Tag Archives: contests

Market Evolution And The Demise Of Good-Til-Canceled And Stop-Loss Orders

Summary There have been articles in SA recently touting common stocks of some major exchange management firms. These are not stocks for your retired aunt who taught grade school. They are stocks for your cousin who runs a surfing equipment shop on Maui when she’s not on tour. Exchange management is a high tech business where a winner can become a loser in a matter of months. Decisions like NYSE, NASDAQ and BATS’ prohibition of good-‘til cancel orders, beginning in February, show that exchange management is crisis management. This is Part 1, the introduction, of a discussion of winners and losers among the corporations that manage exchange trading, including CBOE Holdings (NASDAQ: CBOE ), the CME Group (NASDAQ: CME ), the Intercontinental Exchange (NYSE: ICE ), NASDAQ Inc. (NASDAQ: NDAQ ), and London Stock Exchange Group, for example]. These articles will analyze “What’s in?”, “What’s out?”, and “Who Knows?” This first article sets the table for those that follow. What’s in? The future of processing securities and futures transactions is very bright, as the cost of entering, clearing, and communicating results of transactions goes to zero and execution approaches warp speed. The future of banking is in making big investment decisions, finding the right financing, the right companies on the investment execution side, and advising investors about participation in the enterprises they sponsor. Some exchange is going to remember that serving the needs of legions of small investors is profitable. That exchange will find a way to create an environment where these traders are not constantly swamped by high speed traders and institutions. What’s out? Places where we see men in brightly colored jackets announcing new issues and ringing a quaint bell at the market open, like the building on the corner of Broad and Wall Street. They are museums and retirement villages – glorified photo ops. Financial institutions as a storehouse for securities and other claims on real wealth. One day soon this will be done globally by a computer the size of your fingernail. Financial institutions as trading intermediaries. That business is low margin, high volume, and independent of strategic economic and financial forecasting issues. Forget foreign exchange, deposit trading, and derivatives trading by banks. Financial institutions will advise users and do the trade that originates the use of these instruments by corporations and investors, but the billions of follow-on trades are soon to be non-bank activities. Exchange corporations that make too many decisions like the one made by Intercontinental Exchange ( ICE ), the owner of the NYSE], the other day, to end GTC and SL. Unless NYSE has more changes in mind than simply those, that was a bad decision. Good exchange decisions will attract traders; bad decisions, repel them. This decision will repel many traders. Who Knows? The future of the thing that we now call an exchange, defined as a localized collection of computer servers that confirm trade execution, like the NYSE now, is in some doubt. The future of the collection of companies listed in the first paragraph above is uncertain. If they depend on markets functioning as they do today, they are zombies. If they see themselves as electronic tech companies, in a race to find the fastest, most secure, means of placing, executing, clearing and communicating transactions, they have a shot at being the king of the world of transactions. There is likely to be only one in the end. And it may be none of the firms listed above, but one of the dark pools that wait to usurp these firms’ dominant position. Or a company that does not yet exist. It will be fun to watch (from an investment-free position.) This series of articles is a warning to investors in these exchange management companies: To forecast the fortunes of the firms above, forget the charts. Forget b and a. Forget forecasts of trends in income, the size of income margins, and the like. These firms are the wildcat oil drillers of finance. They exhibit handsome returns in the past few years. (And wages are high for deep sea divers, if they survive and surface to collect.) As a combined portfolio of shares, the sort of analysis that applies to Google, now Alphabet, Inc., ( GOOGL , GOOG ) or Apple (AAPL] is relevant for these stocks. The future of electronic trading and clearing in the next several years is good. But keep a close eye on new players. Also old players, such as dealers like Goldman Sachs (NYSE: GS ) and the hedge fund, Citadel, that have an unexplained interest in trading technology. But the individual corporations are not so secure. Some of them may not be with us in as few as five years. The changing technology of trading and the jockeying of the combatants are as much fun to watch as a Star Wars battle scene. If your money is not invested in one of the losers. As an aside, here is a list of dark horses: Bank of New York Mellon (NYSE: BK ), State Street Corp. (NYSEARCA: SST ), BATS Exchange, and IEX. My guess is that the ultimate king of the hill will be someone we have not mentioned. It’s human nature. Darwin knew about it. Change in the environment always means the death of old species and the rise of new species. So to resist change is instinctive. It promotes species survival. The human animal hates change. NYSE management hates change. Individual investors hate change. Following articles will expand on the reasons for my picks of winners and losers.

