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ETF Update

The ETF marches on.  Traders Magazine Online (14 July) reports that the volume in ETFs is exploding.  According to the article, from last September through May, “ETF consolidated volume averaged almost 49 billion shares a month. That compared to almost 20.5 billion a month on average from the same period one year earlier.” 

This 150% jump follows a report where the NYSE found ETF consolidated volume on average doubled in comparable nine-month periods.

In other words, not only is ETF volume growing tremendously, it is growing at an accelerating pace.  We hold no degrees in rocket science – nor in any science – but we wrote earlier that the entry of such behemoths as PIMCO in to the ETF space all but guarantee that this market will soon top one trillion in assets.  Now, according to the Traders Magazine article, it appears that even the sky may not be the limit.

The article reports that Knight Capital has hired a team of fifteen ETF sales-traders to take advantage of “a tidal wave of volume and liquidity in the ETF space.”  In fact, Knight is going after a whole new customer base.

“We're seeing more traditional mutual fund managers converting more into ETF format for the lower cost structure and transparency that ETFs provide,” says a co-head of Knight’s ETF group.

Traditional asset managers have been steadily increasing their ETF exposure, using them for “core holdings, beta exposure, alpha generation, various hedging strategies. Whether you're bottom-up or top-down, they can be very useful.”

Something for everyone, it would seem.

Indeed, the article makes the following observation: “a traditional asset manager with money for a new account may want to be invested right away. Simultaneously, he also wants to wait two weeks to do some research on some stocks. While doing that research, he can invest the money in a value ETF and, at least, get the exposure until he has the individual stocks he wants to buy.”

This means that money managers who haven’t yet figured out what stocks to buy are sticking cash into an index, while figuring out what to do.  All right, we already admitted to not holding a degree in rocket science, but we wonder whether this lax approach to managing money is “demand-pull” or “supply-push”.  Did some smart money manager figure out that this is a good way to buy time while he does his homework, or are smart salesfolks hitting up money managers with hot new ideas?

In today’s interest rate environment, it makes little sense to park in cash while making an allocation decision.  Thus, an investor might assume that a money manager had ideas at the ready – the notion of being 100% invested, 100% of the time is a key selling point to private investors.  We will content ourselves here with smacking the same bell we have been ringing all year: the ETF trade risks becoming very crowded, very quickly.

ETFs and ETNs appear to trade based on two levels of price insensitivity.  First, the ETF sponsor does not care at what price the individual components are bought for the Fund or Note – their concern is having sufficient holdings in the underlying instrument to be able to issue their shares.  Secondly, the ETF buyer in the marketplace is looking, not at the price of the share, but at the action in the underlying index.  Thus, Best Execution appears to go out the window.

Brokerage firms have written best execution procedures for ETF trading, but the ones we have seen are just retreads of their procedures for best execution of stock trades.  This begs a big question: if the floor traders are scooping up stocks, indexes, oil, gas, and gold based purely on size and timing – with no consideration for price – and if the customer is buying the ETF based on the price of the underlying instruments, on what basis would anyone ever request price improvement?

While this looks like a facetious question, we call your attention to the CFTC’s new initiative to impose speculative position limits on all commodities “of finite supply.”  This means all natural resources, and much hoopla erupted in the last two weeks about shares of the ETF UNG – the natural gas contract – which literally ran out of supply when the SEC did not authorize new notes to be issued.

This has created a situation where the ETF becomes sensitive to actual market demand on the offer side – more buyers of the now-finite ETF will actually drive up the price beyond its intended relationship to the underlying contract.  The bid side of the market might hypothetically remain tied to the underlying natural gas contract; the problem here is maintaining a fair and orderly market.  If a buying panic develops – not impossible in a world where Russia needs to spike the price of oil and gas just to keep making bread and vodka – the market makers may find themselves forced to chase the offer, raising the bid beyond its relationship to the contract.

But it gets better – because if the market regulators see the natural resource ETFs and ETNs spiraling out of control, they will beat their chests and say how very right they were.  The introduction of position limits in the actual corn, gas, soybean and pork markets should be something most professional traders can get used to.  What the locals will miss, once the shackles are on, is the free money they were scooping up filling price-insensitive orders for the ETF managers.

