Tag Archives: finance

investment advisers as fiduciaries: a new Labor Department proposal

April 6, 2016 By in Getting financial advice, How your broker gets paid, Uncategorized Tags: , , , , 1 Comment

The Labor Department proposed new rules today that would require that brokers or financial planners or other professionals giving advice to individuals on their retirement savings act as fiduciaries.

what a fiduciary is

Being a fiduciary means being legally bound to give advice that’s best for the client, without regard for any benefits the adviser might get for recommending one investment over another.

Strangely, in my view, the fiduciary standard is not the rule advisers work under now.  Rather, advisers are only required to recommend products that are “suitable” for customers, meaning they fit the client’s goals, financial circumstances and risk tolerances.

The difference?

Another way of saying the same thing, the fiduciary is required to do what’s best for the client; under the old standard the adviser has simply got to avoid products that damage the customer.

For example:

A broker/planner has two general equity fund offerings:

–Fund A has a long history of strong investment management, consistently beating the S&P 500, and charges low fees

–Fund B has weak managers and an equally long record of sub-par investment performance, consistently losing to the S&P.  It also charges fees that are double the size of Fund A’s.  However, Fund B offers higher commissions to brokers who sell its product, plus trips to weekend informational seminars at resort locations to those who sell the most of it.

Under current rules, a broker/planner is permitted to recommend B over A, even though B is only better for the broker, and will presumably be considerably worse for the client.

costs are the smoking gun

Other than in hindsight, it may be hard to say whether manager X is better than manager Y.  And managers who consistently underperform are eventually culled, even in retail brokerage houses, where the emphasis is typically on strengthening the sales force, not the portfolio management team.

But I think it would be hard for a fiduciary to defend recommending one so-so product over another that costs half as much, and for selling which the fiduciary gets gifts, trips or a corner office and a secretary.

traditional brokers will be hurt the worst by these rules

That’s because they charge the most–partly to compensate highly-paid salesmen, partly to fund an expensive network of retail sales offices.

The traditional retail brokerage business has been dying a slow death since the advent of discount brokerage services in the 1970s.  Imposing a requirement that brokers do the best for their clients is another nail in the coffin.

for now, the rules only affect retirement savings accounts,

…not general savings/investments.  I presume this limitation is the result of fierce lobbying by financial advice providers opposed to the fiduciary standard.  But we may just be seeing the thin edge of the wedge.

is “tenure voting” the answer?

March 15, 2016 By in activist investing, activist investors, tenure voting, Uncategorized Tags: , , , , , 2 Comments

tenure voting

The weapon institutions are currently discussing to combat the potentially negative influence of activists on company management plans is called “tenure voting.”

Under a tenure voting scheme, a shareholder accrues more voting power the longer he holds a given stock.  On day one, for example, the shareholder might have one vote to cast on proposals at a shareholder meeting.  This might rise to three votes after three years of continuous ownership and peak, say, at five after five years.

This heavier voting power given to long-term shareholders would, in theory at least, make it much more difficult for an activist investor with a hit-and-run strategy to coerce favorable action from a timid CEO.

the arithmetic of influence

An activist can have leverage over company management at present by buying, say, 3% of the outstanding shares to obtain 3% voting power.  If the typical institutional holder bought his core position five years ago and if institutions overall hold 60% of the outstanding stock, then with tenure voting in place the activist wouldn’t achieve the same amount of clout until he had accumulated at least 10% of the target firm’s stock.  Of course, the activist could also wait for a half-decade for his stake to achieve maximum voting power, but none strike me as having that much patience.

an effective deterrent

So tenure voting would likely insulate many of the large firms potentially under activist attack from such predation.

But…

–there’s a practical issue of implementation.  Instituting tenure voting at a firm would presumably require rewriting corporate bylaws.

–it doesn’t stop activist action.  It just changes the game.  Activists would have to adopt a two-step strategy, the first of which would be to court one or more big long-term institutional holders of a target firm’s stock.  Of course, this is arguably the intent of proponents of tenure voting–the presumption being that professional portfolio investors would rebuff the activists.  Maybe so.  But maybe not.  However, the obvious place to start would be index funds.  It’s not really clear what unintended consequences this might produce.

