Ethics – Page 10 – The Aleph Blog

Book Review: How To Smell a Rat

Posted on 11 May 2011 by David Merkel

I have written reviews on two Madoff books, No one Would Listen, and The Club No One Wanted To Join.? In the latter of those book reviews, I argued that the Madoff fraud was detectable in advance, which offended one who was defrauded by Madoff.? Ken Fisher lays the blame at her door; she should have been able to see it coming.

Look, I sympathize with her loss, but there are basic rules that are common sense for any investment where discretion is given to a money manager.? I am such a money manager, but I consider it a benefit to me and my clients that I have no ability to touch their funds.? The third-party custodian takes care of that.

Imagine playing a game — before we enter the game, both teams want to know that the umpires will be neutral.? So it is in investment management — we need neutral custodians to assure fairness between investment advisors and clients.

Ken Fisher manages ten thousand times more money than I do.? But he is aware of the many ways that people get skinned by fraudsters.? The leading way is to get investors to give the investment advisor both discretion and custody over the assets.? That opens the door for unscrupulous advisors to misappropriate assets.

This is critical.? Don’t entrust your assets to an advisor without a neutral third party providing custody.? This is more than normal — it should be expected.

There are four other lesser signs of fraud:

Returns are too good to be true — volatility that is too low, or returns that are too high.
Not being able to understand what is going on as the money is invested.
Being blinded by the trappings of wealth.
Trusting the opinions of others, rather than doing your own due diligence.

You have to understand that there are no magic bullets, and those who have great past returns should be willing to undergo extra due diligence, because great returns are rare, and need extra due diligence to prove that they are valid.

Beyond that, don’t be greedy or credulous.? Ignore wealth, and do your own due diligence — the book provides a good outline for doing so.? And unless you are so wealthy that you hire someone else? to hire your asset managers, don’t hire any manager whose processes you don’t understand.

These are basic rules that all investors should heed.? Enough said.

Quibbles

None.

Who would benefit from this book:

Most average investors would benefit from this book, because they are the ones who get targeted for fraud — not that all of them will be defrauded, but all of them need the warning, so that they can be prepared against those who defraud.? I wish I had read this when I was 25.

If you want to, you can buy it here:?How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Series).

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Regarding David Sokol, Part 3

Posted on 28 April 2011 by David Merkel

I would like to start this with the public counterarguments from Sokol’s attorney:

I am profoundly disappointed that the Audit Committee of Berkshire Hathaway would authorize the issuance of its report to the public without the care and decency to ask even a single question of Mr. Sokol. Mr. Sokol had been associated with the Berkshire Hathaway companies for 11 years. During this time, his indefatigable efforts helped create enormous value for the Berkshire shareholders. He deserved better. While I take issue with much of the Committee?s report, I briefly make the following points. If the Audit Committee had asked, it would have learned that:

Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.

Mr. Buffett was told twice, not once, about Mr. Sokol?s ownership of Lubrizol stock before Mr. Buffett engaged in any discussions with Lubrizol.

Contrary to the Audit Committee?s statement, Mr. Sokol?s Lubrizol shares were not acquired pursuant to a ?100,000 limit order.? Rather, they were purchased as a result of several limit orders, over a period of days, at specified prices, for the day only, in order to acquire the stock at low prices. At that time, Mr. Sokol had no reason to anticipate that Mr. Buffett would have any interest whatsoever in Lubrizol.

I have known Mr. Sokol and have represented his companies in business litigation since the mid 1980s. I know him to be a man of uncommon rectitude and probity. He would not, and did not, trade improperly, nor did he violate any fair reading of the Berkshire Hathaway policies.

Okay, let’s take the three points in order:

1) Yes, Sokol may have looked at Lubrizol prior to December 2010, but he only chose to invest in Lubrizol in December 2010.? Personal investments might be allowed by his employment agreement, but not those where BRK might have an economic interest, at least not without full disclosure to the relevant powers inside BRK.? Remember, though Buffett acts as a sort of King inside BRK, even he is subject to the corporation and the committees set up by the board.

2) And that is relevant to Sokol telling Buffett twice, something that was already known.? Buffett is not the head of compliance.? Sokol needed to give full disclosure to the CFO and the Audit Committee

As the audit committee wrote:

?All actual and anticipated securities transactions of Berkshire and its subsidiaries that have not been publicly disclosed should be considered material.?

