The Forest for the Trees

From the Jan-Feb 2006 issue of Advanced Trading

Maybe I have been a part of the industry for too long? Maybe I have lost my cynicism and callousness, or have been listening to marketing pitches for so long that I am beginning to believe them. But, maybe it's time that regulators, legislators and litigators get off the industry's back and let investors and customers take responsibility for their own investment decisions.

I totally am for calling a spade a spade, sending the corrupt to jail, stopping bad practices and not letting grannies get abused by unscrupulous advisers. But, when it comes to institutional brokers and investors, plan sponsors, mutual fund boards and senior fiduciaries, these guys are being paid to make the right decisions - if they don't, fire them, don't string them up by the yardarms.

What has my juices flowing is all of the pressure to manage trading costs at the expense of picking the right investments. Last month, I attended a conference at which the SEC said that it was going to more proactively analyze firms' best execution process and hold fiduciaries more accountable. Now, that is a fair statement, but what the SEC does not explain is what best execution is exactly - is it price, liquidity, timeliness, all of the above? And what about asset selection and portfolio yield? Are we focusing on the trading desk because it is easier to measure, and less worried about asset selection because everyone can make an investment mistake?

Trading costs significantly contribute to portfolio yield, and lower trading costs are always better than higher trading costs (if you define cost to include commissions, impact, opportunity costs and delay). But does that mean the SEC will come down hard on a high-alpha momentum manager because its market impact is high but its performance is tremendous? Does that mean that using one-penny DMA technology to bid up a low-cap stock 50 cents or a dollar is better than paying a nickel or a dime and sourcing the liquidity from a dealer?

This also ties into the issue of investment research and soft dollars as more firms are banning soft dollars, making it more difficult to fund research and leaving a greater number of companies uncovered. In a USA Today (egad, I am quoting USA Today) article last month titled, "'Consensus estimate' may be from one analyst," Ashwani Kaul, chief spokesman for Reuters Estimates, states that "more than half the 8,416 public companies have no analyst coverage."

Is this good for our markets? While I went on a rant about the broken research model in my December Wall Street & Technology Perspectives column, in fact, I understated the number of uncovered companies. All of this translates to an over regulation of the investment process, which actually makes it more difficult and more expensive to make investment decisions.

So, why don't we go back to being rational? The bottom line is portfolio performance. Research is good. Research generates trading ideas that drive investment, which, in turn, drives trading and the financial ecosystem. Low costs also are good, but plan sponsors, fund boards and financial fiduciaries are not bean counters and should not be treated as such. Yes, boards should look at trading costs, they should have a better handle on the managers they pick and their internal processes, and they should understand the business. However, the bottom line is portfolio strategy, yield and expense. If the manager is not performing as needed, either work with the manager to increase performance, or fire the manager or the board.

In a capitalistic society, individuals are responsible for their decisions. Good money management cannot be legislated; it can only be pressured from the movement of capital away from bad managers to good, away from a low-return environment to high returns. If we don't legislate or regulate corporate value propositions, positioning, messaging or cost structures, why are we trying to do that to the financial markets?

Let regulation focus on transparency, and let investors, fund boards, plan sponsors and senior fiduciaries worry about yield. Let's worry about the health of the forest and not every single tree in the woods.

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. [email protected]

On The Net

www.global-estimates.com