Alternatives For The Future

The article first appeared in the December issue of REP . magazine and online at WealthManagement.com Along with other Yuletide treats, some Yanks are now anticipating the gift of a Fed rate hike. Better-than-expected employment numbers, an uptick in the manufacturing sector and pickup in wages have given the U.S. central bank the backstory for normalizing the nation’s monetary policy. The odds of a rate step-up, implied by Federal Funds futures, shot up from 7 percent to 70 percent in November. Simultaneously, expectations pushed the Treasury long bond yield up nearly a quarter of a point, effectively discounting the Fed’s anticipated action. Now that the markets have priced in the first Fed rate hike, it’s debatable whether it will be “one-and-done,” or the first step along a steady path of snugging. Either way, the die is cast: Rates are bound to rise, and sooner rather than later. With the coming of the end of the zero-rate environment, investors and advisors must rethink their portfolio strategies, most especially their alternative investment allocations. The basic question facing them now is which exposures are most likely to continue providing risk diversification in a rising rate environment. To answer that question, let’s look back at the liquid alt universe over the past five years and gauge each category’s correlation to a fixed income market proxy, the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ). AGG tracks an index of investment grade notes and bonds including Treasuries, agencies and corporates as well as mortgage- and asset-backed paper, all with a weighted average maturity just under 13 years. Currently, AGG offers a 2.4 percent distribution yield. Two Things An ideal diversifier should be negatively correlated to AGG. Thus, when rates rise (and AGG’s price, as a consequence, falls), the alternative investment should appreciate. There are five categories that are negatively correlated to AGG: arbitrage, hedged equity, commodities, long/short equity and market-neutral. Based on the foregoing criterion alone, the arbitrage category seems to have the best track record over the past five years. Keep in mind two things, though. First, the correlation coefficient doesn’t measure cumulative returns. It only depicts the statistical relationship between each investment’s month-to-month price movements. And second, the category performance represents the market-weighted average of several portfolios. The arbitrage category, for example, comprises five products, four mutual funds and one exchange traded fund (ETF). Market weighting gives us insight into investor behavior and allows us to more clearly see how investors are actually putting their capital to work. The stand-out arb portfolio is the relatively small Quaker Event Arbitrage Fund (MUTF: QEAAX ) with a correlation of -0.21 to AGG and an average annual return of 2.39 percent. QEAAX deals in mergers, takeovers, spin-offs and other reorganizations, hoping to capture securities mispricings. The obvious problem with QEAAX, if a problem is to be found, is its high correlation to equities. QEAAX, after all, buys and sells stocks. If the prospect of rising rates spooks the equity market, as indeed it seems to have done, the Quaker fund’s NAV will likely be pressured. Hedged equity funds are also highly correlated to the broad stock market. The “hedge” in the category’s title refers to the variety of strategies employed by constituent funds to attenuate, but not necessarily eliminate, beta. The Schooner Fund (MUTF: SCNAX ), for example, is a long-biased fund that utilizes a buy-write (covered call) strategy to boost income. That said, SCNAX, with a -0.19 correlation to AGG, benefits most from a mildly bullish equity market. SCNAX pays just 0.57 percent in dividends. Commodity funds-long-only indexed portfolios-are only modestly correlated to stocks, but are suffering from a four-year disinflationary malaise. All, save one, are negatively correlated with AGG. It’s the PIMCO Commodity Real Return Strategy Fund (MUTF: PCRIX ), which overlays an actively managed fixed income strategy atop the index portfolio, that earns a 0.04 correlation to AGG. It should come as no surprise that long/short equity funds are highly correlated to the broad stock market. Nearly half of the 16 funds in the category, in fact, correlate to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at better than 0.85. Of these, one with the most negative correlation to AGG (-0.31) is the Diamond Hill Long-Short Fund (MUTF: DIAMX ), a portfolio that commands a 22 percent share of the category. Market-neutral funds attempt to hedge out general market exposure, i.e., aim for a beta near zero, to allow full expression of the manager’s concentrated bets. The multi-manager Deutsche Diversified Market Neutral Fund (MUTF: DDMIX ) accomplishes this with the category’s most negative correlation to AGG (-0.16). Alternative Income There’s a category we haven’t yet examined: alternative income. Three funds, in particular, have five-year track records, two mutual funds and an ETF. Collectively, these funds exhibit a modestly negative correlation (-0.06) to AGG, though you can see there’s a fair degree of “zig” to AGG’s “zag” in Chart 2. Viewed separately, these funds offer distinct value propositions: The $7.6 billion ALPS Alerian MLP ETF (NYSEARCA: AMLP ) tracks the price and yield performance of the