TRANSPARENT BUNDLES by Seth Goldstein

Thread 1: Interview with Goldhaber: Attention & Productivity

The following is an excerpt from a conversation with Michael Goldhaber in March 2006, directly following OReilly's Etech conference entitled The Attention Economy, where both Michael and I spoke.  I will release the full interview transcript in bite-size nuggets in the coming week/s.

Thread 1:  Attention and Productivity

MG:  ...In an attention economy, everyone’s trying to get more attention, but the net amount really isn’t going to change very much. It’s just moved around.  The individual may feel they’re being more productive in the sense that they are doing things that ultimately get more attention, but you’re not really changing the sum total. So, why you’re doing things is much more because, whether it’s your software or somebody else’s software, you want attention from a Web site or whatever. And if people feel that that’s going to help them get attention in some way – I’m generalizing obviously  – they will then go for that.  They may be wrong; but there is the sense that they can get more

SG: I think the productivity argument is derivative of attention.  Meaning, I think that understanding the exchange of attention potentially allows you to save time.  So, if I’m able to understand whom I am paying attention to – if I’m able to understand the people I’m influenced by – what they’re paying attention to – Seamlessly – then maybe I can waste less time on things that I’m really not interested in.  So, the byproduct of that is productivity.  Right?  I think that’s the real, pure filtration.

MG: Yeah, I suspect that’s true, but what does wasting less time mean?  Wasting less time means in some sense being more effective in the allocation of your attention and in the sense of getting more attention than you’re giving.

SG: But is that related to productivity, if you get more attention?  I don’t see the connection.

MG: I would define productivity in a zero sum world, a world of attention scarcity, that getting more attention is the closest you can come to being more productive.  A society as a whole does not get more productive, because how do you define productivity?  We now define it in terms of money, but if I’m right, money is something that to a large extent, not completely at this point, but to a large extent, tracks attention.  And it will track more and more attention.  In other words, the more attention you get, the more productive you are.  Personally, the more attention you save, the more productive you are.  So, the more you can get attention, while paying the least attention, I would say maximizes your personal productivity.

SG: Why productivity?  I think of it as influence, being influential.  Why are you being more productive?  Is productivity a required variable in an economic framework?

MG: Productivity is an old term from the old economy in a way, but what I urge you to understand in effect is that what productivity increasingly means is, you’re more productive if what you do gets more attention.  That’s why a janitor gets paid a lot less than a movie star.  And we measure productivity in money terms and basically money goes largely, increasingly, to people who have attention.  So, the more attention you have, in effect you are counted economically as more productive.

SG: For the technology world, productivity is more like: I can get more shit done; I can get more tasks done.  It’s like calendar management - time.

MG: Right.  But for that to be economic productivity, it has to affect some output.  And that output ends up being essentially attention.  Anyways, that’s just one thought.  That’s a small thought in a way, but significant.

SG: I don’t think anybody is as evolved in their thinking about the attention economy as you are, but you see it’s like the stages of evolution that people go through mentally to kind of get to the attention perspective.  At first it’s like they’re a kid and they’re just throwing around words without any rigor, and then I think you start to see a little bit more care, and then a little bit more and more.  We’re used to using the word attention in a very un-rigorous way.  When you look at attention as a physics, as a substance, then you take it more seriously.

Media Futures, Part 5/5: ARBITRAGE: IV. New Markets

Securitization is a financial technique that pools assets together and, in effect, turns them into a tradeable security. Financial institutions and businesses of all kinds use securitization to immediately realize the value of a cash-producing asset. Securitization has evolved from its beginnings in the 1970s to a total aggregate outstanding (as of the second quarter of 2003) estimated to be $6.6 trillion. This technique comes under the umbrella of structured finance. (from Wikipedia)

In the 1970s, from his perch at the Salomon Brothers trading desk, Lew Ranieri famously applied securitization to the mortgage market, creating what is now referred to as MBOs (mortgage backed securities).  This application has enabled (1) millions of consumers to more easily become homeowners by (2) transferring credit risk away from banks and thrifts to independent financial investors in the bond markets.  To put the size of this market- $2.5 trillion- into perspective, you could take the combined market cap of the entire Internet sector (including paid search, ecommerce, advertising, travel, etc):

• TWX = $90B
• MSFT= $250B
• GOOG= $65B
• YHOO= $50B
• IACI= $15B
• AMZN= $15B
• EBAY= $50B
• Combined Internet market cap= $600B

The innovation and size of the MBO market qualifies Ranieri as a special blend of creativity and capitalism, and this led to his becoming one of the great financial alchemists of all time.

Business Week, November 29, 2004   
Lewis S. Ranieri: Your Mortgage Was His Bond
The bond trader turned home loans into tradable securities 

The past quarter-century has seen a revolution in finance. It's felt every time a homeowner refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this revolution-- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for converting home loans into bonds that could be sold anywhere in the world. What Ranieri calls "the alchemy" lifted financial constraints on the American dream, created a template for cutting costs on everything from credit cards to Third World debt -- and launched a multibillion-dollar industry.

