Family Offices, Dentists and Quants
The foundational story of the American financial system is one of upper-middle-class financial capitalism, in which the ideal imagined investor is a thoughtful, financially literate but non-professional small investor who, with the help of a trusted adviser, buys stock in individual companies because they have good businesses and are fairly valued. Much of what is interesting in modern financial markets comes from the fact that that story is no longer true, is indeed viewed as a laughable myth by many savvy people. Who buys individual stocks? It has become an old-timey hobby for the modestly wealthy and eccentric, like model railroading.
So now there are huge public companies that are mostly owned by index funds and "quasi-indexers," diversified mutual funds who own stock in all of the companies' competitors. But our corporate-governance system is based on that older story of stock-picking individuals, in which managers' duties are generally thought to be to their shareholders as shareholders of that company, rather than to the shareholders' broader interests as holders of the market portfolio. There are tensions there. Or you have market-structure rules intended to protect individual investors, so they can compete fairly against the big institutions, even though a moment's thought will tell you that's impossible: The institutions have way more money and technology and time and access than the individuals do, and will of course have advantages in making investing decisions. But regulators pay lip service to the assumption of a level playing field, because the story of upper-middle-class non-professional investors needs that assumption to work.
Anyway here's a story about rich people's family offices, which are becoming bigger and more numerous and a more powerful force in the financial industry, increasingly doing their own private-equity deals rather than investing in funds:
The offices are alternately linking up with buyout firms and competing against those firms to do acquisitions. They are providing financing to startups. They are buying distressed debt, real estate and esoteric insurance products. They are lending to companies and occasionally going into battle with companies as activist shareholders.
Investment bankers are courting them the way they used to court institutions. One banker calls them "insti-viduals," which I hope he's trademarked.
This is very different from the story about index funds, etc., but it seems to me as a related phenomenon. Both are about, as it were, the hollowing out of the investing middle class. Nobody buys stocks any more: Now, either you buy an index, or you buy a whole company. More people are using the most generic budget form of investing, and more people are becoming institutions themselves and getting involved directly in dealmaking and corporate management. The old story, of broadly dispersed individual shareholders in a single company who delegate management authority to professional executives, is no longer the norm.
The foundational story of the American financial system is one of upper-middle-class financial capitalism, in which the ideal imagined investor is, let's face it, a dentist. Dentists are the traditional backbone of our financial markets, educated people with money to invest but no professional investing expertise. But with the hollowing out of the investing middle class, the dentists are hurting:
Dr. Stein and some fellow investors gather most months in a side room of Bertucci’s, an Italian restaurant 35 miles east of Wall Street here on Long Island, for seminars sponsored by the American Association of Individual Investors. September’s guest speaker was Marvin Appel, an anesthesiologist-turned-financial adviser. His pitch: Invest in dividend-growth stocks, emerging-market funds, junk bonds and mortgage real-estate investment trust preferred stocks, vehicles that can offer higher returns than plain-vanilla, fixed-income investments but typically come with more risk.
Steve Stein is an 82-year-old retired dentist in Huntington, New York. A generation ago he'd have bought stocks when he was young and then transitioned into conservative but nonetheless yieldy fixed-income investments as he got older. ("My dad used to put his money in CDs, getting 15%," says Stein, of his dental-technician father.) Now that doesn't work as well, and Stein is 95 percent in stocks at 82. And he finds himself in Bertucci's, mingling with the other dentists and anesthesiologists, wondering what went wrong and what to do about it.
Here's a story about how the quantitative investing business has changed over the last 10 years, in ways both reassuring --
While its quants might have tapped into only a dozen or so signals in 2007, they now use more than 250 with much less leverage. That means the dangers of crowded strategies that proved so toxic nearly a decade ago should be reduced.
-- and not --
“It’s the biggest worry I have,” says Richard Bookstaber, a former risk manager at Morgan Stanley and Moore Capital, now a research principal at the US Treasury’s Office of Financial Research. “What is going on now is not just the growth of quant hedge funds, like before the crisis. Now it’s system-wide across the investment world. In 2007 it was localised because no one else was pursuing these strategies. Now everyone is.”
Well sure but what are "these strategies"? The basic process of investing is that you look at some historical information, you make some predictions about the future, and you invest based on those predictions. At that level of generality, that's not a strategy that can become crowded; that's just what the process of investing is.