After that, we think SEC Chairman Schapiro starts applying the same logic to the stock market and the indexes – perhaps not the broad ones, but the narrow-based sector tracking indexes, most probably.

Earlier this year, there was a great outcry by the senior executives of REITs who complained that their shares were being whipsawed in the marketplace by ETF creation and liquidation trades.

Public companies have fixed numbers of shares outstanding, and even under a shelf registration, new shares are not issued intraday.  We think CFTC Chairman Gensler’s proposed position limits are a done deal.  The Next Big Thing, though, may be similar restrictions in the equities markets.  In short: the ETF marketplace is big and growing – for the time being, though, it is decidedly messy.

We keep coming back to our old conclusion: Goldman bowed out of the bidding for iShares.  Could Goldman have won, if they really wanted to?  We think so.

Is it safe to assume Goldman knows something we don’t?

Count on it.

Cuban Embargo – Lifted!

My old pals from the 1980’s wouldn’t recognize me now.

- Ross Mandell

In the same week the judge dismissed insider trading charges against Mark Cuban, the SEC has issued insider trading rules for agency staffers.

The rules require pre-clearance of all trades by agency employees, prohibit the trading of securities of corporations under investigation, and require SEC employees to certify that they don't have non-public information about the companies whose securities they are trading in.

In a related matter, the House Financial Services Subcommittee is taking up an SEC report examining “alleged inappropriate trading” by government officials, and legislation has been introduced in the House to prohibit insider trading by members of Congress or their staff. The bill is known as the Stop Trading on Congressional Knowledge, or STOCK Act.

Compliance officers in the audience will recognize that introducing these rules is only ten percent of the task – the SEC staff are held to no more rigorous standard than employees of banking and brokerage firms.  The whole exercise smells too much of government, and not enough of ethics and common sense.  This is another case of a political institution taking a political step to fix a political image problem.

The entire industry remains on the honor system.  Will this enhance public protection?  Will this enhance the transparency and proper functioning of our markets?

Only time – one resource we have in pitifully short supply – will tell.

Nails In The Coffin

How are the mighty fall’n!

- 2 Samuel, 1:19                                                       

Just like in the Bible, there are no coincidences in real life.  The past weeks saw the Icarus-like plummeting of two high-flying financial Daedaluses.  Far apart as their stories may seem, we find far more similarities than differences in these twin cautionary tales.

News media can be misleading.  Thus, one might be forgiven if, upon reading the Financial Times headline (10 July) – “The Storms That Swept Away Meriwether’s Flagship Fund” – one formed the impression that John Meriwether was the victim of an irrational market. 

We ask that you refrain from pointing out the unerring acuity of hindsight.  Hindsight was staring us in the face in the avatar of Long Term Capital Management.

Among our favorite financial media moments is the excellent segment of Public TV’s “Nova”, dedicated to the rise and demise of LCTM (PBS airdate: February 8, 2000).  LCTM, staffed by the rocketingest of rocket scientists, and supported not by one, but two Nobel prizewinning economists – Robert C. Merton and Myron  Scholes – managed to create one of the greatest pools of risk in the history of finance.  We keep being reminded of the fundamental truths we learned from the successful old-time stockbrokers.  Those who strive belly-to-belly in the trench warfare of money are most sensitive to the true driver of economic forces: emotion.

Andrew Racz, he of the Eraserhead hairdo and staccato Hungarian accent, told us years ago, “Smart people never buy.  They only sell.”  Meriwether & Co sold risk.  The banks, the brokers, the investors – even the regulators all bought it.

The denouement of the Nova segment includes clips of a Who’s Who of the “Models Model” of market economics – Paul Samuelson, Myron Scholes, Alan Greenspan and others – musing on the humbling of the “model” model of market economics.

Here is Merton Miller: “Models that they were using, not just Black-Scholes models, but other kinds of models, were based on normal behavior in the markets and when the behavior got wild, no models were able to put up with it.”

Peter Fisher, Executive VP at the New York Fed during the LTCM crisis, says “I don’t yet know the balance between whether this was a random event or whether this was negligence on theirs and their creditors’ parts. If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on.”