Last month, online mortgage lead generation company LowerMyBills (LMB) was bought for more than $300m by Experian.  According to the press release, here is how the two companies are described:

LowerMyBills.com is a one-stop destination that offers savings through relationships with more than 400 service providers across 17 service categories including home loans, credit cards, long-distance and wireless services, and auto and health insurance. Since its inception in 1999, LowerMyBills.com has helped more than 500,000 consumers save nearly $200 million.

Experian is a global leader in providing information solutions to organizations and consumers. It helps organizations find, develop and manage profitable customer relationships by providing information, decision-making solutions and processing services. It empowers consumers to understand, manage and protect their personal information and assets. Experian works with more than 50,000 clients across diverse industries, including financial services, telecommunications, health care, insurance, retail and catalog, automotive, manufacturing, leisure, utilities, e-commerce, property and government. Experian is a subsidiary of GUS plc and has headquarters in Nottingham, UK, and Costa Mesa, Calif. Its 12,000 people in 27 countries support clients in more than 60 countries. Annual sales exceed $2.5 billion.

This is interesting on a number of levels, not the least of which is the premise that (1) the mortgage leads and data process of LMB are valuable to an information broker such as Experian and not simply to traditional mortgage companies and (2) the consumer benefits from easy access to creditors who bid in a competitive environment for the consumer’s business.

The essence of securitizing mortgages was to shift the credit risk away from the lenders’ balance sheets and into a open market.  Whereas before, the complexity and regulatory requirements of banks meant that getting approved for a loan might take months, now the determination of credit worthiness was established by a far more efficient marketplace where investors in the business of taking such risks were able to establish a price for this risk quickly and provide consumers with a rate in a matter of weeks (which has become days, hours and increasingly seconds).  Consumers benefit greatly because they are much more in control of their financial futures and not at the mercy of institutions with conflicting priorities. 

I only have a passing understanding of the nuances of the modern bond market but I am looking forward to seeing the Internet evolve into the multi-trillion dollar market that structured finance has become.  Many markets have emerged online in the past 10 years where buyers meet sellers, consumers meet advertisers, and advertisers meet publishers in low-friction, value-added environments.   

Using Chris Anderson’s framework, as one moves down the tail by searching for ever more obscure (ie "un-covered") keywords, one inevitably finds companies like Nextag, Amazon and eBay/Shopping.com as the minimum bidders.  They believe that they have enough liquidity of product opportunities so as to be able to convert any cheap click (ie $.05) into a more qualified activity within their network.  In so far as Amazon sells actual products, its role is as much marketer as anything else.  eBay sells other people's products and so is one step removed from Amazon (which of course also sells other people's products through its marketplace).  Nextag and Shopping.com don't sell anything, but are simply better engines for comparing products and finding the best prices.  Shopping.com is doing more than $100m in annual sales off of these and other techniques leading to their recent acquisition by eBay, while Nextag remains private but purports to be doing just as much revenue.

As we move further beneath the radar, there is another group of companies, mostly emerging from the online direct response agency world, that are generating significant profits by purchasing media, attracting prospects and selling leads to advertisers.  Four companies in particular stand out as the leaders in this space:  Adteractive, Azoogleads, Quin Street and NetBlue.  Together they will generate more than $500 million in 2005 sales with 30%+ profitability.  Yes, $500m.  Adteractive recently sold a minority share for more than $100m to a prestigious private equity firm.  In the next few months one of these will likely be bought or merged with another on the way to one of these going public in early 2006.

While the majority of Internet advertising is paid for on a CPM or CPC basis, the real driver of spending is advertisers’ willingness to pay on a pure Cost Per Lead (CPL), performance basis.  Remember the hand-wringing in 1999, for example, as to the efficacy of online advertising?  Strange isn’t it how we don’t hear much about that anymore. The emergence of pay-for-performance advertising online has effectively transferred the risk away from the medium.  With PPC, Internet media no longer has to convince advertisers to trust its ability to perform as effectively as other media (Cable, TV, Radio, Print…).  The quality of the commercial transaction is self-evident to the online advertiser, who now inherits all the risk from the publishers. 

Just to be clear, the fact that the risk now resides with the advertiser and not the publisher does not a pure market make.  Advertisers are companies in the business of selling things to consumers and other companies.  Their business is not buying advertising. 

Tiny (Internet) Markets

Within these new markets, there are millions of micro markets where a query or a unique user path comes into contact with one of more targeted advertisements.  A constructive tension emerges between the user who intends to find something or do something, and the sponsor of the link who is trying to lure her into their particular commercial environment.  Each one of these tiny interactions feature a buyer (advertiser), seller (publisher) and asset (consumer's att/intention).

