4 posts tagged “clientele”

The reason for some institution's refusal to sell their positions that have appreciated dramatically (and that are most vulnerable to decline) can be deeper than the impression desired by publishing the positions. Management's compensation is usually a set percentage of the market value of the assets managed. If a profitable position is sold, the gain may be subject to taxation and paid out to clientele as a capital gains distribution. This effectively reduces the amount of money being managed and the associated fees.

The problems associated with selling positions that have profited most can be particularly acute in small mutual growth funds that have followed the practice of "taking losses and letting profits ride" for an extended period. The result is that their portfolio consists of only a few issues. By having locked themselves into holding a few profitable stocks, the fund's value becomes a function of the value of the rigid holdings and has nothing to do with the overall ability of management.

Keep in mind that money managers are human beings with basic needs such as food and shelter, which require employment. Also recognize that, especially in the larger institutions, clientele are not aware of the identity of the individual analyst making the investment decisions. This anonymity is often strictly enforced and a prerequisite for employment.

In this environment, the individual analyst (whether a genius or an idiot) is under pressure to conform to the crowd. To be too good or too bad relative to one's peers involves risks of criticism or resentment with the associated occupational hazards. This effect is obvious to anyone familiar with the financial media. When an analyst (usually independent) becomes popular because of accurate forecasting and then stumbles, the mistake (even though the overall return over time has been far superior) is pounced on. On the other hand, a spokesperson for a large institutional analytical service that has consistently been wrong, but that is one of the crowd, attracts media attention when making forecasts without criticism of past mistakes.

Understanding the structural aspects of institutional investing practices and employment pressures, you would logically conclude that the average institution would underperform the market, with the underperformance magnified by the fees involved. Yup.

External

Aside from the difficulties associated with internal structure and characteristics, institutions have the added problem of dealing with their clientele. Discretionary clientele who do not properly understand the stock market, although they have entrusted their investment decisions to someone else, often have a tendency to self-destruct. This is particularly evident in mutual funds, whose investors are continually adding or withdrawing (redemptions) money. People tend to add money when the market is highand the mood optimistic. Redemptions tend to dominate when the marketis low and the mood pessimistic.

The institutions are forced to invest the money—that is what they arebeing paid to do. Therefore, with more money coming in when the market is high, the institutions so affected are forced to buy at relatively high levels. Conversely, when redemptions dominate and the market is low, the institutions are forced to sell at depressed prices to fulfill the investor'sdemand for cash.

From the professional standpoint, the process is marvelous. We knowwe have buyers at high prices and sellers at low prices because of the demands of discretionary clientele creating a supply/demand imbalance. When they are doing their forced buying, it creates underlying buying demand and we can raise our prices. When they are forced to sell, we know there is "overhanging supply," and we can lower our purchase prices.

This buy-high/sell-low behavior (required to fulfill clientele's wishes) is not limited to mutual funds. It can affect any funds that can redeem or add capital according to their client's emotions: bank trust departments, pension funds, and the like. An important exception is closed-end mutual funds where the capital base is fixed and the investor must buy/sell shares in the open market rather than affecting the funds' specific holdings.

The market is a business. The purpose of the business is to acquire the monies of others through the process of buying low and selling high. Because of the anonymous nature of trading structure, it is very difficultto specifically identify the individual to whom you are selling or from whom you are buying. Consequently, physical coercion to create losingbehavior among fellow market participants cannot be applied. People do not enter the market to lose. However, they must be placed in a situation in which they will willingly part with their money. The only way to elicit losing behavior is psychological pressure. The most effective tool for applying the pressure is a change in market price. Faced with "paper" losses, those vulnerable to the emotion associated with "apparent" losses will capitulate, accepting the loss in the form of cash to relieve thepsychological strain.

The discretionary manager is subjected to the same emotional pressuresas all other market participants. It is not uncommon for discretionary managers to buckle under the pressure and sell low in direct conflict with historical or statistical precedent to alleviate pressures both self- and clientele-imposed. Conversely, when prices are too high, the emotionallure of greed can stimulate buying when prices are most vulnerable to severe decline. Those who conduct themselves professionally are acutelyaware of the psychological effects of price on institutional managers and take advantage. Such advantage is possible only by strict adherence to a methodology that prevents being lured into the irrational (emotional) behavior of the crowd. This is easily accomplished by having predetermi_ned buy/sell points dependent upon market condition, not price in itself.

