The folly of trying to level the investment playing field

July 25, 2013

The government is cracking down on insider trading; isn’t that great news for you? Last Friday, the Securities and Exchange Commission charged hedge fund mogul Steve Cohen with failing to supervise two employees who themselves face insider trading charges; on Thursday morning the Justice Department filed criminal charges against his firm, SAC Capital. Earlier this summer, the news broke that New York’s attorney general, Eric Schneiderman, was investigating the early release (by Thomson Reuters, which publishes this column) of the University of Michigan’s widely-watched index on consumer sentiment to a group of investors. Faced with a court order, Thomson Reuters agreed to suspend the practice, while asserting that “news and information companies can legally distribute non-governmental data and exclusive news through services provided to fee-paying subscribers.”

In a statement, Schneiderman said that “the securities markets should be a level playing field for all investors.” Preet Bharara, who is the U.S. Attorney for the Southern District of New York, has also invoked the notion of fairness. He told CNBC’s Jim Cramer, “I think people need to believe that the markets are fair, and that the same rules apply to everyone…I don’t want to buy a stock because I have a feeling that someone knows more than I do.”

Let’s give both Schneiderman and Bharara credit for good intentions. What could be more desirable than a level playing field in the all-important game called our financial security? But the playing field isn’t level, it never has been, and I’m not sure it can ever be. If history is any evidence, attempts to level it have only tilted it all the more. So, maybe the real problem is the pretense of fairness.

The notion that individual investors could compete with big institutions in the stock market began, according to my friend, co-author, and New York Times columnist Joe Nocera, on May 1, 1975, which was when commissions were deregulated. That gave rise to discount brokerages like Charles Schwab, which catered to individual investors. The movement gained currency (no pun intended) as the first dot-com bubble made investing seem easy, and brokerage moved online. Technology democratizes everything! Information is free! A veritable flood of ads, including those featuring stock-trading teenagers with their own helicopters and tow truck drivers with private islands, all preached “some version of the mantra that you can get rich faster if you take charge of your own investments,” as the New York Times put it in an October 1999 piece — which, not incidentally, noted that the top 10 online brokers were budgeting about $1.5 billion in the coming year for advertising, more than Walt Disney and Coca-Cola combined. Old line brokers like Merrill Lynch and Morgan Stanley Dean Witter got into the game too, offering low-priced trades with the perk of access to their stock research, which was supposed to help guarantee your success. In a message meant to scare people away from operating without access to the firm’s research, Morgan Stanley warned investors, “Life’s not fair.”

No, life isn’t fair, and as we all know now, the playing field hadn’t been leveled. Individual investors, whether operating via discount brokerages or with the dubious benefit of Street research, were just cannon fodder for the so-called smart money—including, not surprisingly, Cohen’s SAC Capital — which made fortunes by shorting dot-com stocks ahead of the crash. (The “smart money” isn’t necessarily smart, but it is well-connected.) Nocera has argued that without fixed commissions, research was less profitable, so research became a subsidiary of the investment banking division — oh, the law of unintended consequences. Along came Eliot Spitzer (I’m hitting all of the summer’s headlines!), who documented that research analysts, far from providing investors with objective advice, were basically shills for the investment bankers. A buy rating bought investment banking business, instead of paying for your retirement. Ten big firms jointly paid $1.4 billion to settle charges, and agreed to changes in how they did business, such as putting a wall between research and investment banking, and compensating analysts based solely on their performance.

Just as commission deregulation may have backfired in some ways, so did Spitzer’s reforms. Analysts went from being stars, whose compensation was juiced by rich investment banking fees, to mere grunts. As a result, the quality of Wall Street’s research — which smart people relied on for information, not for the tainted recommendation — has declined dramatically. I emailed two longtime sources who are professional investors to make sure I was right about the decline in the quality of research. Both wrote back YES in all caps.

Then came the rise of hedge funds, who will pay almost anything for even a shred of information. That’s led to the growth of all sorts of exclusive services. Most prominent are so-called expert network firms, which match investors who are willing to pay hundreds of dollars an hour with “experts” in a given field. In addition, hedge funds swap ideas and insights with each other at exclusive dinners and charity conferences. The big investment banks sponsor their own exclusive dinners and conferences where their top clients can sit down with company management or other particularly compelling experts. A few years ago, a controversy broke out over Goldman’s “trading huddles,” where favored clients — including SAC, natch — got access to analysts’ ideas. Goldman paid $22 million to settle charges that it failed to supervise research analysts’ communications adequately, which is utterly absurd due to the pretense that communications can be supervised: Important investors can have a private conversation with an analyst, or with company management, whenever they want.