–tenure voting has been a traditional practice in places in Continental Europe like France.  In my view, it has been a disaster there, cementing in place an elitist old boy network of corporate managements that have had little regard for ordinary shareholders.  More than that, the French government’s move last year to make tenure voting mandatory for all publicly traded firms met with violent opposition from investors who know this system the best.

All in all, although I’m not necessarily a fan of activists, I think in this case the cure is worse than the disease.

institutional investors vs. “activists”

March 14, 2016 By in activist investors, Uncategorized Tags: , , , , 1 Comment

As I see it, today’s activist investors are the successors to the corporate raiders/ “greenmailers” of the 1980s.  In some cases–Carl Icahn is an example–they’re the same person.

Greenmailers (a takeoff on blackmailers) would typically attack small cash-rich companies by buying a 5% – 10% equity position and threatening to launch a hostile bid to take over the firm unless they were bought out at a high price.  That price would typically be all the cash in the corporate treasury.

The tactic often worked.  A CEO who had spent thirty years clawing to the top of the heap  so that he could exercise power and reap large cash/stock rewards during a five-year tenure as chief executive, knew he would be out the door if a change of control took place.  So he might be all for acquiescing to the greenmailer.  Sometimes, too, a company might have questionable accounting or other dirty secrets that could scarcely stand to see the light of day.

The issue for other shareholders:  while the greenmailer would make a financial killing, he would leave behind a firm drained of cash and typically worth considerably less than before the greenmailer showed up at the door.

Activists play a slightly different game.  They attack large companies (perhaps because smaller prey has long since been devoured).  They typically invest millions of dollars in buying a company’s shares, but because of the size of the target, may only hold 1% – 3% of the outstanding equity.  Activists typically demand seats on the board of directors and offer “advice,” which may be sound (or may not), and which usually consists in actions like dividend increases, stock buybacks and/or spinoffs of business lines.  These are all levers designed to get the stock price up quickly–so the activist can sell and be on his way.

The threat is the same:  the sitting CEO has run a grueling thirty-year corporate marathon only to see the prize snatched away as he’s crossing the finish line if the activist decides that he’s part of the problem.

The issue for other shareholders:  none of the actions activists recommend may be good for the long-term health of the company (look at what happened to J C Penney).  And unlike the greenmail case, where the attacker’s threat is to take over the firm–meaning a profit for other holders and resolution to the issue–the activist may well tie up management time and energy with proxy fights or other distractions that go on for years.

Tomorrow:  what to do.

 

 

Active Share (ii)

March 11, 2016 By in Active Share, Uncategorized Tags: , , , , 1 Comment

As I wrote yesterday, Active Share (AS) is a way to measure the portion of a portfolio that deviates from its benchmark index.  It’s arrived at by adding up all a portfolio’s underweights and overweights, dividing by two and expressing the result as a percentage of assets.  AS can range from 0%, which means the portfolio exactly replicates its benchmark index (i.e., is an index fund), to 100%, meaning the portfolio holds nothing that’s in its benchmark.

what’s good about AS

I’ve always used it as a measure of the riskiness of my portfolio.

If I had four potential outperforming stocks that I thought would carry my portfolio for the current year or more, and the same number of underweights that I had similar conviction in

and if I established, say, a 1.5% difference from the index with each of the eight positions,

and if I thought that my good stocks could outperform the index by 20%, and the bad ones underperform by the same amount,

then I could earn outperformance of 20 percentage points on the 12% of the portfolio that differed from the benchmark.  That’s the same as outperformance of 2.4% for the portfolio as a whole, assuming that everything went according to plan.  (That rarely happens, of course.  Things are either a lot better–or a lot worse.)

+/- symmetry

If we assume the world is symmetrical and that I would lose 20% on any position that went against me (this is a wildly arbitrary assumption), then the worst that could happen (I’m shuddering as I type this) is that the portfolio would underperform by 2.4%.

performance vs. expectations

Okay, I now know something about the risk character of my portfolio.  As a money manager, I also have to ask how this corresponds with the needs and expectations of my clients.