The forced behavior of institutions provides one of the most important profit centers for the true professional.

Although the emphasis is to assist individuals in developing and implementing their own investment strategies, we do not mean to imply that all money managers should be avoided. There are many competent managers.

Yet the selection of a manager cannot be taken lightly. The fate of the monies entrusted is most likely sealed at the time the manager is selected. It is no time to blindly follow friendships, media hype, or personal emotion. Almost all of the difficulties associated with the selection process can be eliminated by following three simple guidelines.

1. Familiarity with the Investment Technique

Money is a tangible: Either you have it or you don't. Generating money from money is a very specific process: Specific investments, must be chosen and the investments managed under specific techniques. Irrespective of how money is applied (even hidden in a mattress), there is an element of risk. To place the element of risk in a context suitable to individual resources, needs, and goals, it is mandatory that investors understand the specific investment techniques determining how monies are invested.

Obviously, avoid managers who stipulate techniques that have not produced suitable results when back-tested over a long period or who stipulate that their methods are proprietary (secret to all but themselves). Despite the glaring dangers, people seem to be attracted to proprietary "systems," the bait probably associated with greed. The fact is that the markets have been around for a long time. There is little that is not known and has not been adequately tested. In other words, would you entrust your life to a brain surgeon whose operational procedure was his own little secret? Suffice it to say that, within the financial community, there is ongoing communication among the ethical elements to provide clientele with superior products.

In effect, the investment method being utilized by the manager should be the same method you would personally use had you not decided to entrust the day-to-day investment routine to the expertise of others.

2. Familiarity with the Individual Analyst

Little known to the investing public, there has been a prolonged and ongoing battle within the financial community over full disclosure to clientele as to the specific identity of individual analysts managing the clientele's money in larger institutions.

Institutional management generally favors anonymity, stating that specific investment decisions (unless very bad and some underling is selected for blame) are a "team effort," and no one individual should be singled out as being better or worse than the team.

Many analysts counter that the "team" argument is a joke. It allows the institution to maintain fat salaries for dead wood ("good old boys") while inhibiting the advancement of truly superior individual analysts—sort of a slave labor relationship. These analysts further contend that the institution's desire for anonymity is to keep monies under institutional management. If the better analyst, known to clientele, were to leave the institution, _the clientele would also leave to keep their funds with the superior analyst.

To us the bottom line is simple. You should know the specific analyst who is involved with your money and have some means of individual _communication. It is your money and you have a right to know both the investment methods being used and the individual making the investment decisions.

In the world of investment techniques, the originators of the methods often manage money using those techniques. In effect, the investor often has access to the source. If the source is not in the money management business, he or she will probably be willing to direct the investor to a manager who has demonstrated a familiarity with the originator's work. If the originator is dead or out of business someone else will likely emerge as the best known analyst following the technique who can personally provide (or personally recommend another for) appropriate discretionary management. If you want the best, nothing can be lost by seeking it.

Price decline, therefore, is not usually the result of brokerage firm's direct sell recommendations. The decline in stocks that had been advanced by concentrated sales efforts within brokerage firms can be the result of sales emphasis shifting to another stock (or group), with a corresponding lessening of the sales effort in the previously favored stock (or group). The buying demand is lessened, the selling supply begins to dominate, and down goes the price of the stock.

Our intent is not to make you suspicious of the ethical motivations of brokerage firms or their research. Most brokers are quite ethical and constantly attempt to serve their clientele well: To do otherwise (except for the scummy types who have no intent on long-term broker/client relationships) would effectively hurt the broker's business. However, if a brokerage firm's research is consistently wrong and/or is presented in such a manner (primarily nonspecific in forecasts or untimely) that it cannot be used in market endeavors, it is only reasonable to avoid the research whatever the cause of its inaccuracy or uselessness.

Bad research does not mean the brokerage firm is extracting trading profits through its influence on the buying and selling of clientele. As mentioned previously, many widely accepted theories on market pricing are erroneous and the researcher may believe in such theories. Or the researcher may simply be stupid. The possession of fancy suits, plush offices, academic credentials, and other such status symbols do not make the difference between investment success and failure. The differential is who ends up with the other guy's money.