In the wake of Enron, I remember being struck by how tightly closed the circles of information really were. Plenty of people were skeptical about Enron, but their skepticism never made it to the ears of your average investor. If anything, the circles might be even more closed today. Hedge fund managers — unlike mutual fund managers, who were usually trolling for new clients and wanted their names in the press — can’t take money from your average investor, have little incentive to talk, and the best ones often don’t, meaning their ideas don’t leave their circles.

It was an expert network, Primary Global Research, or PGR, that became central to the government’s insider trading investigations. It turned out that PGR consultants were getting their hands on inside information, either because they themselves worked in critical areas of companies or via other friends, and feeding it to hedge fund clients. The government’s investigation into PGR helped point to a group of friends at different hedge funds that shared inside information from a variety of technology companies, including Dell. “I have a 2nd hand read from someone at the company,” an SAC analyst named Jon Horvath — who has pled guilty to insider trading — told his boss, Michael Steinberg, before Dell’s earnings in the summer of 2008. Steinberg, who is one of Cohen’s lieutenants, has been criminally charged over that trade too, and the SEC alleges that Cohen got Horvath’s email, too. (SAC says Cohen didn’t read it, and that neither he nor the firm has done anything wrong.)

But the line between what’s insider trading and what isn’t is most definitely not the line between what information an average investor can access, and what information a hardworking hedge fund manager who can spend thousands of dollars and hundreds of hours on expert research can access. “I shudder to think how much of my alpha comes from failed individual investors,” one hedge fund manager tells me. The group of analysts could have done almost everything short of getting a source inside Dell. They could have worked Dell’s investor relations department, used sources at other companies, called customers to do so-called “channel checks” — research on what’s selling — set up meetings with management and industry analysts and pooled all their information. That’s all legal. “Edge,” as they call it in the hedge fund community, can refer to inside information, but it can also be that little bit of knowledge gleaned from incredibly hard work. And within those circles, “edge” gets shared — but not with you.

I don’t know if there’s any way to fix this, or for an individual investor to deal with it effectively. (Your run of the mill mutual fund manager isn’t that much more plugged in than you are.) You can buy index funds or ETFs, which you probably should do anyway. You can stay away from short-term trading, which is where edge matters most. Or you can play the game. You might even win sometimes, because edge is just edge — it isn’t a guarantee. But if you choose to play the game, know what you don’t know, and when people tell you that they’re leveling the playing field for you, don’t thank them.

PHOTO: People walk past a building that includes SAC Capital as a tenant in New York, July 25, 2013. REUTERS/Carlo Allegri


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Remember, Wall Street is expert at making Your Money Their Money

Posted by DOOM2U | Report as abusive

Apparently one of SAC’s crimes was hiring industry experts. No investor should be allowed to do that because it discriminates against the poor who can’t afford to hire industry experts. Go Eric!

Posted by nixonfan | Report as abusive

So privatizing Social Security will make life even less fair for the muppets, and maybe less honest as well. Why is any lawmaker or academic suggesting this “reform”?

Posted by StuartG | Report as abusive

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Posted by Laster | Report as abusive

There wasn’t a thumbs up button but I thought the story deserved one…

Posted by Laster | Report as abusive

This game of monopoly has been played to long. We need to start a new game before all of the players are completely broke.

Posted by tmc | Report as abusive

And? What’s your point? People spend billions around this country on the lotto with full knowledge that they’re gonna lose.

Posted by Davdomm | Report as abusive

It is a bit reassuring that there are a minority of commentators who can still report the truth. However, none of this is in the slightest bit news. In fact, the whole article is a total resignation to what “must be the real world” as if nobody else was aware of this reality. So, the implication is that the growing disparity between the haves and have nots is to be embraced? Instead of “In God We Trust”, will our new national motto be, “Let them [the Pee-Ons] eat cake!”? The United States is destined to return to the feudal system of the Middle Ages?


The One Percenters Club will send you a thank you check.

