.