Fade to the past couple of weeks, where another icon was toppled as unceremoniously as the statue of Saddam Hussein.  Former baseball star Len Dykstra – whom Jim Cramer described in glowing terms as a stock picking Wunderkind – filed for bankruptcy, leaving in his wake a Hall Of Fame list of lawsuits.

In rebutting allegations that Dykstra was a beard for a scrum of no-name stockpickers who used Dykstra’s name recognition for marketing purposes, Wall Street pro Richard Suttmeier wrote (quoted in Silicon Alley Insider, 16 June 2008, “Lenny Dykstra makes His Own Stock Picks, Says Pro Who Helps Him”) “Lenny makes his own picks after reading tons of research notes from the most respected independent minds. He has become one of the best stock pickers after doing several years of homework. I can’t even explain how he uses his deep in the money call strategies.”

We especially like that last sentence.  Suttmeier devotes half his piece to bristling at being characterized as “a little-known strategist”, detailing his own professional resume, and his many television appearances.  He finishes with a flourish: “It was after one of these CNN ‘Talking Stock’ shows when Lenny Dykstra called me and said, ‘Hey Dude, can you teach me how to read a stock chart?’”

As our CEO, Keith McCullough, points out, running a P&L is not the same as running a business.  And – in his former capacity as Captain of the Yale hockey team – we are sure he would agree that even a .310 season batting average does not qualify one to handle investments.  Not one’s own, and not someone else’s.

The fault, to paraphrase Shakespeare, lies not in our markets, but in ourselves.  Markets, like computers, give us back what we provide: Garbage In, Garbage Out.

The traditional Wall Street management model consistently promotes excess over good sense.  In many firms the most successful salesmen are routinely turned into managers.  The apotheosis of this process is perhaps the elevation of Jimmy Cayne to head of Bear Stearns – accounts of the demise of that once-great firm - but it has deep and untouchable roots.  The finance business is, after all, about getting other people’s money – not about making money for other people. 

Superstar traders like Meriwether are able to generate outlandish profits for their firms for a number of reasons.  Not the least among those reasons, to be sure, is their own unique market acumen.  But running a profitable trading desk uses one skill set, while running a successful financial company uses a different one.

Meriwether was an all-star at Salomon Brothers, where he was Head of Fixed Income Arbitrage.   Traders who worked under him there credited Meriwether with applying a “yield-to-worst” analysis to their positions, trying to gauge the effect on their positions of, as one trader put, “the world going down.”

Here’s the rub: this is the right process for a trading desk manager to apply to protect his P&L.  In the meantime, he needs pay no attention to the cost of his office rent, light fixtures, telephone lines, or the expensive lunches he caters to feed the traders on his desk.  One would think that a well-run firm would charge these items back to the profit center.  But on Wall Street, the profit centers, to paraphrase the old management saw, walk out the door at the close of business every day.  Come year end, the same conversation takes place in every boardroom, when the heads of the profitable desks sit down with senior management.  We can just see Meriwether sitting across from Gutfreund.  Gutfreund is holding a gigantic cigar and gazing with his impassive basilisk stare as Meriwether, red pencil in hand, cuts expense items from his desk’s P&L.

In good times, firms end up eating the lion’s share of the expenses of their profitable departments.  The most profitable department – and Meriwether was a super-duper-star – gets first crack at ramming expenses back down the throat of the shareholders.  By the time this exercise is done and bonuses paid, the company ends up with a winnowed-down profit number, and the traders get new Porsches.

Who shoulders the burden of business decision-making at these hedge funds?  Managers who run world-class desks at major financial institutions find themselves paralyzed by having to face personnel decisions, by having to make decisions on compliance procedures, by having to negotiate with portfolio managers who insist on hiring staff.  Never mind the year-end bonus discussions.  High-profile traders at major firms are insulated from serious business decisions, and frequently falter when they must take them on in running their own firms.