?Other public companies to which this prohibition is applicable include those that may be involved in a significant transaction with Berkshire. . . .?

?If a . . . Covered Employee is aware that Berkshire has taken or altered a position in a public company?s securities or that Berkshire is actively considering such action, trading in any securities of such public company ... [trading in the securities] is expressly prohibited prior to the public disclosure by Berkshire of its actions . . . (or until the [employee] becomes aware that Berkshire did not take and is no longer actively considering such action).?

and wrote again:

?Covered Parties who have access to confidential information are not permitted to use or share that information for stock trading purposes or for any other purpose except the conduct of the Company?s business.?

?Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company.?

And further wrote:

All of these internal policies are underscored by the law of Delaware, where Berkshire Hathaway is incorporated. Under Delaware law, corporate representatives owe their company a duty of loyalty. The duty of loyalty includes? a duty of candor, which requires them to disclose to the corporation all material facts concerning corporate decisions, especially decisions from which they might derive a personal benefit. Mr. Sokol?s actions did not satisfy the duty of full disclosure inherent in the Berkshire Hathaway policies and mandated by state law. His remark to Mr. Buffett in January, revealing only that he owned some Lubrizol stock, did not tell Mr. Buffett what he needed to know. In the context of Mr. Buffett?s question how Mr. Sokol came to know Lubrizol, its effect was to mislead: it implied that Mr. Sokol owned the stock before he began considering Lubrizol as an acquisition candidate, when the truth was the reverse. A candid disclosure would have revealed the timing and size of the purchases, and the communications with Citi concerning obtaining a meeting to mutually explore interest in a potential acquisition that had preceded them. Knowledge of those facts would likely have prompted further questions by Mr. Buffett and could have allowed Berkshire Hathaway to evaluate measures that could have been taken to alleviate the problem before negotiations proceeded with Lubrizol.

Mr. Sokol?s answer to Berkshire Hathaway?s CFO, Mr. Hamburg, concerning the investment bankers similarly fell short of the degree of candor required of a corporate fiduciary, and suggests his answer to Mr. Buffett?s earlier inquiry noted above was intended to deceive.

The main idea here, as I have written about before, is that Sokol owed a duty to BRK as an employee.? Could he buy stocks of companies, as specified by his employment agreement?? Sure, but within limits which he violated.? BRK deserved the initial benefits of his work, when the data was intended for BRK and not for Sokol.

3) That the orders were not 100,000 share limit orders is not relevant to the case at hand.? Mr. Sokol, if your attorney is making such bogus arguments, either you have a really bad case, and should compromise, or you need a better attorney.

As I commented to the excellent Colin Barr, in his early piece on the topic:

I don’t think we need a new law here. If Buffett wants, he has grounds for a tort against Sokol on his misappropriation of data that rightfully belonged to BRK. I suspect Warren will just let it slip — Sokol did a lot of good for BRK, and Buffett has loyalty to managers generally. At least, that’s how it seems today. His ruthlessness for the reputation of BRK is subordinate it seems to his loyalty.

Which leaves any complaints that shareholders might have against BRK. Now, those complaints are not against Sokol, but against Buffett and his management team’s oversight of Sokol and his activities.

So, let’s be careful here. BRK is a conglomerate that owns insurers, and not an asset manager per se. The SEC and other regulators probably do not have something actionable here. But the two actions that I mentioned above could be taken in the civil courts, should Buffett or a group of shareholders decide to pursue those remedies.

Well, now we have a court case against BRK and the possibility of BRK proceeding against Sokol.? Both of my tort remedies might happen.

But What About Buffett?

I think Warren Buffett can defuse most of his troubles through a heartfelt apology at his annual meeting.? Something like, “Yes, I blundered.? I should have asked Sokol for details, but I was rushed that day.? I still firmly believe in the ethics that I have promulgated for BRK, but I slipped in not enforcing them as best I could.? I gave him the benefit of the doubt, because he was so valuable to us, and I should not have done that.”? And before that, go to those suing BRK and seek a resolution.? Your reputation would prevail, Warren.

Look, I try to be an ethical guy, but I make mistakes also.? The greater error as to deny guilt/fault when it is obvious to many.? I have confessed fault freely during the times I have blown it, and have ended up stronger for it.? Warren, the same would be true for you.? People will forgive you if you accept your responsibility in the matter.