The latest Release 1.0 article on Spyware features a fable that imagines advertisers as merchants at a Bazaar and their various adware proxies as pushy street urchins, “Miss!  Miss! Look here!  Special deal!."   Efficient markets are based on trust.  This relates to markets of any scale, from the NYSE and eBay to my decision whether or not to accept an invitation into somebody else’s LinkedIn network.   

While the modern US interpretation of the Bazaar has been typically pejorative (with a few notable exceptions), there is nonetheless a very useful economic system for transferring value that has emerged in around the Bazaar, namely Hawala.   Hawala is a peer-to-peer payment system that enables any participant to make a decision as to any other participant's credit worthiness:

The unique feature of the system is that no promissory instruments are exchanged between the hawala brokers; the transaction takes place entirely on the honor system. (From Wikipedia)

It is unfortunate that Hawala got associated with the terrorist activities of 9/11, since as a structural mechanism it has much to offer us as a model for enabling the liquidity of attention markets that Media Futures require.  It takes courage to create new markets, but in so far as new markets establish new currencies of trust and individual control, then they are well worth the risk.

*

Note:  This is an abridged post. Transparency finds its limits in posts about arbitrage.  While there is likely long term benefit in an open exchange of intellectual property, specifically around the collective invention of an attention marketplace,  the fact remains that capital is usually created by the introduction of friction and opacity onto otherwise smooth, transparent surfaces.  So long as I continue to debate the benefits of openness vs the importance of discretion, I will continue to hold certain things back.  In this series on Media Futures,  I have used all sorts of "A" words to articulate how media operates on the Internet in 2005.  I am looking forward to synthesizing the Media Futures series into a book, which will include much that is now only in note form or else is too sensitive to share at this juncture..

Finally, all comments here reflect my personal opinions and not those of any firm or organization I am associated with.  Specifically, I am proud of what our team has accomplished at Majestic Research in terms of reinventing investment research in a rigorous, unbiased and real-time fashion.  Majestic's insights are driven entirely by data, carefully interpreted by smart quantitive analysts.  When I comment on this blog about any public or private company, such comments are entirely distinct from the investment research that Majestic provides to its clients. 

Media Futures, Part 2/5: ALGORITHM

An Algorithm is a set of instructions or procedures for solving a problem.

In the same way that computer scientists 50 years ago focused on the single problem of designing a general purpose computer, there is a similar focus in 2005 among leading Internet service architects:  creating a social media computer that leverages user generated content to automate the production of commercial content.  In so far as this represents the important problem that the best and brightest of us are looking to solve, then to an extent it is a race for the best algorithm. 

From PageRank to PeopleRank

Hovering over this endeavor is the shadow of the last great algorithm, namely Google search engine.  At its core, Google is PageRank (which nominally cites both one of its founders Larry Page and its subject of operation, Web pages):

"PageRank relies on the uniquely democratic nature of the web by using its vast link structure as an indicator of an individual page's value. In essence, Google interprets a link from page A to page B as a vote, by page A, for page B. But, Google looks at more than the sheer volume of votes, or links a page receives;  it also analyzes the page that casts the vote. Votes cast by pages that are themselves "important" weigh more heavily and help to make other pages "important.”"

In this case, (1) the input for the algorithm is the population of web pages, (2) the instructions rank them in value based on their link structure, and (3) the output is the list of links that you see when you search for something.

Now transpose people for web pages, and you see how the race for the next great search algorithm has less to do with organizing static HTML content than with coordinating the constantly changing expressions of millions of distributed people.  For an interesting perspective, see my fellow entrepreneur Mark Pincus's riff on the PeopleWeb.  Many Internet businesses have tried to direct user behavior into certain architectures of participation.  Services such as Friendster, Orkut, and even Pincus's own Tribe, presume to address all of a person's social communication needs in one place.  All of these services, however, are now rapidly trying to reinvent themselves to stay relevant to a community that refuses to be intermediated by somebody else's system. 

The services that seem to do the best job at enabling users to communicate on their own terms are those that manage to find a middle ground between the DIY (do-it-yourself) ethos that is beginning to pervade the web and the need for structure to guide constructive interactions (ie the reason by Wikipedia succeeds and most other Wikis fail).  LinkedIn, with its two million profiles of professional affiliations, provides the tools for interesting social media production, even if the site itself limits one's imagination (open up the API please).  The reason behind the annoying digerati blogfest on folksonomies (myself included) stems from the simple but mildly heretical notion that users, given decent primary (meta)data, might actually be able to create their own systems that scale.  Clay Shirky (lighting designer for the Wooster Group, CTO of SiteSpecific, advisor to Flickr, current leading pundit for the digerati at shirky.com) captures the anxiety perfectly in his title to last week's panel at ETech:  "Folksonomy, or How I Learned to Stop Worrying and Love the Mess".  The question is, then, whether a PeopleRank algorithm that uses community driven tags as its input, could do to About.com, Gawker Media, and Weblogs what Google did to Alta Vista, namely deliver a superior end-user experience that requires only incremental server bandwidth to scale. 

