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Monday, 6 February 2012

What’s YOUR Competitive Advantage?

The Zanzibar Effect

Everywhere you look in the investment industry it appears that the odds are stacked against the smaller investor. In every trade we make there’s a counterparty against whom we’re taking a bet and all too often they’re better informed and equipped than we are. For the most part trading is simply a way of enhancing the profits of the securities industry.

As any investor knows, the key to a successful business is establishing a competitive advantage, so it makes it all the odder that most traders seem determined to compete head on with institutions in exactly the areas they want us to. There’s no rational explanation for this other than people are blind to the ways in which they’re being exploited. In terms of competitive advantage private investors engaging in short-term trading against financial institutions is the greatest mismatch since the Anglo-Zanzibar War of 1896 which lasted only 45 minutes – and which ended with the British being paid for the shells they’d fired into their opponent’s country.

A Bear-Woods Scenario

Almost every innovation in the financial services industry that we’ve ever looked at serves to disadvantage private investors. Taken individually each is explicable in some way, taken in the round they strongly imply that we’re being taken for a very expensive ride. This is – finally – being taken on board by regulators. As the UK’s new overseer, the Financial Conduct Authority, observes:
“In retail markets in particular there can be opportunities for firms to exploit consumer behaviour such as lack of confidence or knowledge. Firms may seek to increase revenues to preserve return on capital at the expense of treating customers fairly. There may be incentive structures driven by sales targets rather than outcomes for consumers. These opportunities can be magnified where competition is not effective.”
Do tell. Or as the head of the FCA has recently remarked:
“You have to assume that you don't have rational consumers... The profitability to the firm appears to be a bigger concern than the suitability to the customer”.
Which ought to be less of a surprise than what happens when a bear encounters a wood, but the old ideas of economists tend to die out one old economist at a time. Still, it’s a welcome advance, but only really starts to scratch the surface of the problems – and certainly doesn’t address the issues faced by the private investor who insists on playing a high stakes gambling game at the lunatic asylum that is the stockmarket.  As the old adage has it; if you're playing poker and you don't know who the sucker is, it's you.

Selective Briefing

The investing game has always been biased against the individual. You’d probably think that the days of overt trading on insider information are over as regulators take steps to discipline alleged perpetrators but you’d likely be wrong. As Brian Bushee, Michael Jung and Gregory Miller conclude in Conference Presentations and Selective Access to Disclosure:
“We find significant increases in trade sizes during the hours when firms provide off-line access to investors, consistent with off-line access providing selective access advantages. We also find significant increases in trade sizes after the presentation when the CEO is present, consistent with CEO meetings providing selective access advantages. ... Finally, we find significant future absolute abnormal returns after the conference for firms providing off-line access, suggesting such access is potentially profitable for investors. While we cannot conclusively state that managers are selectively disclosing new information outside of the presentation, our evidence does suggest that investor conferences confer a selective access advantage on the buy-side investors that have been invited to attend.”
And, of course, politicians have routinely used inside information to make money at our expense, as Pete Schwiezer's recent book, Throw Them All Out, describes in detail.  We only need to look in the mirror to see who the suckers are at this table.

Even if regulators and enforcement agencies can find a way of blocking insiders from exploiting privileged information private investors would still be disadvantaged in the short-term, simply because money talks. For instance, the evidence we saw in the Death of the Accrual Anomaly suggests strongly that hedge funds have arbitraged away the accrual anomaly by exploiting it for all it’s worth. This is a perfectly legal way of making money, but it can only be done by organisations with deep enough pockets to hire the relevant experts, design the appropriate algorithms and automate the necessary trades: and some mug sits on the other side of every one of them.