Remedies

This is not the end of the Audit Committee?s work. Still under way are:

Work with Company management and legal counsel to identify and implement lessons learned from these events, including possible enhancements to its procedures.
Cooperation with any government investigations relating to this matter, and monitoring any developments that may emerge from them.
Consideration by the Board, or the Audit Committee, or such other committee as the Board may think appropriate, of possible legal action against Mr. Sokol to recover any damage the Company has sustained, or his trading profits, or both, and of whether the Company is obligated to advance Mr. Sokol?s legal fees associated with proceedings in which he is named.

They may go after Sokol.? The damages are far greater than the gain of $3 million on the takeover.? As Buffett said he cannot afford to lose any of his firm’s reputation.? Now may Buffett heed his own advice.

Vote Your Proxies

Posted on 12 April 2011 by David Merkel

Part of being a shareholder is corporate governance.? It is incumbent on us to vote the proxies we receive.? To my left, I have ten or so proxies I will vote tomorrow.

If we don’t vote our? proxies we have no right to complain about corporate governance.? And, for those who own mutual funds, have you told your mutual fund company what you care about?? They may or may not listen to you, but if they hear a decent number saying the same thing, they might take your position, multiplying your opinion by ten or more.

Voting proxies is a matter that helps keep shareholder capitalism morally legitimate.? Without it, corporation managements are tempted to do as they please, which generally leads to worse results for all but management.

And if I might get on the soapbox for a moment, I would like to say that we all as investors should begin to vote down management pay and incentive packages where we can.? Let’s engage in brinkmanship.? They are paid well enough already.? If they don’t get the increase, where will they go?? And, isn’t there a lot of talent in the wings that could replace them?? My view is the best management teams are those that love what they do for the challenge, rather than the money.

Incentives for the rank and file are another matter, and should be approved, unless they are excessive.? Also, ignore the special interests of the loony left who own stock only to affect corporate policy.

That’s all.? I have been traveling and am rather tired.? But vote your proxies!

Regarding David Sokol, Redux

Posted on 31 March 2011 by David Merkel

I am republishing what I added to yesterday’s post, and adding onto it, because many readers would have missed it.

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In the cold light of morning, I have thought of one more issue? why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Every firm I have worked for, and even now at the current small firm that I run, there were/are mandatory disclosure rules. My promise to clients is that I get the same results they do, win, lose or draw.

Regardless, it highlights a weakness in Buffett?s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the ?fairness code,? however defined. And, he has said as much to his managers in his biannual memo to them:

The priority is that all of us continue to zealously guard Berkshire?s reputation. We can?t be perfect but we can try to be. As I?ve said in these memos for more than 25 years: ?We can afford to lose money ? even a lot of money. But we can?t afford to lose reputation ? even a shred of reputation.? We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say ?Everybody else is doing it.? This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can?t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it?s very likely that if a given course of action evokes such hesitation, it?s too close to the line and should be abandoned. There?s plenty of money to be made in the center of the court. If it?s questionable whether some action is close to the line, just assume it is outside and forget it.

And Buffett implicitly confirms such a view by accepting Sokol?s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol?s unethical behavior led to him leaving Berkshire Hathaway ? one can try to dress is up otherwise, but it fails the smell test.

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There are other issues in play here.

1) Sokol received a list of possible takeovers from Citi.? He was acting as an employee of BRK at the time.? As such, BRK should get the first benefit of his insight.? Yes, BRK is an industrial/financial conglomerate, and not a mutual fund.? But the first duty of an employee is to use data given to you for the benefit of the firm, and use it for the benefit of the firm.? Citi was not offering data to David Sokol as a retail client.

I faced similar situations at a fund that I worked for, where I did not make my case well enough for the portfolio manager.? After he did not want to buy my idea, I asked for the freedom to buy it myself.? It was not granted, and I did not buy it.

2) Sokol sent an assistant to hand Buffett the resignation letter; he did not want to face Buffett.? I suspect he knows that he disappointed Warren, and did not want to face him.

3) Buffett comes off high-handed in that he deems his initial letter to be all the data anyone will get on the matter.? I’m sorry, Warren, but the SEC may have a lot to say here — they don’t know that all of the relevant data has been disclosed.? Maybe you don’t either.? Sokol withheld material information from you; might he have withheld even more data from you?