Media Futures, Part 1/5: AUTOMATA

Self Operating Machines

The most exciting new Internet companies are focused on lead generation, behavioral targeting, co-registration paths (aka coreg) and domain name brokerage.

I seem to stumble every day across some new firm propping itself up on the shoulders of Google, Yahoo! or others to take advantage of a current wrinkle in an otherwise perfectly efficient landscape.  The fact is, however, that these wrinkles never seem to disappear.  These advertising mechanisms emerged alongside of the pure media companies, starting with Doubleclick back in 1996, and followed by other advertising networks such as Flycast, Overture and Advertising.com, each firm iterating on the prior model to gain some head room from the imminent internal advertising service offerings of the pure media companies.

Although these advertising technologies have focused on targeting the behavior of consumers, they have also tended to ignore the role of consumers in the production process of the media that they consume.  This is why these networks tend to dynamically balloon in terms of sales growth.  They capitalize on a behavioral blindspot, where the supply of inventory versus the demands of advertising value are disjointed.  As consumers become smart about these artificial mechanisms (banners, keywords, freeipods) their effectiveness drops and they look to get acquired by larger media entities.

The elusive goal of internet media (and the advertising that drives its value) has been to keep up with changing consumer preferences as the technologies of communication continue to evolve.  The adoption of a new means of using the Internet (whether it be ecommerce, webmail, search engines, or shortly blog readers) creates enormous economic value for the donors incredibly quickly. 

The latest shift in online consumption has been the institutionalization of amateur publishing tools.  The unique attribute of RSS is how simply it enables individual publishers of data to connect with individual subscribers to such data.  RSS tools like typepad, flickr, adsense and del.icio.us have made it easy for individuals to syndicate their preferences, memories and desires.  RSS tracking tools like feedburner make it easy for individuals to track who is paying attention.  At the site you are on, I am streaming my Flickr photos, am recommending books as an Amazon associate and am promoting a Google ad-sense ad.

Not unlike dial-up authentication protocols (remember the classic AOL logon "hand-shake"),  the interaction between RSS feeds and their readers is a structured negotiation:  do you, John Q. Public, agree to take the whole feed, nothing but the feed, until you delete it?  I do. Click.   

When you aggregate all of these individual reading and writing agents, it looks more like a landscape of cellular automata than a tradition publishing model.  This would seem to be the essence of social media (props to my wife and guide Tina Sharkey for coining this years ago and registering the domain) and social computing, two memes that seem to be growing in influence.  When individual decisions such as applying certain tags to pages or photos achieve a broad social consensus, then it as if these tags begin to self replicate which is the essence of automatic behavior.

There is a good word to describe this, which comes out of physics, namely Excitable Media.  as per Wikipedia:

Cellular automata provide a simple model to aid the understanding of excitable media. Each cell of the automaton is made to represent some section of the medium (for example, a patch of trees in a forest, or stress in heart tissue). Each cell can be in one of the three following states:

Quiescent or excitable -- the cell is unexcited, and can be excited. In the forest fire example, this corresponds to the trees being unburnt.

Excited -- the cell is excited. The trees are on fire.

Refractory -- the cell has recently been excited and has not yet been through the refractory period. A patch of land where the trees have burnt and the vegetation has yet to regrow.

The concept of cellular automata is useful as a metaphor for next generation Internet content, which is similarly dynamic, member-generated, and excitable.  In the next post, I will focus on algorithms, as they transform the automatic social media into business rules and procedures. 

Web Platform as Equity Analyst

Last month I held a workshop with the elegant, imaginative programmer Steve Steinberg of GGH at Web 2.0.  The conference was at times a best-hits convention of the SF Internet scene circa 1999, but in other important ways a series of discussions about the evolution of the Web as a platform.  Instead of large sites connected by single links, as the web may have looked 10 years ago, now we have niche pages and targeted offers connected through elaborate search algorithms, RSS feeds, and affiliate marketing networks. 

The conversation with Steve started as follows:

It is easy to confuse the Internet as a medium of distribution with the Internet as a computational platform. Nowhere is this confusion more pronounced than in the use of the Internet by investors.

Usually, investors think of Yahoo! Finance or Ameritrade. No doubt the Internet has emerged as a useful source of information and a convenient brokerage interface, but do these uses qualify as platform applications?

Beneath the user functionality of the web hums a constant drone of data processing. This is the under-web of click-streams, item listings, user queries, and other flora and fauna of network behavior.  This is the web tone for investors: filled with important data insights usually lost in the noise of random traffic.

