What is the value of a relationship?
It probably doesn’t come as a surprise to anybody reading this that most large investment banks have proprietary trading desks, which buy and sell different investment instruments to generate earnings for the banks. Although the banks don't generally break out the specifics, the overall results are impressive. In its last quarter, for example, Goldman Sachs reported $4.12 billion in revenue from trading and principal investments, up 47 percent from the year-earlier quarter and up 57 percent from the fourth quarter of last year. At the same time, many of these same banks (for example, Goldman, Morgan Stanley and Bear Stearns) are managing more and more prime brokerage assets on behalf of hedge funds. For example, according to Richard Lindsey, president of Bear Stearns' global clearing services unit, Bear Stearns' global clearing unit has generated about 25 percent of the company's pretax profits since 2000.
My intention is not to bore you with the nuances of these firms’ lines of revenue, but rather to point out what appears to be at the heart of the unholy alliance between the buy-side and the sell-side of Wall Street. Investment banks are disclosing the results of their proprietary trading activities, at the same time as they are busy looking to prime broker hedge funds assets . These banks have employees that are paid to trade internal assets. They also have employees whose jobs are to become as familiar as possible with the movement of of their clients’ hedge fund assets. As far as I am aware, there is no current or pending legislation establishing any sort of wall between these two conflicting activities. This is not to say that some banks aren’t being proactive in terms of separating these functions. It’s just to acknowledge the status quo.
A few weeks ago, the Financial Services Authority fined Deutsche Bank’s Morgan Grenfell unit along these lines:
The FSA found that Morgan Grenfell commenced proprietary trading in seven of the constituent securities of a client's programme trade, prior to its award, based on limited information provided to enable the firm to quote for that business. The proprietary trading resulted in the client paying more for the programme trade than they would otherwise have done.For the full release, click here.
As the FSA uncovered at Deutsche Bank, some of these banks are so successful at managing their own internal proprietary trading desks because they are learning from their external hedge fund clients. What is the trading cost here to investors? Maybe it’s not a $.05/share price after all, but rather closer to $.08 or $.10 per share when you factor in the costs of the banks themselves mucking up the hedge fund’s trades.
Hedge funds are some of the smartest financial minds around and they definitely are not continuing to entrust their funds to bulge bracket investment banks out of ceremony. In addition to asset management, trading technologies, executive recruiting, etc., hedge funds also assess value to getting access to shares of Initial Public Offerings. In a nutshell, funds are willing to put up with a lot of shitty execution and mediocre research in order to get the highest possible allocation of Google shares at the IPO.
And so for a brief diversion I offer you Miami Vice:
For me, everytime I think about Hot Issues and Safe Harbors, I think about Tubbs and Crockett. On one level, the metaphors of heat and waterways immediately conjures up that pulsating introductory sequence of fast boats cruising through Miami. On a deeper level, Tubbs and Crocket demonstrated multiple levels of moral conflict in order to penetrate the netherworld of sophisticated drug brokers and dealers. This is very much like the balance struck by the buy-side and sell-side. Everybody is conflicted, to a certain extent, since each is trying to profit from the other: "you hook me up with Google shares and I’ll do more trades through you;" "you help me set up my infrastructure and I’ll let you roll me out as the next hot US hedge fund manager your clients in Europe." At stake are enormous fortunes paid out each year for the fund managers at the top of the food chain and for the brokers that help them get and stay there.
Yes there are structural tensions underlying the relationship of the investor and the trader, but these tensions are another word for edges which is what the buy side is forever looking for. Last week I was fortunate to have an audience with the former head of the equities division of a premier sell side firm. He is launching his own fund soon, and so he is pretty engaged with the notion of what the sell side can do of value for the buyside.
In less than a minute he described a scenario that for him represented maximum value. It wasn't a single function but rather a combination of services that revolved around trading smartly in the market. Imagine a sales trader that you could call up about an idea or a theme. He had access to the most current company information, and was able to put this in the context of what everybody else on the street was expecting from the company. This benefit was further supported by anonmyous trading which nevertheless had real capital behind it. As the trader played out potential outcomes over different time periods, he was able to suggest options and other derivative strategies to take maximum value of the idea.
In the midst of these complex interconnections of learning about, buying and selling shares in a company, the relationship between the institutional investor and the broker dealer persists and even thrives. The obfuscation of interests benefits both parties. While many may correctly refer to markets as efficient, the relationship of the parties making these markets is not necessarily so. The inefficiency manifests itself in high transaction costs that affect the industry.
The next logical question is then whether high transaction costs are necessarily bad, and if so for whom. Even if the ultimate execution of a trade is done electronically for less than a penny per share, chances are that the idea generation and analysis that led up to the trade, not to mention the broader context of staying smart about a sector through attending conferences, meeting management, etc, together add pennies and even quarters of costs to each share traded.
This would seem to be "expensive" in terms of ultimate costs to investors, and yet at least in my limited dealings with hedge fund managers and analysts, I continue to hear their willingness to pay a premium for what they perceive to be a proprietary advantage. In the end, their competition is less other hedge fund managers and more the growing efficiency and commodification of equity markets. In a friction-free environment, there is no reason why everybody should not invest in index funds anf etfs. What distinguishes successful fund managers is their ability to outperform the averages and take advantage of unique sources of information and insight to produce alpha. The fully loaded commission and the performance fee of the hedge fund manager are related costs. I wonder if with increasing downward pressure on transaction costs (from the regulators, from the media, from shareholder services, etc) that there will be that much more scrutiny there will be of the economics of hedge fund management.
One can argue that hedge funds are unregulated and therefore should be free to charge investors whatever the market will bear, and that funds can pay out commissions based on whatever they perceive to add the most value. The relationship between buy-side and sell-side continues to pad the margins that benefit both sides of the trade.
What will more transparency into this relationship do?
Will funds continue to build out more functions that have been traditionally the role of the sell-side, such as electronic trading platforms, independent research and their own internal analyst corps?
Or will funds establish deeper links with investment banks at levels that are increasingly difficult to monitor.
Or perhaps both?