4) Look, give Buffett some credit here — after so many years of doing business and trusting his managers, he has one blowup from a fellow who is temperamentally hotter than most of his managers.? This incident does not characterize Berky, but it does point out a weakness.? If I were talking to Warren, I would say this:

Look, Warren, you can centralize your company now, under your terms, while you are still alive and thinking clearly, or the company will do so after you die, and you will have no influence in the matter.? The failure with Sokol is basic, and you should have admitted fault in not asking him the size of his position, since you have been informal in requiring disclosure of investments from high-ranking employees.? Start analyzing Berkshire now, as an integrated company, and ask what you want centralized, and what you leave to the subsidiaries.

5) Sokol did not follow BRK’s ethics rules:

All directors and executive officers of the Company, and the chief executive officers and chief financial officers of Berkshire Hathaway?s subsidiaries, shall disclose any material transaction or relationship that reasonably could be expected to give rise to such a conflict to the Chairman of the Company?s Audit Committee. No action may be taken with respect to such transaction or party unless and until such action has been approved by the Audit Committee.

and

Covered Parties are prohibited from taking for themselves opportunities that are discovered through the use of corporate property, information or position without the consent of the Board of Directors of the Company. No Covered Party may use corporate property, information or position for improper personal gain and no employee may compete with the Company directly or indirectly. Covered Parties owe a duty to the Company to advance its legitimate interests whenever possible.

Sokol had the idea of Lubrizol as a result of his position at BRK.? That data belonged to BRK, not Sokol, and he should not have used it for personal gain.

6) Is Buffett too trusting?? I would say no, but would add “Trust, but verify.”

7) As for Charlie buying shares of BYD, Charlie was not an employee of BRK, but a director, and as such, has a different standard of duty to BRK.? Sokol was an employee, and as such owed a duty to BRK to use data he received for the benefit of BRK first.

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I intend this as my last comment on Sokol, unless some amazing new data arrives.? Sokol and Buffett both blew it, but in different ways.? Sokol could have:

Left years ago.? Why wait to pursue a dream when you are already rich?
Told Buffett the full story voluntarily.? He had a lot of credibility inside Berky, so why not?
Donated all profits to charity.? (Weak, but mighta worked.)

Buffett could have:

Asked for the position size.
Asked him to sell as a condition of the merger.
Had better more regular disclosure of brokerage accounts from top employees.

What a mess.? Buffett should say more on this matter.? I believe he will be hurt if he says nothing more, without government coercion.

Regarding David Sokol

Posted on 30 March 201131 March 2011 by David Merkel

David Sokol knows how Buffett and Munger think. He knows what would be attractive to them.

So, even if the initial comments from Buffett were negative on the purchase of Lubrizol, Sokol, having more data, could be confident, because once the full data were available to Buffett and Munger, the deal would likely be done.

Sokol has been one of Buffett’s CEOs for awhile.? You think he can’t recognize another man who would be a good fit for Buffett?? I suspect he knows the pattern intuitively.? Buffett likes managers who think as he does; Sokol knows what sort of manager that is; once Buffett talked to the CEO of Lubrizol, the deal would be done.

With that as background, I fault Sokol for buying a lot of shares of Lubrizol, knowing that he would recommend the purchase to Warren, where the odds were in his favor that Warren would buy.? This also takes into account the goodwill that Sokol has with Buffett and Munger, given his management of MidAmerican, and his turnaround of NetJets.? Don’t think that that means nothing, even if Buffett says otherwise.

My view is that it was unethical, but not illegal, for Sokol to recommend the purchase of Lubrizol without disclosure of the size of his position in Lubrizol.? Mere mention of a position is not enough, unless it was a small position.

Yes, Sokol could not force the purchase, but he could have not brought it to Warren, in which case he would have made or lost money off of operations.? By buying, and then recommending the stock to Buffett, he raised his odds of a successful outcome.? That is a way of misusing your influence within the organization that you serve, which is unethical.

UPDATE 9:30 AM 3/31

Kid Dynamite did a post on this, and asked me to comment.? Here it is:

You have not misinterpreted me, KD. But in the cold light of morning, I have thought of one more issue… why is Buffett so loosey-goosey with things that ought to be mandatory disclosures for avoiding potential conflicts of interest?

