Transaction-based Brokerage in light of EMH

[kkent]

For the many institutional money managers and individual portfolio managers (i.e. small RIAs) who charge fees as a percent of the total assets under management, the efficient market hypothesis is really irrelevant as far as conflict of interest is concerned.

But let's just assume (for the sake of this question) that the EMH is true and that a full-service stock broker (i.e. a person who manages money and even conducts estate planning but whose fees are transactionally based) is managing money. Under this scenario, the broker has an incentive to buy INDIVIDUAL stocks and bonds and to buy and sell more frequently, but in reality, the broker (as a money manager) should be constructing diversified portfolios of both stocks and bonds and, for the most part, holding steady with the exception of a few transactions here and there to rebalance assets. Do you all see this transaction-based compensation as a conflict of interest, especially in light of "modern" portfolio theory and in the scenario of at least semi-strong EMH being true? If so, how does a broker reconcile this with his career? Should he switch careers or just try to do the best job he can with what he's got?



Edited 1 time(s). Last edit at Friday, August 10, 2007 at 04:38PM by kkent.

 

[gobucksgo]

Kevin,

I sent you an email awhile back after my job thread post; not sure if you got it or not. Either way, it's understandable considering the turn of events with your job. GL with everything.

Anyway, in regards to this post and a few others you've made in the past where you're assuming that EMH holds true...the fund I began working for has beaten the respective benchmark 7 out of 10 years (net fees), is ahead YTD, and overall has beaten it by a pretty wide margin. Sure, there are a ton of terrible funds/analysts out there who don't know what they're doing. It's laughable when you here people call someone like Bill Miller at Legg Mason lucky and that probability is finally catching up with him. There are geat analysts out there. So, to answer your question, if you feel the market is efficient and have strong morals, then yes, I would see it as a conflict of interest. In my case, I know that EMH only exists in academic theory, so I don't subscribe to this feeling.

 

[kkent]

I hear what you're saying. I'd submit that modern theory tells us that there ARE some inefficiencies in the market and that good managers--like you and your firm--can take advantage of that. But it also recommends that if you aren't a "superior analyst" or aren't great at picking stocks (like most people--like me? Like others?) then you should not engage in trying to beat the market. So I guess the question is more guided toward average analysts/managers, which is probably the majority of analysts.

BTW, with a good FI strategy and with the ability to short sell, I'd think a lot of managers could beat the averages, but I digress from the focus of the question (conflict of interest).

BTW, I'm writing you back tonight.



Edited 1 time(s). Last edit at Friday, August 10, 2007 at 05:20PM by kkent.

 

[newsmaker]

If you are generating fees for yourself by doing something that you believe reduces clients' after-fee returns, you're being unethical.

 

[kkent]

newsmaker Wrote:
-------------------------------------------------------
> If you are generating fees for yourself by doing
> something that you believe reduces clients'
> after-fee returns, you're being unethical.


Man, for me, that would be a tough question to answer. In one sense, most people who hire professional money managers do so because they have no clue what they're doing and/or they've got a pile of money under their mattress. They're better off getting a below-market return than no return at all. But that has to be ethically balanced out by the "fact" (for EMHers or mediocre managers) that they COULD be getting higher returns through other methods. Not black and white.

 

[JoeyDVivre]

gobucksgo Wrote:
-------------------------------------------------------
> Kevin,
>
> I sent you an email awhile back after my job
> thread post; not sure if you got it or not. Either
> way, it's understandable considering the turn of
> events with your job. GL with everything.
>
> Anyway, in regards to this post and a few others
> you've made in the past where you're assuming that
> EMH holds true...the fund I began working for has
> beaten the respective benchmark 7 out of 10 years
> (net fees), is ahead YTD, and overall has beaten
> it by a pretty wide margin. Sure, there are a ton
> of terrible funds/analysts out there who don't
> know what they're doing. It's laughable when you
> here people call someone like Bill Miller at Legg
> Mason lucky and that probability is finally
> catching up with him. There are geat analysts out
> there. So, to answer your question, if you feel
> the market is efficient and have strong morals,
> then yes, I would see it as a conflict of
> interest. In my case, I know that EMH only exists
> in academic theory, so I don't subscribe to this
> feeling.


None of those statistics is particularly compelling even if they are completely true.

1) Beating the benchmark in 7 out of 10 years is reasonably likely if you just randomly invested around the benchmark. Throw in fees and, admittedly, it becomes less likely.

2) There is a nasty inspection problem in it; you only work there because the firm has managed to outperform the benchmark. Those other firms that might have hired you are gone now because they didn't outperform the benchmark or didn't grow to hire new people. Virtually all new hires can say their firm outperformed the benchmark in 7 of the last 10 years.

3) I can give you oodles of strategies that will beat the S&P 500, e.g., in 9 out of 10 years (e.g., buy S&P and continually sell deep OTM puts). It's that tenth year when we have a problem. There is no measure of risk in your statement and the risk can be either realized vol (e.g., Sharpe ratio) or unrealized vol (the options that didn't get hit).

4) Depending on your firm, EMH might not cover it. For example, EMH does not say that you can't make outsized returns by being big enough to influence management, arrange buyouts, etc.. A very common misunderstanding on AF is that EMH says something like "you can't beat a passive index". It really says something only something like that.

You need to be pretty careful about laughing at people when they are defending EMH. There are some wickedly smart people out there who will own you right after you get done laughing at them.

 

[FourCastles]

Another point on EMH: efficiency is not binary and different markets are efficient to varying degrees. Market for shares of a small tech company trading on Nasdaq will be less efficient than market for NY:CSCO. Similarly, NYSE today is more efficient than it was 30 years ago, due to more larger number of institutional investors engaged in program trading/arbitrage and due to electronic access to information.