A story you could tell about quantitative investing is that, early on, computers could only look at certain kinds of information and make certain kinds of predictions. Most of the investing world was therefore off-limits to quant funds, so not that many quant funds existed and they all did similar stereotyped things. As funds get access to more types of data and develop more ways of analyzing it, they are not just changing what happens in the "quant hedge fund" sector: They are expanding what sorts of investing can be done "quantitatively," applying quantitative techniques to a wider range of strategies.
Mr Walsh outlines how they can profit from even the most common of corporate events: quarterly earnings calls. Using an AI technique called “natural language processing”, Goldman’s algorithms can systematically look for verbal cues from analysts on the call that might indicate whether they were pleasantly or unpleasantly surprised at the results — and therefore upgrade their outlook in response.
Is that "quant"? I mean, sure, yes, a computer is telling you how to invest. There is math. But "reading between the lines of what analysts say about a company" is not quite the same "strategy" as, like, on-the-run/off-the-run Treasury convergence arbitrage. Getting a gut feel about analysts' views is a classic job for non-quantitative human equity managers. It's just that now computers can do it too, and faster.
Interactive Brokers Group, Inc., is getting out of options market making:
Thomas Peterffy, Chairman and CEO, said, “Having initiated the first automated option market making operation in the mid ’80s, which grew into the largest such business on a global scale over the next 25 years, it’s been painful for me to see it deteriorating in the last few years. But we do not have a choice in this matter. Today retail order-flow is purchased by large order internalizers and joining them would represent a conflict we do not wish to have. On the other hand, providing liquidity to sophisticated, professional synthesizers of short-term fundamental, technical and big data is not a profitable activity.
A story that you often hear about modern U.S. equity market structure, in which internalizers pay brokers for retail order flow, is that it is bad for the retail investors whose orders get sold. That's probably not true: The retail investors get cheap trades and better prices than they would on the public markets. It's win-win for them. Various conspiracy theories posit that the retail investors nonetheless are somehow harmed, but those theories seem to be mostly -- not entirely! -- wrong.
Instead, the real objection to payment for order flow is not that it is bad for the retail investors, but that it is bad for the market. If you take all of the unsophisticated small orders out of public markets and sell them to internalizers, all you have left in the public markets are "sophisticated, professional synthesizers of short-term fundamental, technical and big data." Providing liquidity to them is a much riskier activity than providing it to retail investors, or to a random mix of retail and sophisticated investors. (If you squint, it's another story about the hollowing out of the investing middle class.) This is usually a pretty hypothetical point -- it's hard to know whether spreads would be much tighter on the public stock exchanges if retail brokerages didn't internalize so many orders -- but here is some empirical evidence. When retail investors leave the public markets, public-market liquidity providers like Interactive Brokers are next.
The Perfect Scam.
What is the Alberta Securities Commission getting up to these days?
The ASC held an event on February 22nd, which was billed as a real estate investment seminar held by "Maplestock Investments", a fake company that was created by the ASC. An actor was hired to play the role of the 'mastermind' – British-born financier Jonathan Fisher. The ASC developed a detailed fake profile for Maplestock and Mr. Fisher, including a website, Facebook page and LinkedIn profile. The seminar was advertised on numerous channels including Facebook, Eventbrite, Google display ads, Craig's List, Kijiji and home delivered flyers. Forty-eight people registered for the event and 22 people attended, looking for a new investment opportunity.
Halfway through the packed event, it was revealed to the audience that the entire seminar was a setup, designed to educate Albertans about the realities of investment fraud. The entire event was filmed and turned into an educational video for Fraud Prevention Month.
If that doesn't make you want to be an Alberta securities regulator, there is something wrong with you. This is pretty much my dream: designing, building, and home-delivering flyers for investment scams, without the risk of going to prison. (Or the payoff of a successful scam, but whatever.) "Everything about the fake investment opportunity – from the company's name and logo, to Jonathan Fisher's bio and the colour of his tie – was extensively researched," by people who were probably having a lot of fun. I bet the tie was red.
I should just do this freelance. Rent a room, print some flyers, put a tie on a British man, and then do a big reveal: "No, hahahaha, we're kidding, you just got scammed! Just for fun I mean. I'm not going to take your money, and I don't work for a regulator; I just wanted to see the looks on your faces. Enjoy the free continental breakfast!" I wonder if I could raise some funding for this.