Posted by ptiffany | Report as abusive

You’re equating the outright gambling on the known negative return of lottos and other forms of gambling to investing in the stock and bond markets? Of course, some do gamble, but is that the case with most investors? Tell that to all those suckers with 401(k)s. Apparently the entitled class, the One Percenters, think of stocks and bonds as a lucrative form of investment, even if the Pee-Ons get screwed. Of course the brokers to the privileged class beleive they are “entitled” to their bonuses even if they do tend to bend the trading rules a bit. Poor Martha Stewart, scapegoated for what is a well entrenched process of making the rich richer.

Posted by ptiffany | Report as abusive

I think as always diversification is necessary. I’m involved in both long and short term trading and a variety of markets. My shorts are pretty conservative. As a retail investor, the best I can do is be able to allow for a week or so to go by before I sell with the minimum preferred price that I have set in mind for a specific profit. Again, I’m pretty conservative on the range that I expect in regards to price changes.

As for leveling the playing field a bit more. I always get creeped out when this discussion comes up. The idea of bringing back Glass-Steagall seems like it would break up the firm that I use which is both a bank and a brokerage. I find that unnecessary. A better way to level the playing field in my mind is 1. shorten the transaction period of stock trades from 3-4 days to less than a few minutes. 2. Abolish the Pattern Day Trader margin rule. There are plenty of retail investors starting up with $500 in accounts such as Scottrade who fall into this pattern before ever reaching the $25k minimum balance required by the regulation. This creates a disadvantage for traders who are just starting off and have less funds than your more experienced trader.

With the whole SAC issue and previous insider trading issues, I often think back to David Brin’s book “Transparent Society.” Perhaps if we focus on a single rule for more transparency over that of a number of other new regulations in attempt to suppress all that is seen as unfair practices, we could have a more fair and efficient outcome. We could stop worrying about insider trader, legalize it ..and with transparency allow for specific actions in the markets to be seen by all who are active and allow them to decide from there which way to go in regards to following the pack or betting against it. From this point then, the market needs to become 24/7, thus effectively removing after trade hours and incorporating it to the average trading hour day.

Posted by Proxyariesman | Report as abusive

Money goes to money… so what’s new?

Posted by UauS | Report as abusive

Two of the key people who engineered the demise of Glass-Steagall, John Reed and Sanford Weill of Citigroup now believe that Glass-Steagall should be reinstituted. That says a lot, especially when you listen to their reasoning. “We bankers became overenthusiastic in the advantages of no regulation in trading [gambling].”

John Reed is now very active in encouraging his fellow bankers and Members of Congress in eliminating the Wall Street Casinos and returning to high-integrity, but boring banking.

Of course, lots of people SAY they no longer support bailing out the too-big-too-financial institutions in covering their gambling losses with taxpayer funds. Then, the Dud-Frank Bill has accomplished so much in reining them in, that they have all grown much bigger and more powerful and spend even more filling the campaign coffers of the Members of Congress. Why are they doing that?!

Posted by ptiffany | Report as abusive

I don’t see any reason to reign in trading on wall street, let them rip each others guts out. I don’t believe institutional investors such as pension funds should be allowed access to the casinos.
Separate commercial and investment banking, remove ALL derivatives exposure from FDIC insurance, get the FRB to enforce the rules under its regulators, and let wall street pick a REAL winner.

Posted by Laster | Report as abusive

Three card monte is as “honest” as insider trading. What is really going on is not “fair” and it is not and should not be legal. Fraud is fraud is a felony, and they should all be off to prison for a long time.

Trust is essential in financial transactions, and it is a primary function of Government to assure that such trust is not misplaced. Con games work. But confidence players should also become convict players. The alternative is for all the victims to square their own deals, personally. Would that be “fair”?

Posted by usagadfly | Report as abusive

The evolution of this debate has extended the meaning of “insider” from someone who KNOWS about the outcome to include someone who, through diligence and intelligence, can make more educated GUESSES about the outcome. The two differ greatly in many ways. Perhaps the most important though is that knowing means no risk whilst a guess carries a great deal of risk. I make no defence of the insider but the latter is simply competitive behaviour designed to generate private information. Making educated guesses requires a (none-too-easily defined) combination of experience, education, intelligence, data and the time to use them. The fact that some of those guesses can be lucrative is not a guarantee that any of them will be. In short, investment research is a risky activity that has winners and losers, not just winners. The promise though that almost anyone can acquire a process to make educated guesses (much less any successful ones) is an egregious lie. The truth is that few people can. The only beneficiaries of perpetuating that myth are the companies selling the products. One suspects that none of these well-intentioned officials really intends that outcome.

