Oct 9, 2005

hedge funds

For the most part this article does a decent job of describing a hedge fund. In fact halfway through, Bill Fleckenstein, nails it,
The term hedge fund means nothing anymore," said Bill Fleckenstein, founder of Fleckenstein Capital, a short fund in Seattle. "Many or most hedge funds are long funds, leveraged long funds masquerading as hedge funds."
I read the article because sometimes I don’t even know and I work at a hedge fund. In the strictest sense, it means any fund that is both long and short and uses those contrasting positions to remove some market risk. In general, the perception of hedge funds is anything but low risk. They are usually viewed as something that has high risk and high return. And they can be. But in general a hedge fund can be pretty much anything. All funds have a philosophy whether they acknowledge it or not. Some are risky and some are quite conservative. Ours falls somewhere in the middle. Our team couldn't be a more sedate, hyper-analytical, 'don't invite those jokers to the next party' kind of group. But we do invest in small caps and take leveraged positions. We do expect to beat the S&P but we don't do it by loading up on junk bonds and Russian small cap stocks and leveraging up to the hilt. We just do it through hard work and investigation. In many ways most hedge funds aren’t that different from any kind of investment fund.

What’s not often discussed is how Wall Street in general works. In general there are two sides – the buy-side and the sell-side. The sell-side you know -companies like Goldman Sachs, J.P. Morgan, etc. The buy-side you probably don’t know so well. The names are a poor choice because they don’t really describe the situation well. The buy-side invests money in investment vehicles. People or pensions or companies give the buy-side money to invest. The sell-side doesn't really do the opposite of the buy-side analysts. They 'sell' information. They offer up research and perspectives on investment vehicles to the buy-side. They also typically do other things like help companies go public and merge with other companies.

Now many people pooh-pooh the sell-side work. Images of Blodgett saying Amazon will go to $400 in the dotcom era helped usher in that image. But in fact the work they do is often quite good. They certainly help buy-side analysts with little niggly items that would take them a while to find out. Things as simple as what their tax rate should be going forward or what kind of share dilution a company might have in the future. They also have an ear closer to company management and entities that affect or might be affected by the company - distributors, customers, etc. They also help you set up meetings with companies. This sometimes can be difficult without their help. And since you can influence sell-side analysts when you talk to them, it’s a way to get bullish or bearish concepts you have about your positions out into the broader market of buy-side firms.

Now why would the sell-siders go to all this work? Well they get paid. And paid a lot. But it isn’t like you send a check in the mail to them. Here’s how it works.

Buy-side firms need to buy, short, sell, and close positions. They do this through brokers. The sell-side analysts work at brokerages (in general). In return for information the buy-side analysts promise to use their respective brokerages to do a certain amount of their trades. For each trade they receive a commission - just like when you trade stocks online. This ‘promise’ to do trades is done by voting. The analysts and portfolio managers vote twice a year on how much they used each sell-side firm. It’s an utterly inexact science. At the end of the tallying some rearranging is done to make sure the big guys get what they expect and the right small guys get something. Otherwise they might cut you off when you need information next time. And in fact some companies don’t get any money and do in fact cut you off. So you place your votes on those companies that offer you some value. (Note there are companies that offer research that send you a bill.)

Now in the pre-Spitzer days a number of things were different. For each buy-side firm there is a ‘salesperson’ assigned from the brokerage-research firms (sell-side firms). That salesperson was in charge of making sure he knew what his buy-side clients wanted in terms of research and helping them get it. But in fact a lot of their job was spent wining and dining the buy-side. From what I hear it was lavish. And you can guess why. The buy-side analyst is going to remember that awesome bottle of 1787 Chateau d'Yquem come voting time. Since Spitzer came through town with a Colt 45, the Street hasn't been the same. And I would say largely in a good way. You can imagine the kind of impropriety that went on.

Today salespeople do what they are supposed to – assist the sell-side analysts in getting their work in front of the buy-side. And I would in general say most of them are fish out of water. They really have no idea what to do. Before it was easy. Set up a round of golf somewhere. Set up a nice dinner at a new expensive restaurant. Now they flail about giving you stock ideas that are half baked. Half of them still have that greasy sheen to them that didn’t matter when a $10,000 bottle of wine was being opened. Now there is no such buffer to cushion their blow.

