The folly of trying to level the investment playing field
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