Alerian MLP Infrastructure Index, a modified capitalization-weighted and float-adjusted benchmark of two dozen U.S. energy master limited partnerships (MLPs). To allow a full allocation to MLPs, AMLP is structured as a C-corporation, which means it can’t pass through the full return of its underlying index. Payouts are distributed net of corporate tax, which translates into a daunting expense ratio of 5.4 percent. The good news is that most of these distributions come tax-deferred to investors, making its 8.4 percent distribution yield doubly attractive. Worse News There’s, of course, worse news: The energy sector’s tanked this year, taking AMLP’s share price with it. The fund lost 28 percent on the year through mid-November. The JPMorgan Strategic Income Opportunities Fund (MUTF: JSOAX ) is an unconstrained bond fund with an absolute return orientation. The $18.4 billion fund has the flexibility to allocate its assets across a broad range of fixed income securities and derivatives as well as strategies employing cash and short-term investments. JSOAX is not afraid to load up on high-yield securities. JSOAX tends toward a short duration and holds a heavy slug of cash, all of which reduce its interest rate risk. The fund offers a 2.6 percent distribution yield. At $698 million, the Highland Floating Rate Opportunities Fund (MUTF: HFRAX ) is the category’s smallest asset collector. Still, it’s the best performer. HFRAX invests in floating rate bank loans-obligations with interest rates pegged to a spread over Libor (the London Interbank Offered Rate). This puts the fund in the catbird seat in a credit-tightening cycle. Currently, the fund offers a 5 percent distribution yield. You can see in Table 2 the countertrend nature of the HFRAX fund in its -0.22 correlation to AGG and a Sharpe ratio 40 basis points above that of the iShares product. So what have we learned from our little exercise? Simply this: When it comes to hedging interest rate risk, fund performance doesn’t draw assets. At least not yet. The Highland HFRAX fund, despite its impressive metrics, remains relatively obscure. It accounts for barely one-half of 1 percent of the alternative funds’ assets examined here. Perhaps that makes this fund-and newer funds on similar trajectories-undiscovered gems in the upcoming rate environment.

David Einhorn And Reasons Why Widely Followed Stocks Get Mispriced

Over the weekend, I was reading David Einhorn’s book Fooling Some of the People All of the Time. I’ve had it on my bookshelf for some time, and it has always taken a back seat to other books until I decided to pick it up recently. It’s an entertaining read, basically recounting his short thesis on Allied Capital in great detail. It is a good book because it provides a glimpse into the significant amount of research and due diligence that a great investor like Einhorn performs in his investment approach. Source: Columbia Business School Don’t Count Einhorn Out Einhorn – like many well-known value investors – has had a very tough year . But we have not seen the end of Einhorn’s run as a top-quality investor. To borrow an analogy I used in a post last year – just as so many were so quick to write off Tom Brady after an early season loss to Kansas City last year that left the struggling Patriots at 2-2 and looking like a shell of their former dominant selves, I think far too many people are writing off Einhorn (as well as others) who have had a bad year. As I said last year, if the Patriots were a publicly traded equity, the stock would have been beaten down after the Chiefs blowout and it would have been one of those rare opportunities to load up. Lo and behold (and as painful as it is for me to say as a Bills fan), the Pats rattled off a long string of consecutive wins on their way to their 4 th Super Bowl title, and continued that winning streak until a surprising upset loss last night to the Denver Broncos (coincidentally led by a young QB who is temporarily replacing another legend that many are also writing off-perhaps prematurely). Back to the book – there is one chapter where Einhorn describes a meeting he had with a well-known mutual fund manager. To put this meeting in context: Einhorn was in the midst of doing significant due diligence on a company called Allied Capital, a business development company (BDC) that used aggressive accounting practices, questionable reporting of their financial results, and very liberal valuations of the illiquid equity and debt securities that they held for investment. Einhorn had been short the stock for some time, and although it slowly was becoming apparent that Einhorn’s thesis was largely correct, the stock hadn’t fallen much and continued to trade in the same general range that it had prior to Einhorn’s famous speech where he announced his short thesis. So Einhorn was introduced to this fund manager through his broker, who thought that it would be good for both sides to hear each other’s thesis on the stock (Einhorn was short and this mutual fund manager had a large long position). Einhorn showed up to the meeting fully prepared with a briefcase full of his research, and the mutual fund manager came in with nothing but a notepad and a pen. As it turned out, this fund manager hadn’t even read Einhorn’s research – this is despite being long a stock that was very publicly criticized by Einhorn and others who had published significant and detailed research