That isn’t the only change that is happening right now. In theory the commission for the trades pays for the cost of the trades and the cost of the research. In actuality it's not that straightforward. There is no price list that shows how much goes to trades and how much goes to research. But I’m sure you can guess that regardless of how it is cut up, it is a crapload of money that is changing hands. Wall Street is like the software or book business. It is highly leveragable if you are good at what you do. The more assets you can manage or influence the more you can make while your costs don’t necessarily go up proportionately. You might wonder why this hasn’t been arbitraged away. Why hasn’t someone created a more efficient system if there is so much money to be made? In a way this might be happening right now.

Two things are occurring on Wall Street right now that could shake all that up. The first is that the UK equivalent of the SEC, the FSA, has started making overtures that a price list should exist for these two services – research and trading. In other words soft dollars created from voting should become hard dollars. Pay based on use. Since Wall Street is really an international entity this does affect the sell-side firms here. And it does seem like the SEC may go down this path soon as well. And second, electronic stock exchanges and software technology that facilitates trades have grown rapidly in the last few years. These services are offering up trades at what seem to be extremely cheap rates. If you assume that the cost of these services represents one line of the price list discussed above, then you can make a back of the envelope calculation of what the second line (the information service costs) looks like. I won’t tell you what this number is but it is obscene. Once asset managers start really understanding what they are paying for each individual service they are going to start going elsewhere. Consultants, other information services, Indian outsourcers, etc. can replicate a lot of what the sell-side does for a fraction of the price. What does this mean? Does the sell-side go away? It’s possible. 5 years from now it certainly won’t look anything like it does today if it is still around. That is a lot of wealth that is going to disappear from this city.

What's also interesting is the reality of asset management has changed as a result of Spitzer. Compliance is the word of the day. Compliance can mean a lot of things. There are all types of conflicts that can arise when you are investing other people’s money in securities. What you are able to do with your own personal stocks and bonds is an obvious area for conflict with your clients. Compliance is structured around the concept that asset managers are fiduciaries. That is, they have an obligation to do the right thing for their clients, even at the expense of themselves. This automatically creates a conflict because the asset managers want a fee. Most of the compliance rules are set up to avoid or at least manage these types of conflicts. But there is one area that sticks out in my mind as broken – insider trading.

Most people know what insider trading is – trading securities with information that is not known to the general public. And that is a pretty decent definition of what the spirit of the law is. To date, most insider trading that has been brought to a prosecution stage has been fairly black and white. But if you read the legal documents you can only come to one conclusion – the sell-side and the individual companies repeatedly and frequently provide information that if acted on by buy-siders is technically insider trading. If information is material and non-public then it is insider information. But buy-siders spend most of their working hours trying to get information that is exactly that.

There are two ways to have an edge on the Street. Fundamental and quantitative analysis. Most funds use some quantitative analysis to find stock winners and losers. This can be as simple as a stock filter or screen or as complex as… Well I don’t even know the name for some of the techniques. Let’s just say that’s where a bunch of math PhD guys end up. I’d further split fundamental analysis up into two more types. The first one is to perform financial analysis on companies that are stressed. By stressed I mean undergoing some kind of radical change – both good and bad – that has caused the consensus view of their future finances to also change radically. In many cases there is over-reaction to these changes. Apple would be a great example where it has been on both sides of those reactions (take a peek at their long term chart to see what I mean – AAPL). This type of analysis requires a cool head and good financial modeling skills. The second fundamental approach is to get information that is technically insider information. For example, is there a price war going on with a competitor? Is the company building up a huge amount of inventory? Are they doing shenanigans on their financial statements? Are they being hyper-aggressive in their sales tactics during the last week of the financial quarter? Things that aren't 'priced' into the stock.

All 3 can give you an edge in the market and all 3 are probably used by most buy-side firms to some degree or another. Almost assuredly 99% are using that last technique. And where do we get the answers to those kinds of questions? Well the buy-side asks the sell-side, the management of the companies, and any 3rd parties who might have some insight. And technically, if you really look at the nature of the compliance documents, this is all insider information. It’s clearly 'material' otherwise the buy-side wouldn’t be looking for it. And it’s clearly non-public because if you could find this stuff in a 10-K or a press release it would be unusable to get an edge on the market.

At this point it’s clear that this stuff isn’t frowned upon. But I wonder if the day comes when something very grey gets pushed through to litigation. And if so how will that change Wall Street yet again. It seems to further suggest the demise of the sell-side.

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