The trading activities of brokerage firms themselves are difficult to monitor beyond their published research and sales promotions. The degree of such influence varies and as such cannot be incorporated as a constant factor in developing personal strategy. However, the effect of brokerage firms, specifically their advertising, on the buying patterns of their individual and institutional clientele is easy to observe; allowing the true professional advantage because of the institution's effect on aggravating short-term pricing. Yet, it is not a consistent factor in developing total strategy.

If an investor is comfortable with a specific investment technique and has firsthand knowledge of the individual analyst employing the technique, significant benefits can be achieved by aligning directly with the brokerage involved. In these arrangements, the client is functioning in direct conjunction with the research on a timely personal basis, not after the fact, which functions to expand profitability. There is no loss of control because the investor knows the investment technique(s) being employed and the individual analyst(s). Such close relationships are generally not possible in large brokerage firms: The large number of different financial instruments sold by such firms tends to inhibit specialization. The optimal application of specific investment techniques is usually confined to relatively small specialty firms, with generally an established clientele whoseaccounts are under discretionary management and do little or no advertising.

The mention of the existence of specialty firms is not to suggest the investor must seek them out. Indeed, investors who learn to function professionally are specialty firms unto themselves. Brokerage firms can be classified as members or nonmembers. Member firms are those that own a seat on a stock exchange, regional or national. Nonmember firms do not have an exchange seat and are members of the NASD (National Association of Securities Dealers). Most nonmembers have arrangements with member firms to trade stock on stock exchanges. There is no strict difference as to which better serves its clientele. As long as the accounts are adequately insured, the benefit of any firm to the client depends on the expertise of the brokers/analysts involved, not on the member or nonmember classification.

Many investors are unaware that the brokerage firm, upon which they rely for advice and/or the placement of orders, is often a direct market participant and as such is potentially a direct competitor. Brokerage firm_s, on a corporate level as well as through individual officers and employees, are often actively involved in the market on their own behalf.

The reasoning of those who ponder the merits (or lack of them) of broker participation generally gravitates toward one of two categories:

• It is good. After all, if the broker is so convinced of the merits of a particular stock that he or she purchased it, it seems only ethical to share this reasoning with the clientele. And, if a broker suggests a stock, it is an indication of demonstrated good faith that the broker has placed monies alongside those of his or her clientele. If the broker is wrong, all will suffer. Such personal participation may influence the broker to be more astute and work harder in stock selection to ensure success.
• It is bad. If a broker has a position in a stock and then recommends the stock to customers, the broker faces a potential conflict of interest. The broker's clientele could be used to support the price of the stock the broker owns. That is, the clientele, through their buying, will help increase the price of the stock and may even end up conveniently buying the stock owned by the broker at an elevated price.

There are many scholarly (and not so scholarly) discourses as to which line of reasoning is more accurate. The usual compromise is to advise clients (generally in the form of very small print on the bottom of a research report) if the broker has a position in the stock, so that clientscan make up their own minds about the potential advantages or disadvantages.

Such research reports are designed to aid both individual and institutional clientele in becoming informed as to the investment merits of a particular stock. They are sales tools. Naturally, if the brokerage firm owns the stock, the research report is generally favorable.

From our perspective, it makes no difference whether the involvement of brokerage firms as direct market participants is good or bad. We are only concerned that it exists. It is a factor in the market environment thatcan influence supply/demand, and as such it can provide opportunity for profit.

If large brokerage firms concentrate their own buying and/or the efforts of their sales force on a particular stock or stock group, you know you have buyers regardless of the ethical motivation behind the buying. With the influx of buyers, you can be reasonably assured the demand will be greater than the supply, and consequently you can expect the price ofthe stock to be pushed higher, thereby allowing a more propitious selling opportunity.

The major effect of brokerage activities is on buying, not selling, for various reasons. The negative is not as easy to sell as the positive. It is much easier to call clients and state something should be bought because of _optimistic prospects, than it is to tell them that a stock they own is not worth owning and should be sold. From the standpoint of the broker, if the client has bought something previously and it is up, them keeping the profitable position (albeit a paper position) reinforces the broker's ability. Conversely, if the broker has placed the client in a position that is losing, it can fit the "long-term" category with no acute realization of loss as long as the position is held. Also, selling might not be emphasized by a brokerage firm because the stock might be that of a corporate client of the brokerage firm. The brokerage firm might either be receiving fees to handle a corporation's offering of new securities or have the corporation as a client through its pension fund and/or managing personnel. In such instances, suggesting selling the corporate client's stock would be an obvious business blunder.