Investment Decisions – Know Your Competition by Lukas Neely, Investor Vantage

 

“If you know others and know yourself, you will not be imperiled in a hundred battles; if you do not know others but know yourself, you win one and lose one;
if you do not know others and do not know yourself, you will be imperiled in every single battle.”
Sun Tzu
(Chinese Military General)

“This game is too hard…”

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“I can’t hope to win or compete with the likes of the “big boy” hedge funds and banks…”

This is the general sentiment toward investing in the stock market, and essentially this sentiment is correct.

However…

Instead of finding areas in the market where an individual investor could be successful, he/she still invests like the rest of the crowd, which is exactly what the big Wall Street players want you to do.

“When you play in someone else’s sandbox, they are going to make the rules.”
Noah Kagan

In this section, we will point out some weaknesses of the market, so you will be better-equipped to make great investment decisions.

Investing long-term goes against the very nature of Wall Street (and human nature for that matter). Wall Street makes very little money when investors just buy and hold investments. They would cease to exist in their current capacity if all investors did this. Now with that said, I also don’t think they are going anywhere, anytime soon. So, it’s best to understand their existence and their rationale behind various decisions.

Wall Street is everywhere: CNBC, Bloomberg, newspapers, financial reports, getting a mortgage for your house. There is very little you can do to evade them on a daily basis.

Because their very existence relies on activity, it’s incredibly difficult for Wall Street to take a contrarian stance. Major Wall Street firms cannot pay their bills with customers who won’t generate fees and commissions for the firm.

I will probably get a lot of hate mail for this, BUT investors would do well to avoid interactions with Wall Street (as best you can).

It is important to keep in mind you cannot blame Wall Street for their actions. They are merely fighting for survival, doing what they were taught to do.

Does it make it right? Of course not.

But it’s like blaming the shark for eating the seal. Animals have been hardwired a certain way over centuries. It is difficult to reverse that instinct in any person’s finite lifetime. It happens over generations and centuries.

It’s not the individuals, it’s the system and the incentives that need to change. (My guess is this will never happen. Too many people are making too much money to let it go now.)

Most of Wall Street gets paid on transactions, not how effectively that transaction ultimately does over the long run. Underwriting fees, Investment Banking fees, and commissions are usually paid up front, and collected from each trade or transaction, regardless of whether the security goes up or down. Now, you can begin to see why Wall Street wants you to keep transacting more and more (it’s how they get paid).

Outside of commission fees to brokers, mutual fund managers are paid ‘management fees’ to cover day to day expense and salaries, regardless of how the actual fund is doing.

Hedge Funds typically charge a 2/20 fee of assets under management. This means a 2% management fee and 20% of profits (sometimes above a hurdle rate). Through my conversations with some hedge fund managers, and having been in the industry for a number of years, the fund usually pays all of its bills, salaries, and bonuses from the 2% management fee. The 20% performance fee is just a “cherry on top.”

Essentially, there is no real incentive for them to perform. All they need to do is make sure they keep your money and perform relatively in-line with the major market indices.

It seems registered investment advisors are popping up everywhere nowadays and essentially act as a “fund-of-fund” or mutual fund. They may tout themselves as having lower fees than their competition, but they are still charging management fees of at least .5-1% and then recommend an appropriate asset allocation strategy with additional fees.

Do you recognize a theme going on here…?

Wall Street and the burgeoning “robo-advisor revolution” is slowing forcing money management into a commodity business with very little value-add to their clients.

Because of the lack of independent, contrarian thought to investments, the big players are chasing each other’s tails and concentrating in the same areas as their competitors. This provides no real value to YOU, the investor.

Very few firms on Wall Street have the incentive to make you money or generate a significant amount of Alpha (outperformance) for your portfolio. Listening to them may feel like the right thing to do because you’re told they’re the “experts,” but it’s really just lining their pockets, not yours.

If money managers followed the Warren Buffett Partnership fee model, we probably wouldn’t have near the amount of aggressive activity or risky behavior that we see on Wall Street day-in and day out.

In his early partnerships, Warren Buffett charged a 0/25 fee.

Which means there were no management fees, and he kept 25% of the profits.

Wait there’s more…

He only took 25% of the profits if he made you at least 6% on an annualized basis (or “hurdle rate”).

So if you earned 5% or if you lost 20%, Buffett earned nothing.

How’s that for incentive?

If he didn’t make money for his investors, he had to foot the bill out of his own savings to pay for staff salaries, his own bills or pay bonuses.

How many Wall Street firms would be able to do this…?

That’s an easy answer…NONE!

Obviously there are many other market participants’ brokers, institutional funds, etc., and to write about them and detail all their strengths and weaknesses would take at least 500 pages.

The reason I point this out is to show how Wall Street and the Stock Market are incredibly short-term oriented and put very little emphasis on the fundamentals of the underlying business.

There is very little reason to look beyond the next quarter or next year because they are concerned with commission based activity or just trying to match the major market indices for management fees (closet indexing).

Because of the stock market’s short-term orientation, individual investors are provided opportunities in certain areas of the marketplace.

Knowing who you invest against can provide insight as to where opportunities will present themselves. Wall Street institutions and Hedge Funds dominate trading and flow of funds in the market. Being ignorant of their tactics and behaviors is sure to be a detriment to your investment success. Looking for opportunities that are caused by the short-term nature of Wall Street is ultimately a worthwhile endeavor.

Not having knowledge of Wall Street’s short-term behaviors and decision-making process is akin to entering the forest without the map.

The time to have the map is before you enter the forest.

Bottom Line: What’s good for investors is not necessarily good for Wall Street (and vice versa). The interests are not aligned properly for Wall Street to serve as stewards of long-term capital.

ABOUT THE AUTHOR:

Lukas Neely is a former Hedge Fund Portfolio Manager and author of the Amazon #1 bestselling book (valuation), Value Investing Edge: A Value

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