Compromising My Values Every Day, For You

18th Feb '10 by Baruch De Spinoza

2 comments 2047 reads

Right now active investors and speculators are about as popular as genital herpes. This is unfortunate because I, Baruch, am one of them.

Examples of this anti-speculator animus are everywhere. Paul Krugman has long had in mind the creation of a special level of hell for “Masters of the Universe”, as he calls us, not kindly, in his excellent Return of Depression Economics. He thinks I’m “socially useless”, if not dangerous, and wants to have a special tax levied on me.

Alice Schroeder, author of the latest Warren Buffett biography (how clever of her to realise that another biography of Warren Buffet was what the world needed!), has a very maximalist interpretation of securities law. She believes it’s impossible “to make a living on Wall Street without compromising your values,” and goes so far to suggest that when it comes to investing, “It’s hard to make a living legally.”

Felix Salmon, sworn enemy of active investing, links to a largely incomprehensible blogpost from profs Fama and French which suggests investing in mutual funds is like buying an index fund but you pay more fees, ie it is a bad idea and thus “alpha-peddlers,” people like me, are snake oil salesmen. AllAboutAlpha (HT Abnormal) put it best last month in an apposite post about the emergence “of a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.”

Summing it all up, the charge sheet goes as follows:

institutional investors like me are unable to deliver things we claim we are able to deliver, viz outperformance, alpha, whatever you want to call it.
As such my activities make no contribution to society and perform no useful function. In fact we are positively dangerous, and our widespread use of illegal information makes us unethical to boot.
Society would benefit much more if retirement savings were invested in index funds, which contain all the upside of equity investing but at lower cost, and meanwhile the rest of us who foolishly insist on trading for a living should be taxed.

A lot of this stems from the traditional malice and envy of those who “review” for those who “do”. We can’t do much about that. But there are intellectual assumptions behind some of it which are…

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AliceSchroeder

21st Feb '10

Dear Baruch,
I can understand why you would be upset at proponents of strong-form EMH because I don't believe in it either. It's complete crap. When I wrote

There is only so much alpha — that excess return above a baseline average — to be had in an efficient market. The incentive to create some artificial alpha one way or another is very high. Those who bend the rules successfully post good numbers, which adds to pressure on other Wall Streeters to push the gray boundaries of legal information flow.

It didn't suggest anything about my views on strong or weak form EMH.

What I was writing about was my own 15 years of experience on Wall Street. A number of institutional money managers got in touch with me afterwards to say thank you for pointing out the obvious -- that those who bend the rules make their jobs so much harder. How? Oh, by squeezing salespeople and analysts for finely shaded descriptions of how "enthusiastic" the analyst is about a stock -- using so much pressure that the squeezed souls give away whether the stock rating is about to change. After all, it's only their job at stake. Then there was the little problem of after-hours trading... of naked shorting .... the problems surrounding the way public offerings are priced and marketed.... frequent rumors of a CEO's impending death or the FDA's denial of a drug approval or whatever, that circulate right before earnings on so many stocks, just in time for shorts to cover.... these are only a few examples.

The most important reaction to my column, though, had to do with its main point, which is the unlevel playing field between individual and institutional investors. There is nothing that can be done about this because it is only simple economics. You and your brethren are paying the freight. A $50k account paying a 1% wrap fee is not going to get the same information as you. This is why the market is inefficient and the strong form of EMH can never happen. There's not even anything wrong with that, except that we pretend the impossible, that everybody is being treated the same under our unrealistic securities laws.

Meanwhile there is every incentive for a brokerage firm to take advantage of their retail clients Not all do but it's a continual problem. I got an email from an FA who cuts down trees part time rather than sell products that cheat his clients out of money. He's trying to help his retail clients get richer, which means he can't make a living himself. Many FAs feel the same way.

So yes, it's hard to make a living on Wall Street without compromising your values. The lucky subset who can and do should realize they are in a fortunate position. Nowhere do I agree more with you than when you say that the market isn't pretty, it produces results that are unpleasant and unjust, and many of its most successful practitioners are highly unpleasant people.

Those who stay and work with highly unpleasant people in a system that produces ugly, unpleasant, and unjust are perfectly entitled and may have myriad reasons. We must have people searching for inefficiencies in the market to have a market that is even partly efficient. Everybody's got to feed their family. My own solution was to walk away to become one of those who "review" instead of "do."

Lastly, I would respectfully suggest that you lay off Felix Salmon. You don't have to agree with everything he says to learn some interesting things from him. The man makes a living by being provocative but he's no dummy.

Baruch De Spinoza

Hi Alice, thanks so much for commenting! I thought it quite an old, overlong, overcomplex and basically obscure post that the Stockopedia guys wanted to republish (but I didn't say anything). Epicurean Dealmaker snarkily said it needed Cliff Notes. It seems to have found another lease of life. Which is nice.

Anyway, Felix is actually a pal of mine, and I have said much worse to him, so I don't think he will be offended. Note I thought the blogpost he linked to was incomprehensible. His own posts are models of clarity and fine prose, as we both know. He honestly is a sworn enemy of active investors, though, and really does recommend to everyone who will listen that they invest in index funds.

Forgive me if I misrepresented you and your EMH convictions. I should have known that someone who wrote a book on Buffett might not actually be a strong EMHer. In my defence, the idea that "there is only so much alpha. . . in an efficient market" does sort of imply an assumption of efficiency. My own view is that there are lots of ways to make money in markets, and frankly am not sure what "alpha" is (I wrote a post on that, too, here http://ultimibarbarorum.com/2008/01/26/schmalpha/). Whatever "alpha" is, it may be there is an unlimited supply. The obvious fact it is hard to get doesn't preclude that being true.

Where we still differ is in seeing most, or even a large minority of market participants as bad actors, which you still seem to do if you think that those who don't "compromise their values" in the process are "a lucky subset".

Maybe I'm naive, but most of the people I know in fund management haven't compromised anything (although uncharitable people, and I know you are not one of them, might suggest we didn't have any values to compromise in the first place). Very few of the investors in my acquaintance are in a position to get their hands on any inside information and would be terrified if they ever did. They would have no idea how to spread a rumour. The sell side guys I know do their job; they have their call lists and their talking points. They call people, and try to get them to trade. Nothing really wrong with that.

There are dodgy shenanigans of the kind you mention, but the majority of returns for the majority of successful investors seem to be from bigger swings and market moves which are out of the control of any one person or group of people, no matter how well heeled they are. Dodgy shenanigans gone wrong are also a very quick way of losing money; trying to manipulate prices using one's capital is a very risky business. That's why I think there may not be as much of it going on as we fear.

Clearly, I may be naive. I haven't had your experience. I don't know what you have seen. And technically, I don't work on Wall Street, either.There are areas of financial markets richer in possibilities to fleece the ignorant, and retail wealth management is certainly one of them. But the fact you have so many FAs writing in tells me there's probably a lot of them who haven't written to you who feel the same way, that the game is skewed, and it's their role to try and help their clients. That's something you can flip -- shouldn't that comfort us?

I think the game just seems more ethically skewed than it is -- because making money consistently in financial markets is just very very hard.

Compromising my values every day, for you

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Baruch De Spinoza

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