Regardless, it highlights a weakness in Buffett’s highly qualitative way of managing his company and managers. You not only have to avoid breaking the law; you have to avoid the appearance of breaking the law, or even the “fairness code,” however defined. And, he has said as much to his managers in his biannual memo to them:

The priority is that all of us continue to zealously guard Berkshire?s reputation. We can?t be perfect but we can try to be. As I?ve said in these memos for more than 25 years: ?We can afford to lose money ? even a lot of money. But we can?t afford to lose reputation ? even a shred of reputation.? We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say ?Everybody else is doing it.? This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision. Whenever somebody offers that phrase as a rationale, in effect they are saying that they can?t come up with a good reason. If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it?s very likely that if a given course of action evokes such hesitation, it?s too close to the line and should be abandoned. There?s plenty of money to be made in the center of the court. If it?s questionable whether some action is close to the line, just assume it is outside and forget it.

And Buffett implicitly confirms such a view by accepting Sokol’s resignation, with no hint that he tried to argue him out of it, as he did twice before. Implicitly, Sokol’s unethical behavior led to him leaving Berkshire Hathaway — one can try to dress is up otherwise, but it fails the smell test.

On Con Men

Posted on 17 March 201117 March 2011 by David Merkel

Recently, I made a visit to the Cato Institute, and I bumped into a guy who indicated he was interested in investing with me.? We exchanged cards, and around 10 days later he called me, telling me about his scheme for investing the money of (my and other) IRA investors in wind farms that he had in upstate New York.

He talked for a while, and I said, “So are these limited partnership interests?”? He said no and rattled on about the opportunity.? I then asked, “Is this a private company, and you are offering shares?” He said no and rattled on about the opportunity.? I then asked, “Are these general partnership interests?? He said no and rattled on about the opportunity.? I then asked, “Is this some sort of structured note?”? He said no and rattled on about the opportunity.

I then said, “Stop.? If after five minutes, I can’t tell what it is that you are doing, it can’t be anything good.? I have worked in almost all areas of the securities markets, and if you can’t tell me the legal form of what you are doing, I have no interest, particularly not for my clients.” He rattled on about the opportunity, and I hung up on him.

Note: confidence is not a bad thing, but hyper-confidence is.? If someone is not willing to quickly trot out the risk factors on an investment, avoid them.? All investments have risk.? REPEAT: ALL INVESTMENTS HAVE RISK.? There, I feel better now.

I have said before, and I will say it again, “Don’t buy what someone is trying to sell you.? Buy what you have researched and want to buy on your own.”? Hey, I got cheated on penny stocks when I was young and inexperienced.? Many of us make mistakes when our knowledge is immature.

Also, even in institutional investing, I can tell you that complexity is the enemy of the one receives it.? I avoided most complex transactions when I was a corporate bond manager.? While working for the hedge fund, I happily set up a structured note that reflected my view of the world, after refusing one the broker created.? We won on that one.

So avoid complex investments.? Particularly avoid investments that you don’t understand.? At minimum, find a competent friend, or some neutral party that will look at the deal.? If you can’t find such a friend/party, don’t do the deal.? The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

I have a friend, the son of a dear deceased friend of mine, who seemed to attract Nigerian-style scams the way dryer traps collect lint.? I finally took him aside and said to him, “Ignore these.? If it is too good to be true, it most likely is too good to be true.”? Happily, he took the hint, and did not lose a dollar to the scammers. (I lost a couple hours proving the opportunities were bogus.)

Financially, this is a dangerous world, outside of the well-established channels for investment.? (I write this as one with significant private equity investments.)? Be careful in how you allocate your funds, and don’t give into a slick pitch that promises high returns (over 7%), or extreme safety (no way you can lose), without significant due diligence.

Update: One more note.? I often find it useful to ask the seller to send me all of the documents, and tell him that that I might pass them by my lawyer.? I don’t have a lawyer; for practical purposes, I am my own lawyer on securities matters.? I can read the documents myself as well as any lawyer.? But that usually cools the ardor of any con man; he knows that the deal will not get done, and he gives up.

Active Share

Posted on 18 December 201019 December 2010 by David Merkel

I often have to deal with practical “small institution” problems, because of the church I belong to.? Here are two of them:

1) The pastors have a defined contribution plan.? There are two questions.? Are the funds the best that we can get?? Are the asset allocation options that draw from those funds properly calculated? (Two-thirds of the pastors use those.)

