TRANSPARENT BUNDLES by Seth Goldstein

Transparent Bundles from Wall Street to Web 2.0

I am slowly starting to settle into a routine here in California.  The past few months have been filled with new beginnings- a new school for the kids, a new job and commute for Tina, new grocery stores and restaurants and little league fields.  The Taxi cab-hailing hustle of Manhattan has given way to hustling my bike to the top of Mt Tam. Ideas don't change at the same pace as activities, however, and I find myself thinking through the same issues about transparency that stimulated this blog in the first place.  Back then I was focused on soft dollars and the opacity of financial markets not media markets:

...soft dollars and bundled commissions are the vig that generates much of the wealth among the brokerage industry in New York, which in turn lubricates expense accounts at lunch time and grand Park Avenue co-ops and East Hampton beachfronts. Is it not ironic that New York has a mayor whose namesake company benefits more from monthly soft dollar payments than perhaps any other financial institution. In a way, Bloomberg has taken the notion of value-added brokerage services to the peak of civic duty. Our city itself reflects the residual value of opacity in financial markets. And so the question comes back to what happens to the brokerage industry when transparency become of more value to investors than opacity?

Three years later, soft dollar pratices are as opaque as ever.  The SEC has catered to the rich interests of hedge fund and stock brokerage lobbyists and enabled both sides to continue their practice of doing business with eachother in a very gray market.  Even the most sophisticated individuals outside of the financial services industry have little sense of what is really going on, in terms of the ways in which large institutional investors and large banks and brokers profit from closed data practices.

This is not that different from the dynamics of the online advertising environment- there are large institutional advertisers doing business with large media companies and advertising networks.  Despite the pre-text of openness and transparency, the online media market works hard to obscure the discovery of price by the very individuals producing it; namely the people who are using the medium, searching for things, clicking on ads, and conducting commercial transactions.  The web user, like the individual  investor, has resigned himself to letting larger interests capture, aggregate, and monetize his data behavior.  He has been led to believe that this is simply part of the bargain of having such "low" transaction costs for trading stocks or searching for information.

If I had to draw a continuous line through all of my disparate activities over the past ten years, this would be it:  identifying and interpreting the direct economic value of an individual data actor.  We may never in our lifetime see a day when a person develops an acute, vested interest in the value of his data; the spread between the value of a handful of clicks and that of a mass of aggregate behavior is significant.

Although it may be hard to keep track of the progression of Media Futures, we are stuck between the end of Alchemy and the beginning of Arbitrage.  This is where the creativity stops and the money kicks in; not that surprising against the backdrop of so much M&A activity (DoubleClick, RightMedia, StumbleUpon, etc.)

In May 2005, I made this transition in the first Media Futures series.  It was etymological in nature and only hinted at the real activities that I was engaged with as an entrepreneur, as I handed over the reins of Majestic Research to a new CEO in order to focus on creating Root Markets.  Flash forward two years and I am at a similar juncture; this time moving from Root in NY to AttentionSoft in SF. The transition from Alchemy to Arbitrage that I want to describe this time will be more personal, now that the philosophical ground work has been established.  I want to trace the evolution of a central idea- transparency- through the founding of a new investment research process in 2002 all the way through the creation of a new consumer data platform in 2007.

As always, thanks for staying tuned.

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.

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 I

Transparent Bundles

Open network access has vitalized the argument for transparency. This seems to be playing out across a number of key economic sectors: in software, the rise of Linux is forcing Microsoft to unbundle its suite of systems and applications and charge on an a la carte basis; on the Internet, cheap access has forced AOL to justify each component of its service; and in the institutional investor world, which is what I focus on, electronic access to liquid markets is forcing brokers to break down the costs of their bundled commissions.

When dealing with brokers, investors are typically led to ignore pennies and instead focus on the notion of added-value. After all, what Merrill Lynch, Morgan Stanley, Goldman Sachs and others do is far more than simply execute trades. They provide liquidity and anonymity for execution. They provide prime brokerage services, access to capital and provide allocations of IPO shares. They offer conferences and set up one on one interviews with company management. They also produce research, reams and reams of information and analysis on thousands of companies and sectors around the world. For their best clients, they even procure tickets to events, restaurant reservations and golfing and skiing trips. All of this adds up to millions of dollars in value, or so investors are led to believe. All of these components are integrated into a single unit of value, otherwise known as the commission price. Typically, this is about five pennies per share.

If you were walking quickly down a busy street and came across four pennies, would you pick them up? This is roughly the spread between a typical bundled commission and what it costs to simply execute a trade. The difference is supposed to account for the range of value-added services described above. Brokers do not readily break down the relative price of each component bundled into this commission. Investors, meanwhile, are so used to the convenience and perceived value of the bundled commission so as to not question brokers' opacity.

At least until now.

On Monday, March 15 2004, Fidelity wrote plainly to the SEC:

The bundling of research and execution is the least transparent aspect of transaction costs, and the Commission should not do anything to favor it over other uses of commissions to obtain legitimate benefits for the adviser.

A number of other mutual fund complexes are racing to stand on the same transparency platform by banning soft dollars entirely and paying for each service out of their own management fee pocket. Even Morgan Stanley, a broker nonetheless, has come out to say it will stop accepting soft dollar commissions.

Soft dollars are clearly in line for increased transparency. I am not sure if anybody really benefits from a full ban on them, which seems like excess grandstanding among those accused of impropriety. Still, the increased scrutiny on transaction costs on behalf of investors is a good development of late.

What is not ok, however, is if in the context of more closely investigating soft dollar commissions and the related payments to third party research providers, that investors dont look equally closely at commissions that combine trading and execution at full service brokers. In its letter to the SEC, Fidelity argues that:

...we estimate that research bundled with execution represents a larger share of commissions than third-party research, and we expect this would be true at other firms as well. Thus, in addition to giving rise to competitive unfairness for third party research providers, quantifying third party research without quantifying bundled research would significantly understate total soft dollar use and could be highly misleading to investors. (see full article here)

Here is where the rubber hits the road and where, in circuitous yet logical fashion, Fidelity's words threaten everything from restaurants to residential real estate in most financial districts- specifically New York. The fact is that soft dollars and bundled commissions are the vig that generates much of the wealth among the brokerage industry in New York, which in turn lubricates expense accounts at lunch time and grand Park Avenue co-ops and East Hampton beachfronts. Is it not ironic that New York has a mayor whose namesake company benefits more from monthly soft dollar payments than perhaps any other financial institution. In a way, Bloomberg has taken the notion of value-added brokerage services to the peak of civic duty. Our city itself reflects the residual value of opacity in financial markets. And so the question comes back to what happens to the brokerage industry when transparency become of more value to investors than opacity? And how will independent research firms and execution only trading platforms emerge to service these needs for increased transparency?