Money Talks

The ability of the securities industry to automate trading to capture the abnormal returns from any anomaly in the market (Pricing Anomalies, Now You See Me, Now You Don't)  means that anyone attempting to out-compete them is facing the hopelessly overwhelming odds of the Zanzibar Effect and, like the hapless Zanzibarians, paying them for the privilege. Being smart isn’t nearly enough of an advantage. For example, consider the High Frequency Trading algorithms that are set up to engage in buying and selling at speeds well beyond human abilities. 

As we saw in Limit Orders, The Crumbling Edge of Behavioral Finance, these systems can exploit the accidental short-term contrarian trades triggered by private investors’ limit orders. That’s on top of engaging in dubious price discovery trades (Rise of the Machines) and posing a systemic risk of market failure (Fall of the Machines). Moreover the idea floated by the industry that these systems provide much needed liquidity to the markets turns out to be true – but only in the sense that it helps the HFT’s at the expense of the private investor: as Hendershott and Riordan find:
"[Algorithmic traders] consume liquidity when it is cheap and supply it when its expensive"
Or, in less academic speak, they suffer less from the costs of the buy-sell spread than do us humans.  The finding in this paper that HFT has lowered trading costs may be empirically true but, as Peter Hoffman points out,  a lot of these cheaper prices are only available to the algorithms themselves.  And don’t get me started on the parasitic markets known as Dark Pools (Dark Pools and Adverse Selection). The industry is set up to suck money out of short-term traders, while doing its level best to make it look as though this isn’t true. 

What's Your Competitive Advantage?

If trying to beat the institutions at their own game is for mugs then we need to look for some form of competitive advantage in other areas. It’s no accident that a lot of the advertising for the industry extols the importance of short-term behavior – the need to react swiftly to events in order to make money. This is true, but as the previous discussion serves to illustrate, the money being made is by the industry; private investors shouldn't bother.

Our competitive advantages are elsewhere; the Law of Big Numbers dictates that smaller companies simply aren’t big enough to justify lots of institutional analysis, so the asymmetric informational advantages often lie with private investors prepared to put in the effort. One reader noted that he invests in smaller French companies because the reporting language rules out a lot of competition. Nor are private investors constrained to make quarterly or annual returns – we can buy companies with good business models but which are temporarily distressed and wait. Or we can make sure we’re ready to supply liquidity to the markets when institutions are forced to give it up in one of their once a decade panics. And, of course, you can no doubt think of other options.

A Less Trodden Path

Nothing surprising in this – small cap, contrarian, value oriented buy-and-hold strategies have been around for a long time. At this point someone will usually point out that such strategies “don’t work any more”. That’s rubbish of course, the problem is foreshortened investing horizons: between 1965 and 1983 markets generally went nowhere while companies consistently improved their profitability. Eventually equity markets came back into fashion and patient investors reaped their rewards.

The idea that it can take years and years to see genuine returns is unthinkable to most market participants which is probably why such basic strategies work, because structural difficulties in the way that they’re set-up means that they’re very difficult for institutions to exploit. Competitive advantage, therefore, dictates that’s where private investors should go: not that this is likely to happen anytime soon while the power of institutional propaganda is used to persuade people to do the exact opposite of what’s in their best interests. Still, we don’t all have to follow the herd, do we?

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1 comment:

  1. Instead of complaining (advocating for the people), why not tell them where the advantages lie and how to avoid the disadvantageous "innovations." While the negatives should rightly be pointed out, there is much happening in favor of the small investor. Fees on mutual funds continue to come down, lower by 25 bps on average over the last decade. ETF's and alternative strategy funds make beta cheap and alphas more accessible to more investors. Accessibility to asset allocation concepts, including that the 60/40 traditional portfolio is 90% dependent on stock, is ever increasing. Low commissions on ETF's, no transaction mutual funds, and low minimums makes asset allocation possible for smaller accounts.

    While we have seen some very destructive, inefficient, and destabilizing financial innovations, they are usually product unaccessible to small investors. The financial press itself unfortunately does harm by trying to announce the latest fad, and ends up providing bad or incomplete advice to the detriment of average investors.