Posted by OneMoreSceptic | Report as abusive

You seem to have something substantial to say, but you completely contradict yourself starting with: “I don’t see any reason to reign [rein] in trading on Wall Street…”, then moving to several ways to rein in the Wall Street Casinos assuming you mean too-big-to-fail Wall Street Banks such as Goldman Sachs that literally changed overnight from a broker (gambler) to a “federally-regulated bank” according to Timmy Geithner. Are they still called a “bank” even when everyone knows they’re a high-risk broker of toxic financial-derivative deals that reach across the globe such as to Greece, guaranteeing its collapse but high returns to the One Percenter investors that are their main clients?

Posted by ptiffany | Report as abusive

To trust in Wall Street, you would have to trust that insider trading is not taking place among the various bankers, traders, analysts, hedge funds, etc. Anyone who still believes that….. gets what they deserve.

Wall Street has always been a racket to squeeze money out of some dumb suckers in Kansas. Makes them feel like ‘investors.’ The internet just speeds up that process.

Posted by AlkalineState | Report as abusive

The only way to level the field, or “fix” wall street is to start by taking back the government. Term limits for congress and SCOTUS, and campaign finance reform are the only things that will have any impact past an election cycle or two. We need a public referendum to accomplish this. Then all things will begin to get better.

Posted by tmc | Report as abusive

Let’s distinguish between speculation and investment. The little guy has can still do extremely well at investing for the long run. I have done so myself. This article makes it clear that those playing dirty will always tilt the playing field for short term speculation. However, those caught crossing the line clearly need to do serious prison time.

Thank you to the numerous readers who have pointed out that we do need to reinstate Glass-Steagall.

Posted by QuietThinker | Report as abusive

Actual Question to my Broker and Reply …another Un-equal playing field by design!

Your FAQ says that, ” Each customer who participates in an IPO offering is evaluated and ranked based on the assets and revenue they have in accounts under their SSN. Assets include all retail assets under the individual’s SSN/TIN and exclude assets or trades maintained on behalf of any divisions of Fidelity Investments Institutional Services Company, such as 401(k) or 403(b) plan assets. Revenue is comprised of the brokerage commissions, margin interest and mutual fund revenue generated in retail accounts of the individual’s SSN.”
Does this mean that if I have $10million on deposit and trade a thousand times a year that I have nominally 10x the probability of getting shares as someone with $1million on deposit and trades 100 times a year? …. or does it mean that since both of these investor are qualified they have an equally likely chance of having IPO shares allocated to them? include all retail assets under the individual’s SSN/TIN and exclude assets or trades maintained on behalf of any divisions of Fidelity Investments Institutional Services Company, such as 401(k) or 403(b) plan assets. Revenue is comprised of the brokerage commissions, margin interest and mutual fund revenue generated in retail accounts of the individual’s SSN.” Does this mean that if I have $10million on deposit and trade a thousand times a year that I have nominally 10x the probability of getting shares as someone with $1million on deposit and trades 100 times a year? …. or does it mean that since both of these investor are qualified they have an equally likely chance of having IPO shares allocated to them?
Thank you for investing with XYZ. I am happy to help.
Our allocation methodology is designed to evaluate a client based on their relationship with our firm. The decision is based off of assets and revenue. If a client has $10 million with us, and does 1,000 trades per year, they would be more likely to get shares than a client with $1 million that does 100 trades.
You may rest assured that the allocation of shares is carried out as fairly and equitably as possible. We really appreciate your business over the past 27 years. Have a wonderful day!

Posted by retweeter | Report as abusive

How about a different approach. How about you do away with insider information (as it is like a War on Drugs-just a show)and rather just make every bid and trade known from a counterparty point of view. And no buying the name of nominees or brokers either. End result – everyone will be able to see if a savvy investment bank buys or dumps stock on insider information and can then make a far more informed decision as to why the stock spiked or tanked.

Posted by BidnisMan | Report as abusive

How about we start a new game? This version of monopoly has been played to long. Most of the players have long since lost and we’re all just waiting on the last few to cave in. Goldman Sachs and friends won the game long ago. It’s also starting to look like the rest of the world is going to start a new game without us. Reserve currency my as…

Posted by tmc | Report as abusive