laying out their thesis for everyone to see. Einhorn couldn’t believe that this fund manager owned a large block of stock and not only did he not do his own primary research, but he didn’t even read the secondary research that was easily and freely available for him to read regarding the potential problems at Allied. What’s the point here? I’ve always thought that there are two main reasons that stocks generally get mispriced: Disgust Large-cap stocks that get mispriced are almost always due to disgust. These stocks are large companies that are widely followed by investors and analysts. There is very little information that is not widely known by all market participants. However, sometimes these large companies run into a temporary problem and investors sell the stock because the outlook for the next next quarter or the next year is poor. Investors can take advantage of this situation by: a) accurately analyzing the situation and determining that the nature of the problem is in fact temporary and fixable, and b) be willing to hold the stock for 2 or 3 years – a timeframe that most individual and institutional investors are not willing to participate in. Some investors refer to this concept as “time arbitrage”. It just means that you’re willing to look out further than most investors and willing to deal with near-term volatility and negative (but temporary) short-term business results. In addition to a company specific “disgust”, these large caps can also get beaten down when the general market environment is pessimistic. In bear markets, companies with no problems at all often see their stock prices get beaten down because of macroeconomic worries or general market pessimism. So although many value investors look at small caps because they feel this is where they can gain an informational advantage, I think taking advantage of this “disgust” factor is just as effective and is an important arrow to have in the quiver. Neglect Often times, the most mispriced stocks in the market are small-cap stocks that are underfollowed and neglected. The obvious advantage here is to locate a situation that no one else has discovered by looking under a lot of rocks and in the nooks and crannies of the market. Sometimes things slip through the cracks. I would also put special situations in this category. Sometimes companies are misunderstood as well-but this is usually because they are neglected to a certain extent. The market has collectively not been willing to put the effort into understanding these situations sufficiently, and this creates potential mispricings. Einhorn’s Experience Einhorn talks a lot about “the guy on the other side of his trade”. In other words, each stock trade has a buyer and a seller and both think that they are getting the better deal (or they wouldn’t be engaged in the transaction). I don’t really spend a lot of time thinking about this angle, but it is interesting to consider who might be selling you shares that you are buying, and the reasons why. In this case, Einhorn thought he might be selling (shorting) shares to sophisticated institutional investors who disagreed with Einhorn and believed Allied was undervalued. However, as Einhorn learned, this wasn’t the case. The institutional investor was “too lazy or too busy”, as Einhorn put it, to put the time and effort into understanding what he owned. So, I’m not sure which category this type of situation would fall into, or maybe ignorance deserves its own category. But the experience with the mutual fund manager that Einhorn describes is certainly evidence of how sometimes even widely followed stocks get mispriced. If an investor is buying millions of shares for reasons that don’t have anything to do with the intrinsic value of the company, then there is the potential for a mispricing to occur. To Sum It Up I think most investors intuitively understand that it’s occasionally possible to find a bargain in an underfollowed stock, but I think just as often, large caps (or more widely followed) companies get mispriced for these reasons (disgust, ignorance, short-term thinking, or irrational behavior). Here is the passage of the book I referenced above where Einhorn met the mutual fund manager: “…so James Lin and I walked over with a briefcase full of our research. We met with Painter and Stewart in the conference room. Stewart brought nothing but a legal pad and pen. “Okay,” he said, “go ahead.” I thought this was supposed to be a two-way dialogue. “First, what did you think of our analysis?” I asked him. “Do you see anything wrong with it?” He said he hadn’t read it. While I could believe that Allied’s shareholders might generally be too busy to have read the lengthy analysis we put on our website, it was hard to imagine a professional, who was the second largest Allied holder, would come to a meeting with us and acknowledge such lack of preparation. So I asked him why he held the stock. Stewart said that in the tough market he felt it was a good time to own a lot of high-yielding stocks and his Allied holding was really part of a “basket approach”… Einhorn concludes: “I left with a new understanding of what we were up against. It wasn’t an issue of investors understanding our views and disagreeing. In addition to the small investors, Allied’s other investors were big funds managing lots of other people’s money-too busy or too lazy to worry about the details, other than the tax distribution.”