The challenge is how to interpret the Internet platform for financial gain. In so far as there is no “Bloomberg” for analyzing Internet and other electronic transaction patterns, investors today are faced with myriad tools, techniques and sources of information that require significant manual effort to correlate.

The typical search box is a limited tool for investors, since understanding what metrics one is looking for is almost as important as the metrics themselves. Most publicly-traded companies (for instance the majority of those in health care, technology, retail and financial services) serve different customers differently and so understanding such companies require monitors across the full length of the supply and demand chain.

We proceeded to lay out a number of examples of how the Web could be searched, scraped, bot-ted, mined, and grokked for unique information on publicly traded equities.  We touched on the dangerous temptation to trust data simply because it’s data (when in fact as we all know data carries with it many of the same assumptions and biases of anecdotal water cooler observations).  We also focused on the gray area separating legitimate data discovery from the act of stumbling across (or better yet, browsing into) material non public information in an otherwise public network such as the Web.

The combination of insider information restrictions and Regulation Fair Disclosure has become the impetus for equity research to continually reinvent itself.  As the SEC has written in the case of Reg FD:

"Whenever an issuer, or any person acting on its behalf, discloses any material nonpublic information regarding that issuer or its securities to [certain enumerated persons], the issuer shall make public disclosure of that information... simultaneously, in the case of an intentional disclosure; and... promptly, in the case of a non-intentional disclosure."

The Emergence of a Packet Switched Research Model?

Insofar as such information is disclosed by a person (ie the CFO) to another person (ie an analyst at a Brokerage or at a fund) then the steps required are simple enough:  issue a press release immediately to everybody via the web.  It is decidedly more complex when such information is disclosed in bits and pieces, asynchronously through a “network of experts” composed of employees and consultants inside and outside of the company in question, issued to a buzzing audience of analysts and portfolio managers pushing and prodding at various aspects of the company’s performance.  If the CFO’s wink to the Sell Side analyst at the 17^th hole was the equivalent of dedicated circuit switch, then the current instance of buy-side analyst communities polling networks of industry and sell-side experts suggests the emergence of a packet switched research model.

Perhaps the full obsolescence of Reg FD as we know it emerges when research shifts its register from people to data entirely—when companies become fully transparent (cf. Bill Gross’s latest invention Snap), or else their transparency is enabled by others (cf. Majestic Research’s analysis of Ebay as well as other examples of Internet-based economic research).  At such moment, the entire notion of a privileged perspective dissolves—there is no longer an edge in trying to "game" the quarter-- and the investor is forced to develop a new strategy for evaluating the equity. 

Otherwise, the index funds may integrate the public data themselves and force a number of highly paid fund managers to leave for the summer house in January.

Hedge Fund Wolves in Mutual Fund Clothing

We live in an equity culture. Perhaps it is because of the the legacy of the 401k, or the cultural influence of Peter Lynch, Warren Buffett the media focus on hi-growth technology enterprises like Microsoft, Intel, Ebay and Google. In any case, the gross majority of adults in this country own stocks of one kind or another, through a variety of brokerage, retirement and college savings accounts. The most convenient mechanism for investing in the stock market remains mutual funds, which typically charge a fee based on assets under management (AUM).

Despite a stellar 2003 where most mutual fund performance mimicked those of the broader indices, retail investors have come to question the credibility of some of the largest mutual fund complexes. This has come in the wake of Spitzer lawsuits against market timing and directed brokerage arrangements as well as the lingering effects of the bursting of the technology bubble in late 2000. Certain funds such as Fidelity and T Rowe Price seem to have managed to keep their reputations in tact, others such as Janus and Strong are working hard to rebuild their brand equity.

In the face of legislation, lawsuits and media criticism, mutual funds have become significantly more cautious. They can't afford to become associated with any more scandals or be on the wrong side of any potential legislation. Mutual funds continue to lose their most successful fund managers and research analysts to unregulated hedge funds where such managers and analysts can make far more money with far less scrutiny. As if the brain drain wasn't bad enough, mutual funds can no longer (by virtue of their huge asset bases) command proprietary information from companies since Regulation FD mandates that all investors receive material information concurrently.

One would expect that mutual funds would take this opportunity to reinvent themselves and distinguish their products through innovative research strategies. Ironically, however, mutual funds seem less willing to try new forms of research than ever. Structurally, there has been a virtual, self-imposed ban on soft dollars within the mutual fund industry. Mutual funds suggest that they will pay for independent research through their management fees, but in reality they would prefer to pay directly through trades to the proprietary desk of the research provider. The only problem is that most of the emerging value-added independent research providers produce innovative research as opposed to provide trade execution. The firms that the mutual funds are comfortable trading with (and thereby willing to purchase research from) remain the same large sell side institutions that have been replacing their equity analysts with in-house proprietary traders, who actually compete with the mutual funds themselves.