I always assumed that the U.S. system of securities-professional licensing exams, whose main requirement is that you have to already have a job at a securities firm to take the exams that allow you to work at a securities firm, was some sort of guild-protection system, though I never quite understood how it works. It's not like the supply of Series 7 takers is that restricted. But here is a proposal from the Financial Industry Regulatory Authority to change the exam structure:
The proposed changes would make it easier for an individual with no prior securities industry experience – whether an investor, a recent college graduate or a professional seeking a second career – to take a general knowledge exam called the Securities Industry EssentialsTM(SIETM) as an important first step to entering the industry. Individuals who wish to enter the industry are also required to pass a second more specialized knowledge exam, and must be associated with and sponsored by a firm.
I guess now every college student who wants a finance job will have to pay a fee to take the SIE exam to prove their skills and dedication, rather than waiting until they're hired and having their firms pay for it.
Elsewhere in credentialing, Harvard Law School will accept Graduate Record Exam scores in lieu of the Law School Admissions Test. I don't want to give you legal advice, but here's some free law school advice: Probably don't go to law school if you don't want to be a lawyer. I mean it worked out fine for me. But it's generally a poor gamble. I'm not saying that taking the GRE instead of the LSAT is proof that you don't want to be a lawyer or anything, I'm just saying, don't go to law school if you don't want to be a lawyer.
People are worried about unicorns.
Here's a story about how Stanford University is trying to fund startups founded by students like Evan Spiegel, who "often hung around the offices of StartX, the school's entrepreneurial hub." Obviously. We've talked before about the recurring fad for financing college education with equity rather than debt, and really Stanford has the opportunity to be a leader in this space. Instead of charging tuition, it could just demand like a 5 percent stake in all of its students' future startups. It's a portfolio model: Classics majors would just get free classics degrees, while the guy who builds the next Snapchat would pay a billion dollars in effective tuition. I actually do not see the downside here. "Adverse selection," you say, but you are wrong; this would probably attract more potential startup founders. Young founders seem to love giving away equity in return for external validation and mentoring. They're as credential-driven as the rest of us, which is why they go to Stanford. Anyway Stanford isn't doing this -- StartX is a more conventional funding/incubator sort of model -- but it should.
Elsewhere, "Uber Technologies Inc. said Wednesday it will stop using technological tools to evade government officials seeking to identify and block the service’s drivers." And here is Farhad Manjoo on how Snapchat will end literacy, which, I mean, surely something will, and soon.
Longtime readers of this financial newsletter will not be surprised to learn that the most controversial thing ever published here may be yesterday's discussion of combining 3,000 Olympic-size swimming pools of sugar with 3,000 Olympic-size swimming pools of water to form 6,000 Olympic-size swimming pools of simple syrup, having Katie Ledecky swim through them, and then using the syrup to make approximately 3 trillion cocktails. There were four broad categories of reader objection to this discussion:
- The volume of simple syrup is less than the combined volume of its components, because it is denser. This is correct. Sorry! Three thousand pools of water and 3,000 pools of sugar would make something like 4,500 pools worth of simple syrup (reported amounts vary). Katie Ledecky could take them down in something like a day and a half, and they'd only supply enough syrup for about 2.3 trillion old-fashioneds.
- Actually you can swim in simple syrup about as fast as you can in water, because while its viscosity creates more drag, it also allows you to generate more force. This is also true. Newton discussed the question in the "Principia Mathematica," and it was settled by some University of Minnesota chemical engineers in 2004.
- A 12:1 ratio of rye to simple syrup in an old-fashioned is pretty aggressive. Well, those are the proportions in this New York Times recipe (taking a "bar spoon" as about a teaspoon, or 5 milliliters), but I am inclined to agree that that's a little dry. (One reader also objected that 1 milliliter of bitters is too much for two ounces of whiskey, though that seems to be at least the amount described as "two dashes.") I confess that I like a bit of Pierre Ferrand Dry Curaçao in my old-fashioneds, and sometimes even substitute maple syrup for the simple syrup, though neither of these is at all canonical. We will call this point debatable.
- You need ice to make the old-fashioneds. Quite right. I suppose I can say that I assumed that each man, woman and child in the world would supply their own ice for their 400 old-fashioneds (now reduced to about 300), but yes, you'd need a few tens of thousands of pools full of ice along with the whiskey, syrup and bitters. Also vast quantities of your preferred garnish, a debate that I am not, at this point, interested in starting.
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