During the mid-1980s, I worked for a couple of years for TIAA, managing money in Pacific Basin stock markets.  In the international area, our performance bonuses maxed out with outperformance of 1% above our benchmarks.  We would receive a small payment for keeping pace with the benchmark.  Even that disappeared entirely, however, if yearly performance fell more than 0.25% below the index.

This is an example, in my mind, of severe risk aversion.  The bonus guidelines told me:  nice if you can get some outperformance, but never, ever, fall below the index.  Arguably, this is closet indexing.

In contrast, I subsequently worked at a firm that for a (mercifully, short) time had a compensation schedule that set the risk bar at +/- 60o basis points vs. the benchmark.  To my mind, this encouraged managers to take crazy high,  risk-the-franchise levels of risk.  More below.

what’s bad about AS

summarizing the good

AS gives a vocabulary for discussing how much a portfolio deviates from its index.  It implictly introduces the idea that portfolio risk consists in such deviation, which I think is correct.

We can also say that there’s something wrong with a $10 billion fund that collects $100 million in management fees yearly for active management, while maintaining an AS that’s at or close to 0.

the bad

On the other hand, there’s a temptation to think that because an AS of 0 for an active manager is bad, that, while an AS of 10% might be good, one of 50% must be even better.

I think that’s wrong, in two ways:

–to get an AS above, say, 30%, a manager has to have deep knowledge and conviction about at least 15 or 20 things.  (One could, in theory, get to that level by making one gigantic stock bet, but regulations and contracts most likely rule out that option.)  I know I could never have been the smart money on so many topics.  I’ve never encountered anyone who could.

Better to be a yard wide and a mile deep than the opposite.

In other words, at some point, I would think, high AS becomes a warning sign that a manager has lost control of his portfolio.  That’s not a positive.

–if an AS of 2% is a Fourth of July sparkler, an AS of 30% is a ton of nitroglycerine.  If all the bets go wrong, the result will be a loss of, say, 12% vs. the index in a year.  No matter what they say up front, this is not what clients expect.  They’ll leave in droves.

 

Toys R Us redux

February 23, 2016 By in Retail, Uncategorized Tags: , , , , , Leave a comment

Toys R Us (TOYS (not a ticker symbol today)) has been an iconic name in retailing over the past forty years.

–In the 1970s urban department stores came under attack by upstart specialty retailers who extracted the most profitable “departments” from the older merchant conglomerates and opened stand-alone locations focused on a single line of goods in direct competition with their older rivals.  More nimble, with a wider selection, often lower-priced, more willing/able to follow customers to the suburbs, specialty retailers ate the department stores’ lunch for years.  Many still do.

Toys were at the top of the extraction list.

TOYS was the first of the three contenders (the others were Child World and Lionels Kiddie City) to complete a nationwide retail network yielding the economies of scale that eventually won out against the other two.  As such, TOYS is a textbook case of the successful 1980s retailer.

It took market share both from department stores and mom-and-pop toy retailers.

–The 1990s saw the rise of Wal-Mart (WMT) and Target (TGT), who, more modern versions of the department store, used their floor space in a flexible way than their predecessors.  Their toy departments were relatively small for most of the year, but expanded dramatically during the holiday season–meaning, in contrast to TOY, they had toy overhead expenses for only a small part of the year.  Because they had other lines of merchandise to sell, they could (and did) use the hottest toys as loss leaders, as well.

For the first half of the decade, TOYS steadily lost market share to WMT and TGT but made it up by taking share from mom and pops.  Then there were no more m&ps   …and TOYS’ underlying competitive issues became more evident (there are a lot more wrinkles to the story–like store locations–but I think WMT and TGT were the main plot line).

–In 2005, TOYS was taken private in the first of a series of attempts to reorganize or restructure the firm to restore its past glory.

 

—today TOYS is back in the news as markets worry about the firm’s ability to refinance its substantial junk bond borrowings.  It’s now being looked at as a possible canary in the coal mine for future troubles in sub-prime debt.

More tomorrow.