Against the backdrop of these challenges, hedge funds continue to acquire assets, track records and brains. In the last few weeks alone, I have heard of one fund that has just passed $1b in assets from only $100m about a year ago; another fund that has gone from $600m to north of $2b in 12 months; and a new hedge fund that just launched with north of $3b. There seems to be no shortage of institutional capital available to the best or most promising hedge fund managers. Risk management technologies and portfolio reporting platforms provide a level of comfort and transparency that has created enormous liquidity among funds of funds acting as intermediaries between single manager hedge funds and family offices, pension funds and endowments. Hedge funds would seem to be happy to ignore the average retail investor and focus exclusively, in perpetuity on institutional investors.

But then I heard something that surprised me. One hedge fund manager that I have enormous respect for shared the basic fact that he rarely makes money on the short side but maintains a hedged strategy because of the 2 & 20 fee structure that he is able to charge. His argument is that he could make less than 1% of AUM with a long only strategy and as much as 5x that with the same long book with a few short positions (even if they aren’t what’s contributing to the performance of the fund).

The second incident that caught my attention was the open rumor that a very large, very sophisticated, and very secretive hedge fund had tried to acquire the assets of a well-known mutual fund complex that had run across difficult times.

The third point in this nexus is the fact that Bill Miller, the legendary manager of Legg Mason’s mutual funds and certain portfolio managers at Fidelity have begun to utilize short positions as well as their long positions in a modified mutual fund meets hedge fund strategy.

And so when I synthesized these trends in my mind, I realized that it is inevitable for the line between hedge funds and mutual funds to become more and more vague. It is only a matter of time before the best mutual funds begin offering premium hedge fund-like strategies (with higher fees) for their top retail customers. At the same time, as certain of the savviest and most institutionalized hedge funds grow beyond their somewhat narrow professional investor base, they will likely acquire and/or merge with existing mutual fund franchises in order to acquire retail investment assets. One thing that has always plagued hedge funds has been the lack of long term equity value. You are only as good as your last year, as it were. With a mutual fund apparatus (and the long term brand equity value it might bring), perhaps hedge funds could establish equity above and beyond the presence of their founders.

As I look out over the next few years, here are some of the consequences that seem to be natural outcomes of these developments:

• Everybody (individuals and institutions) will be able to have their money managed by top hedge fund managers.

• As hedge funds, new long/short mutual fund strategies, and internal funds within banks start functioning more and more as a single asset class, the costs for investors will find a standard rate (2% of AUM and 20% of upside)
• Investors that are not willing to pay the market rate for sophisticated money management, but who do not want to actively manage their own portfolios, will likely simply opt for index funds which may replace traditional single manager mutual funds as the mass consumer investment instrument of choice.

• Funds with north of $1b will be forced to trade in the same crowded names because the number of equities of adequate liquidity is not growing nearly as fast as the funds are (ie hedge fund strategies will proliferate faster than the number of unique, tradable equity ideas available)

• The best opportunities for investment performance will reside in smaller, undiscovered hedge funds that have yet to break $100m in AUM and remain below the radar of fund of fund promoters. Same phenomena as signing Maroon5 when it was playing lounges in LA or Pedro Martinez when he was throwing coconuts in the Dominican Republic. Only these smaller funds will have the flexibility to move in and out of positions in smaller cap names and truly outperform the indices.

• The next generation of the sell-side will take its cues from the current experiments of independent research firms and direct access electronic trading platforms. The most successful sell-side firms will marry outsourced data acquisition and information analysis with electronic trading to become underlying, enabling operating systems for the buy-side to collaborate with and compete against itself.

• As trade execution and traditional equity analysis become commodities given away for free, the value of proprietary trading strategies and exclusive data will rapidly increase.

• The next generation of great Wall Street franchises will be created by software developers and information brokers rather than by equity analysts and sales traders.

Google, Show Us Your Clicks!

The auction-driven IPO of Internet search engine Google has provided a central theme for the financial markets for the past four months since the company filed to go public. The early ebullience has, as the NASDAQ has sold off, given way to a confused, cautious and at times caustic stance towards the company.

In the past 10 days, the company dropped its price range of $108-$135 to $85-$95. The company ended up accepting bids at $85, then opened and stayed near $100 for the first day of trading on Thursday. Yesterday, the stock rallied an additional 8% to rise from $100 to $108 where it stands now. It will be another 10 days or so before the first set of inside holders can begin selling their shares, and another 10 days after that before the legion of investment banking underwriters (CSFB, Morgan Stanley, etc) can begin providing investment research insights on the company. In the meantime, GOOG remains more of a curious cultural event than a fully analyzed public equity.