For the first question, we have a board member who works for a major fund consultant.? He will easily be able to answer the question.? As for the second question, I have analyzed how the offered funds have done over the last 20 years.? Those allocations have done well in the past.? The problem is, when did the consultant do the look backwards and set the percentages?

The tendency is that once the percentages are set, future performance tends to decline.? Select managers who have done better than they normally would, and watch them regress to the mean, or worse.

My view is select managers that have done well for reasons that are not common to the environment that they were in.? There are often trends that benefit certain managers, then once the trend goes, they are gone as well.? But who did well in spite of the trend?? Those are managers to look at.

2) Recently, four members of my congregation came to me and said, “Here’s the list of managers in my401(k), who should I invest with?”? and “Here’s the portfolio my husband left me (after death), what should I do?? I can never turn down a friend, and particularly not a widow.

This was interesting.? As I looked into the mutual funds, I relied less and less on the performance statistics, and Morningstar stars, but looked at the actual portfolios in concert with performance, and decided that those with unusual portfolios with reasonably good performance were better choices.? Why?? They aren’t following the market.

Today, I ran into a name for that concept: Active Share.? How much does a manager vary from the index?? If you’re going to be an active manager, you ought to vary from the index quite a bit.? That is what you should be paid to do.

“But wait,” says the fund marketer, “Beating the index is the best, but missing the index is the worst.? We survive best with performance that is out of the fourth quartile.? So hug the index as you make modest bets against the index.”

Those are the portfolios I want to avoid.? An article in the WSJ concurs.? Don’t pay active fees for index-like performance.

I feel that way about my own investing.? If I am not looking at stocks that are less considered than most, then what am I getting paid for?? I would rather fail unconventionally than succeed conventionally.

And yet I know that managers that have high active shares, though they may do well on average, get excluded by fund management consultants, because they are too unpredictable.

Look, I am trying to make money for clients.? Consultants are a necessary evil in that process.?? Clients would be better off without consultants, but that will never happen, because clients want to stay out of the fourth quartile.

My active share is large, and I have done well.? Does that mean that a lot of people will invest with me?? Probably not, because they are not willing to endure an odd portfolio that isn’t mainstream.? Well, that is their loss.

Against Ayn Rand

Posted on 30 November 2010 by David Merkel

There is one main reason why I have never been tempted to read any book by Ayn Rand.? Her disciples are monomaniacs that if they were anything more than a tiny minority of society, would make life miserable for most people.? I have never met one that I would want to have as a neighbor.? They have the zeal of a religious cult, and twice the negative wisdom.

I write this as one who is a libertarian, but with a sense of ethical values, and a belief in regulating financial promises.? Selfishness is never a virtue.? Anyone who has raised children would know that.? Anyone familiar with what it is like to work in an office with one who is selfish would know that.? Anyone who is the child of a selfish person would know that.? And, surprise, most political scandals involve someone who has been selfish in the use of their office.

Selfishness makes life hard on those nearby, who have to live with the backwash of the actions of the selfish one.? We have seen in corporate America the actions of selfish people who run corporations, and goose their own pay to the detriment of shareholders and employees.? It leads to losses for all, when leaders more farsighted might earn more in the long run than asset-strippers and body-cutters.

Business is a cooperative game, and those that can motivate people to work efficiently and creatively can create a lot of value for many.? But that means sharing the value, not being selfish.

Recently, I have reviewed two books: Secrets of the Moneylab, and Priceless.? One major conclusion of the books indicates that people are not rational profit maximizers.? They care for status and their own sense of ethics.? They don’t want to promote greedy people, and they want to see their own relative status in society preserved.? They care what others think about them.

In one sense, followers of Ayn Rand are no better than Communists because they have the wrong model of man.? Instead of trying to create The New Communist Man, they try to create the New Selfish (Randian) Man.? Both are unrealistic for anyone caring about treating people fairly.

To the man who only has a hammer, everything looks like a nail.? In my own life, I have found that the more I act honestly, and look out for the good of others, the more I get rewarded.? I have known people who try to be tight in every transaction, and they don’t get done what I could, because they aren’t trusted like me.

Trust.? We trust those who are altruistic far more than those who are selfish.? I earned a lot more for my clients by being altruistic to Wall Street than being combative.? I got Wall Street to trust? me, and it yielded dividends for my clients.? Cooperation leads to more benefits than competition.