Just like Lenny Dykstra.  “One of the great ones in this business,” according to Jim Cramer.  Dykstra’s options newsletter on TheStreet.com reportedly netted him $1 million a year until being discontinued earlier this year.  In a sad denouement reminiscent of “Requiem For A Heavyweight”, the public is ghoulishly watching as Dykstra’s former sports glory, his second career, his personal life, and the respect he once enjoyed from colleagues, friends and teammates all go down in flames.  Clearly, Dykstra was “one of the great ones”… until he wasn’t.

Both Meriwether and Dykstra represent what’s wrong with this system.  Both men were outstanding at their chosen vocations – and both appeared untouchable in their first careers.  In their second careers, they have fallen victim to the ultimate Wall Street sin: they believed their own hype.

Worse yet, the rest of the world believed it too.

Split Personality

I seem to be what I’m not, you see…

- “The Great Pretender”

GM shares shot up 35% in value on the news that the company is emerging from bankruptcy. Last Friday, when the announcement hit, the stock traded as high as $1.15.  Oh, by the way… that was not General Motors stock.  Not really.

The Wall Street Journal (16 July, Marketbeat, “Stock Split: New GM vs. Old GM”) scratches its journalistic head over aggressive trading in the shares of General Motors, particularly the 35% surge in the price of the shares in the wake of the announcement that the company is emerging from bankruptcy.

What’s odd about this market action is, the trading is in ticker symbol GMGMQ – the designation for the old GM shares that still trade in the Pink Sheets, the home of delisted public companies.  These shares – as the Journal correctly points out – “represent ownership stakes in the GM assets that remain in bankruptcy court, a company named Motors Liquidation Co., assets that the new GM didn’t want.”

This is the industrial version of the Good Bank / Bad Bank model.  It has been around for a long time, as it is a standard part of the bankruptcy process.  In the public markets, there is invariably a rush of buying in the delisted company around the times of filing for, and emergence from bankruptcy. 

Over the years, retail investors have erroneously believed that they were buying the “new” company for pennies on the dollar, when what they were actually buying was the abandoned assets.  Now – lo and behold – FINRA actually has exercised its Investor Protection responsibility.  Last Friday it acted to halt trading in GMGMQ.  FINRA issued a public statement saying there may be “potentially misleading” information in the marketplace, and that investors should not assume that the mere fact of a security trading in the market should not be interpreted “as indicating that the shares have any value.”

With so many companies in danger of filing bankruptcy, why haven’t the SEC and FINRA – both in their primary capacity, which is investor protection – issued statements advising investors that the common stock of companies in bankruptcy is not the same as the common stock of companies emerging from bankruptcy?

We have not forgotten that last year FINRA – with Mary Schapiro still in the saddle – suspended delistings on the basis of price.  Their logic was that there were many companies whose stock price was unrealistically depressed due to market conditions, and it would cause unreasonable pressure in the markets if they were to delist every company whose price collapsed.  The NYSE followed suit some time thereafter. 

In the midst of all this incompetence – and just in time for the potential bankruptcy of CIT Group – FINRA has suddenly discovered its investor protection roots.

Hear the applause?  It is the sound of one hand clapping,

A Final Reflection

Esse Quam Videre (“To Be, Rather Than To Seem”)

- North Carolina State Motto

To much front-page fanfare, Bernard Madoff has driven the last five hundred miles (Wall Street Journal, 16 July, “Sins And Admissions: Getting Into The Top Prisons”).  Against the recommendation of defence attorney Ira Sorkin, Madoff is now an inmate at Butner Federal Correction Center, a medium-security facility in North Carolina.  The WSJ article mentions that the Rigas boys – pere and fils – are doing their time at Butner for their fraud convictions relating to their tenure at Adelphia Communications.

But of all the places Madoff could have been sent, it is a twisted irony that he is now housed at the same facility as Jonathan Pollard, serving a life sentence for passing US Naval Intelligence information to the Israelis.  Pollard, who violated the laws of the United States, believing his actions would save the Jewish people, is paying the price for what he believed was right.  Madoff, who ruthlessly exploited his close ties to the Jewish community, breaking the laws of the United States to satisfy his own irrational greed, will now pay a price of his own.

Welcome to North Carolina, Bernie.  “First In Flight” – but not for you.

Bernie Madoff, today is the first day of the rest of your life.

Moshe Silver

Chief Compliance Officer