The media has swung from applauding Google’s months ago when it first filed to go public using an unorthodox auction pricing model, to lambasting the same approach in the past month. Now that the stock is public and has risen more than 20% from its offering price, the media seems to be suggesting that Google has indeed succeeded in pointing to a post-Wall Street IPO process even if it wasn’t able to properly capture the full upside of the public’s demand for its equity.

Regardless of the logistical machinations of its IPO, however, in my mind the confused perception of Google has less to do with the recent descent of the financial markets and more to do with some fundamental conflicts of the company’s own doing.

The Google Paradox.

As a consumer service, Google has built its brand on a few core values: clarity, honesty, transparency and accountability. It suggests that as a company it will "do no evil." Google's decision to adopt the open auction model pioneered by WR Hambrecht was a bold attempt to ensure that the company, not its investment bankers, captured all incremental dollars generated by interest in the IPO. Its noble purpose was to ensure that its IPO price was not set artificially low by brokers who wanted to provide access to their best customers who could then lock in immediate gains when the IPO soared way above its offering price.

It has become increasingly hard to reconcile Google's core business values with its attitude towards investors, both institutional and retail. At the core of its IPO process, Google demonstrated a further paradox: it provided tick by tick efficiency into the pricing of its shares in the open market while at the same time provided zero near-term accountability in terms of the obligations of its management to inform. Citing Berkshire Hathaway as a role model, Google has warned that it will not be a "slave to investors" and will refrain from providing quarterly guidance. At its pre-IPO road show, numerous investors and bankers commented that Google executives simply didn't care about educating investors about the key levers of the business. These contrasting behaviors simply don’t compute.

What can Google do?

The good news is that there is a simple way to address this paradox. All Google needs to do is expose its clickstream. Specifically, there are three basic levers of value in determining Google's value both absolutely and relative to its peers:

# Searches

# of Sponsored Clicks

Average Cost per Sponsored Click

These are important metrics because it will allow investors to understand how Google is faring against its arch rival (for now at least) Yahoo! According to comScore as well as our internal data at Majestic Research, Google has managed to grab 35% of all domestic searches in the past 6 months (January-June) while Yahoo! Has managed to grab 29%. Internationally, however, Google captures 55% while Yahoo! Only holds 26% share. Yahoo! has seen the cost that it charges per sponsored click start to flatten, and it is unclear if Google is suffering from the same fate. AOL/Netscape, Ask Jeeves and MSN all boast higher ratios of searches with sponsored ads (the degree to which a company is able to monetize its search activity) which suggests that Google has upside potential, although at the risk of commodifying what makes it such a uniquely satisfying consumer service—the perceived purity of its algorithmic search results.

Interestingly, both Yahoo! and Google generate the majority of their search results from one and two word searches. This behavior is perhaps an outgrowth of the single word directory clicking that predated the emergence of keyword search as the dominant internet behavioral paradigm. One question that remains is whether the sort of natural language search that Microsoft has discussed incorporating into its upcoming Longhorn operating system will be precisely the sort of technology iteration that Microsoft achieved with subsequent versions of IE over Netscape Navigator.

We released our inaugural report on Google earlier this week that comments on these and other trends impacting Google's business. If you are an investor, author or search engine expert and would like a copy of the report, please let me know.

Majestic Research is one of a number of independent research firms that provide investors with transparency into companies that otherwise don't expose their fundamental performance. Like others, we use primary information to address the ironic consequences of Regulation Fair Disclosure and the Spitzer settlements: companies and analysts today are saying less, not more. Corporations and their investment research counterparts have an obligation to educate investors about fundamental trends on a real-time basis. With the advent of the Internet, it is no longer necessary to wait three months for management to collect its results and report on what has happened. Companies, particularly those like Google, Yahoo and IACI that are Internet companies should be telling investors how they are doing as they are doing it.

Sergey and Larry, if you really want to avoid evil, just show us your clicks.

Transparent Bundles Part IV

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?

Transparent Bundles Part III

How is research distributed?

Is it embedded in the trade solicitation?

Or is the idea distinct from how it may get traded?

Why is this important to begin with?

I would argue that the essential value of wall street lies in the location of where the buy side accepts external ideas as a part of its investment process. To a great extent, the buy side has all of the tools at its disposal to do its job, without aid from the traditional wall street brokerage house. The trader at the fund has 6 screens and can monitor pools of liquidity and place trades seamlessly. The virtues of anonymity, transparency, liquidity can all be addressed by technology just as easily as they can by a human sales trader. Some large complicated trades may still require human ingenuity to break up and place properly, but these too will become easier to manage through technology than individuals. Even flow, the near-sublime quality of a human trading desk has become simulated through syndicated web sites, and message boards .

So from a trading perspective it becomes more and more dubious why to pay anything more than the bare minimum ($.004/share maybe for now). To the extent that humans will be required, their skills are such that they will be easily exported to emerging countires at a fraction o the cost.