I have little respect for a woman who wrote a bunch of boring books, partially to justify her immoral life.? I don’t care if she favors free markets or not.? It is far better to consider whether ethical behaviour is present in the markets.

Ayn Rand was an intellectual lightweight, and a moral failure.? Following her is akin to intellectual suicide.

Ethics and Investment Writing

Posted on 13 November 201014 November 2010 by David Merkel

There are three things that I am happy with when it comes to writing about investments:

I am glad that Jim Cramer invited me to write for RealMoney seven years ago.? Motown Josh Brown put together a great piece on the influence that TSCM has had on the financial media.? I heartily agree, and I don’t think we know the half of it.? I interacted with a lot of young TSCM staffers, and it amazed me what an education they got in the markets working for TSCM.? TSCM blended respect and skepticism for the markets, and though you couldn’t have done it without Cramer, the effect on the financial media exceeds him, and for that we can all be grateful, because the financial media is a lot sharper than it was 15 years ago.? (Okay, leave out much at CNBC.)? And who knows, maybe I will return to TSCM someday in some capacity; the door is open.
I’m glad I started my blog.? I still think that financial bloggers are the conscience of Wall Street.? There is a need for knowledgeable people to write about economic/investing/finance issues.? It does not replace journalists, but supplements them.? Intelligent commentary complements “neutral” reporting on a topic.? Journalists learn from area experts, playing them off against each other to get a fuller picture of the debate.? (As an aside, the motive to start the blog began on one of the comment boards at TSCM for Cramer.? Readers were fascinated that I would post there, and told me I needed to develop my voice.? A few called me the anti-Cramer, but I never took up that moniker.)
I am grateful that I am a CFA Charterholder.? Harry Markopolos recently spoke to the Baltimore CFA Society, mainly about his uncovering of the Madoff scandal, but he spent a decent amount of time explaining why the CFA Institute and our ethics code can make a huge difference in reforming Wall Street.? I was impressed; his beliefs in honesty and fair dealing drive his actions.? (I talked with him afterward, and we realized we must have met seven years before, at a regional meeting of the Northeastern CFA societies, when I was sent by the Baltimore CFA Board to represent us in a ticklish issue regarding the leadership of AIMR.? He had helped lead the effort to replace the existing leadership.)

But that’s not my major reason for writing tonight.? I want to comment on two pieces in the Wall Street Journal that comment on shady practices.

The first one is entitled Shining a Light On Murky 401(k) Fees.? The Department of Labor has the dubious distinction of being less effective than the SEC on investment regulation.? A lady I sat next to at the Denver conference regaled us with how her daughter’s 401(k) plan had expenses equal to 12%/year of assets.? I hope she made a math error, but she is a Ph. D; it’s not likely.

From my own experience at Provident Mutual in the nineties, it was easy to see how expenses could get layered.? We tried to be among the more ethical in that business, but the temptation to pay a lot in order get more business was dangled in front of us regularly, and we refused.? We had a rule that if comp was not disclosed, agents had to disclose that comp was not disclosed. And if they took nondisclosed comp, they could not have additional disclosed comp, because it would give the illusion of “That’s all I am paid.”

Do we need limits on 12b-1 fees?? I would prefer a full disclosure of fees — who and how much, poking through relationships to explain who ultimately is giving services to the 401(k) plan, and who is collecting rents as “gatekeepers” for the plan.

There is a lot to be done here.? Would that the DOL would invest a little money in buying skeptical experts, and really grasp the complexity of what is going on there.

The second one is entitled Structured Notes: Not as Safe as They Seem.? When I (along with others) was taking a demo of a custodian recently, the rep of the custodian went out of his way to show the area of the website that offered structured notes.? I commented, “Those are evil. They offer yield, but they make people short expensive options.”? After an embarrassed pause, the rep said, “Let me demonstrate an area of bonds that is not evil,” and he moved onto Agencies.? I didn’t have the heart to tweak him twice.

I wrote a piece a while ago called “Yield, the Oldest Scam in the Books.”? Structured notes offer above market yield, while that yield, or some of the capital, could be negatively affected if events perceived to be unlikely would occur.? The investment banks can hedge those risks more effectively than the Structured Noteholders can, and they pocket large profits.

The concept of “contingent protection” annoys me.? The odds of triggering such protection are much higher than the average person expects.

Do not buy structured notes.? The investment banks know far more than you.? Do not buy what others want to sell you.?? Use your good mind, and buy what you like.

