Wednesday, September 21, 2005

Trading is an Addiction & Your Broker is the Pusher

What Is Active Management ?
A recent article in the Wall Street Journal caused me to consider what it means to actively manage an equity portfolio strategy in an environment in which brokerage analysts constantly vie to create “new information.”

Our strategy, Pathfinder, trades less often than many equity portfolios and funds. If new money is invested, it will be used to buy the most recent equity selections for that month. Otherwise, the strategy holds investments for approximately six months.

The more active part of our management is our constant monitoring of equity market performance in order to position ourselves long or short to the desired degree.

This approach results from rigorous analysis and a desire to employ an approach which combines both fundamental and technical information about the universe of S&P 500 stocks. To trade more frequently than quarterly would be to overweight technical information, as financial reports are released on a quarterly basis.

Another Source of “Information”
There is another source of fundamental “information.” It is the sell side analyst community. By the way, that reference, “sell side analyst,” tells you pretty much all you need to know regarding motivation. The article referred to earlier in this piece appeared in the August 29th issue of that newspaper, in section C- the financial news section. The essence of the article is that some homebuilder sector analysts have been releasing more than one report per day. In one case, an analyst actually published five reports in one day.

Isn’t that thoughtful of them? Otherwise, the major fundamental news would be a company’s quarterly report, or perhaps a sector-wide report issued periodically by some rather more objective institute. Or the monthly new and existing home sales figures. With this onslaught of reports, however, these institutional sell-side analysts are implicitly arguing that what they write is “new information,” necessitating reactions, in the form of trades, from their clients and prospects, the institutional fund managers. Isn’t it convenient that these analysts work for brokerage firms which just happen to have trading desks?

And let us not forget the ever-changing “ratings” activities. Accompanying the many written reports are the solemnly announced ratings of companies by sell-side brokerage analysts. These can vary from the simple “buy/sell/hold” variety to any of countless other categorization schemes. In a manner similar to report publishing, these ratings changes are intended to trigger a stampede of orders from institutional managers in response to the presumably objective changes. In reality, though, any change is beneficial to the analyst’s brokerage firm. It might be said, to use a familiar quote, “the more things change, the more they remain the same.” What “remains the same,” in this case, is the brokers’ revenue streams, in the face of institutional trading triggered by the ratings “changes.”

Mind you, we aren’t even talking about the M&A-related suspect research of the late ‘90s that triggered the Spitzer probes. In fact, in this case, the last thing these analysts want to do is make one large, unidirectional call. It’s far more profitable for a brokerage operation if the analysts activities cause frequent changes in direction, causing more trading as the “new information” flows from them.

The brokerages never directly charge the customers for this research. Instead, it is built into the cost of the trading desks which deliver the resulting trades. Since trading is capital intensive, volume increases due to analysts-driven trading yield the payoff to funding the analysts groups. The institutional customers pay indirectly, even at fractions of cents on the dollar per share traded, or in the bid/ask spread.

An Overlooked Effect
There is another, often overlooked second-order effect from this over-reporting of sector “information.” It is the conditioning of institutional managers, and fund-of-fund managers, to take it as an article of faith that actively managed funds or strategies need to be reacting to all this “information” flowing from the analysts. It is a timeless effect. Somewhere, analysts are pumping out “new information” for the sector du jour of interest. Yesterday it may have been home building. Today it might be energy. Tomorrow- who knows? But rest assured, some sector is always ripe for over-reporting and a steady flow of information on which trades are therefore expected to be made in reaction. If you aren’t trading on constantly-flowing analysts’ reports, you’re just not an “active” portfolio manager.

Where’s the Beef?
What is missing, though, is an objective analysis of whether all this type of “new information” actually constitutes value which can be used to change portfolio positions profitably. There are no studies of which we are aware showing that frequent trading, trimming positions with every jot and tittle of some analyst’s pen, will actually improve fund returns. In fact, the blizzard of analyst reports looks very self-serving for the brokerage firms which employ them. By addicting institutional investors to the steady flow of “research” and “ratings changes,” the analysts help assure a steady flow in the other direction of trades by institutional customers in reaction to the apparent “new information.”

For example, during the week of October 7, 2004, an analyst at one fairly well-known brokerage trashed the entire homebuilding sector. Pulte’s return for the period, from July, plunged from 18% to –3% in a week. It further deepened to –6% the following week. After quarterly results were released later that month, Pulte rocketed back 16% return points in two days. First on news of Toll Brothers blowout quarterly results, and then the next day on Pulte’s own quarterly report. By December 17th, it was back up to a 22% return for the holding period, where it finished the year. Golden West also recovered to a period-near-high of 17%.

So the analyst caused a temporary plunge with ‘new’ information which turned out to be wrong. The market corrected back to its original valuation. How much trading occurred in the interim to drive the prices down, then up? Who gained from that? Well, regardless of the timing of the institutional buys and sells, we know the brokerage firms profited from this little episode. No doubt it is repeated many times each quarter throughout many sectors.

When you think about it, being right isn’t actually all that good for an analyst’s employer. Better, from a trading volume perspective, to cause a change in price in both directions of a stock, rather than correctly signal only one move.

Effective “Active” Management
What puzzles me is why, in the absence of published evidence that frequent, sell-side-analyst-caused trading increases net returns to portfolio managers, more institutional fund allocators and managers don’t frown upon such “active” management.

Why is holding positions for more than a month seen as being a “passive” manager? In the case of Pathfinder, it is a conscious, empirically-research based choice to pursue the accumulation of returns and lower trading expenses. Trading more frequently than quarterly drives a strategy to become technically-based, i.e., defined purely by market price moves. This is where the analysts’ reports come in. By creating a constant flow of “information” with which to affect stock prices, the analysts create trading revenues for their institutional equity desks, while also creating a climate in which managers and investors expect frequent rebalancing and trading as the norm, rather than the exception.

At Performance Research Associates we eschew this frequent-trading approach. Instead, we base our selections and holding periods on longer-time-framed signals and measures. Actively managing Pathfinder means we continually monitor the market for long/short allocation signals to drive that decision, because it is a particularly important and value-laden one. We also monitor positions on a daily basis in order to better understand how economic and company-specific news affects our portfolio selections. However, within existing long/short allocations, we remain confident in our selections, daily ‘new’ analyst-provided information notwithstanding.

We believe the results of equity portfolio management are what count, not the frequency of the trading or investing which produces those results.

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