This may take years, not months, but it is inevitable. Financial markets have an endless appetite for technology solutions and business models that help automate their operations.

If trading becomes a commodity, then one has to look at the other products and services of the sell-side to justify their economic position. Besides trading, it would seem that the remaining values are access to hot issues (IPOs), access to management, conferences, and research.

In terms of hot issues, it seems certain that the allocation of IPOs will come under increasing restrictions by the SEC and the exchanges themselves. Granted, we are entering another bounty of successul public oferings and nasdaq recently eased restrictions on brokers' allocation abilities; nevertheless, Spitzer has demonstrated clearly than any artificial price manipulation benefitting one institution over another (investment banking, market timing, specialist firms, and so on) will come with major penalties for the firms and their principals

Access to management is, after Regulation Fair Disclosure, more of a concierge service than anything else. It's not that different from brokers procuring sports tickets for their best clients, except in this case it's CEOsand CFOs of public companies instead of star 3rd basemen. There is no longer any suggestion that the management content is different based on who is introducing the company to the fund. Simply that management's time is valuable and there are only so many "in person" mtgs they can afford, even if the content is exactly the same as all other meetings.

The buy-side continues to ascribe value to physical contact, over and above any other form of information. Since companies are legally barred from selective disclosure, and understanding how much funds currently value face to face contact with management, we are talking about the most expensive facial expressions this side of jim carrey.

Conferences are somewhat similar, insofar as they tend to be simply opportunities to have multiple "management 1 on 1s" in a single location. The lineup of speakers is interesting, and the collection of friendly buy-side analysts is convenient, but the value again rests in the tics and gestures.

Which leaves us with value of research.

Research as representing the stream of ideas codified in some form of communcation that comes from a sell side firm directly to the buy-side. Of course there are many kinds of research, from the old school of financial models and analyst opinions to the new school of forensic accounting, credit analysis, and access to networks of experts.

Technology threatens to commodify the value of research as well. Smart analysts that attend management meetings, pore through 10K's and produce intelligent analysis are now facing considerable pricing pressure from syndicated management calls, easy access to public disclosure and cheap analytical labor in remote places such as India.

The most successful research firms are those that aren't simply running ahead of the inevitable surge of commodifying technologies, but rather those that figure technology fundamentally into their research process. For example, many expert networks such as Gerson Lehrman's effectively use the Internet to recruit, rank and provide access to experts across the world. The buy-side can to a certain extent bid on this expertise as if they were using Ebay. This is an example of a research product that uses technology to scale insights. To the extent to which it is able to tie the scaling of insights to the generation of trading commissions, then such a firm successfully distributes research in a manner consistent with how the buy side will look to pay for research in the future.

The critical factor that I am struggling to address is why the buy side needs research from the sell side any more than it needs to spend $.05/share to execute trades through the bulge bracket? The economics of a hedge fund are so rich that such funds are able to attract the best and brightest analytical minds to work for them directly. In the past, the sell side was able to subsidize analyst costs through investment banking revenue and so were able to offer folks like Jack Grubman $20M per year. Those days are over, while today a key analyst at a large hedge fund can make more than $1M per year and a fund manager can make 20+x that in a good year.

The solution for the sell side is to come up with products and services that take advantage of its primary focus on research and minimize any consideration of other features such as trading, banking, etc. In the end, the fund is in business to make money trading stocks (or bonds, or commodities, or whatever), so that the fund's internal research will always be a means towards an end but never an end in and of itself. The competition of the sell side is not other sell side firms, but rather the internal research departments of the funds themselves. Every day, the successful investment research firm needs to demonstrate value (in terms of number of experts in its network, or amount of proprietary data, or variety of analytical tools) that grows proportionate to attention and focus. Since the sell-side can't win the war of having the smartest standalone analysts (who will naturally gravitate towards the buy-side for better economics), it can instead emphasize the scale it has achieved in certain areas that a fund will never on its own accomplish (such as building out market research panels, negotiating complex license agreements, cleansing raw data, etc.).

Again, I am talking my position since the company I work for Majestic Research is explicitly trying to take advantage of these changes. What continues to confuse and fascinate me, however, is how the development of these new sell side investment research systems will drive new forms of payment from the buy-side outside of traditional bundled commissions.

The name of this blog is transparent bundles, and by that I am suggesting a means of combining trading and research in a manner than maintains the efficiency and velocity of commission-based compensation while avoiding the shadows and whispers of traditional trading relationships. The MFS rant about soft dollars, Fidelity's scrutiny of bundled commissions, and Spitzer's unyielding assaults on market timing, investment banking conflicts and whatever he comes after next, are all combining to force the need for a "transparently bundled" solution to the forefront of the debate.

Complicating matters even further is the fact that funds are looking to cut down on their trading relationships as opposed to adding new brokers.

Need to do some more thinking on this one and report back when I achieve additional clarity.