There is no one on Wall Street looking to do you a favor, so view your broker with skepticism.

Fairness Versus Economics

Posted on 16 September 2010 by David Merkel

Time out.? Time to have an elementary school education for those that lead us, who have pretensions to understanding economics, at least in terms of how people really work, not the idealized Homo Oeconomicus of the introductory economics textbooks.

Time for them to get a dose of behavioral economics form books like Priceless and “Secrets of the Moneylab” (soon to be reviewed).? People don’t care as much about improving their position in life as much as they do about fairness.? Why? If I did not believe in Jesus, I would say that people assume that the games that they play will be repeated in life, and so they punish those that cheat, because they prize the integrity of the system more than short term results.

There is a simpler explanation, though.? Men/(Women) were created to judge their surroundings and rule it.? Man was created on Earth for moral purpose primarily, not for increase in consumption.? When ethics are transcendent rather than a question of economic advantage (more is better), men will act against their short term interests to promote the long term good.

This is yet another reason why people don’t necessarily act on average to maximize their short-term pleasure.? People will not normally enter into deals that they find morally repugnant even if they would gain from it.? Ask a liberal if they would encourage the Nature Conservancy to sell land to Plum Creek Timber, or one of its peers.? They will object.? Wait, couldn’t they take the proceeds, and buy up more forest elsewhere?? Sorry, this is a sine qua non for them.? They don’t deal with the enemy.

I could come up with many more examples, but I am sure that I would make a lot of people angry, and that is not my goal here.? I am just trying to make people think a little more broadly about economic policy.

So the central bank decides to finance a certain financing market in a panic.? Fairness asks this: why them, and why not me, or everyone?? We don’t care if the economy would supposedly collapse without the aid of the central bank.? Things should be fair; if you are offering it to them, you should offer it to me, or everyone, or you should not offer it.

The same applies to fiscal policy.? Stimulus, should it exist at all, should apply to the broadest category of applicants.? Don’t target troubled industries, particularly those whose products are in oversupply.? Send the stimulus to average people equitably.? Let industries fail, but let consumers choose what they need.? Why should we support industries that are not needed by the public?

So when I read Daniel Henninger in the Wall Street Journal arguing that average people don’t respect spending beyond the budget of the government, I get it.? I GET IT!!!? They have an interest in fairness, which stems from their moral sense that we can’t spend beyond our means, printing press or not.? Yes, the printing press may print, but it does not create value as much as redistribute value into the hands that the government favors, and the average person suspects they are getting none of it.

I am no fan of the Republicans, but do the Democrats understand what fury they have unleashed?? What do average people think when the government runs huge deficits in peacetime?

They look at it and wonder, Why can’t I do that? Why can’t we all do that?? The moral/ethical question pops to the top, regardless of other concerns.

The model of man that economists use is flawed.? Rather than focusing on the weak concept of more is better, they should look at fairness, and other relative comparisons of well-being that people care about.

What’s that you say?? If we do that, all the pretty math doesn’t work?? The pretty math doesn’t work already.? Tests of both microeconomic and macroeconomic theory as currently construed get rejected by the data when they attempt to apply the broadest tests of the general equilibrium theories.? If I am wrong here, please forward onto me the studies contradicting this, because this is what I learned in Grad school economics in the third year — very disappointing to save it until then… why not mention it in Econ 1 & 2?? Oh, you want to keep your jobs, because it beats working for a living?? Aye, laddie, I ken, I ken.? What I don’t get is providing intellectual cover for politicians to run a huge pork barrel.

Many people are sick of the government trying to assure prosperity and failing, to the degree that many are now thinking that the government is not trying to assure prosperity, but merely help out favorites, because that is how a lot of the policy of bailouts, stimulus, credit easing and radical quantitative easing appear.

Summary

I write this because there are many politicians, economists, and journalists/bloggers who don’t get why a large number of people are angry over what the government is doing in the midst of this crisis.? They think that everyone should be grateful that they are applying the Keynesian/Neoclassical remedies that the academics imagine will work.? They aren’t like me, where I think that most of the government’s actions are long-term harmful, and it would be better to do nothing. My hope is that one day average people will know that the government cannot assure or aid prosperity, aside from providing courts and police.

But average people look at fairness, and the snake oil “remedies,” regardless of their validity, do not provide that.? That is why many are annoyed, if not angry.