Portfolio Management – Page 27

“Smart Beta” and Portfolio Rule Seven

Posted on 24 June 2014 by David Merkel

I’m not an advocate for smart beta. ?There are several reasons for that:

I don’t pay attention to beta in the stocks that I buy; it is not stable.
The ability to choose the right brand of enhanced indexing in the short-run is difficult to easily achieve.
I’m a value investor, a bottom-up stock picker that doesn’t care much about what the index does in the short-run. ?I aim for safety, and cheapness.

But today I read an interesting piece called?Slugging It Out in the Equity Arena. ?It talks about an issue I have been writing about for a long time — the difference between what a buy-and-hold investor receives and what the average investor receives. ?The average investor chases performance, and loses 2%+ per year in total returns as a result. ?As the market relative to the index is a zero-sum game, who wins then?

The authors argue smart beta wins. They say:

To us, the smart beta moniker refers to rules-based investment strategies that use non-price-related weighting methods to construct and maintain a portfolio of stocks.^1?The research literature shows that smart beta strategies earn long-term returns around 2% higher than market capitalization-weighted indices. Moreover, smart beta strategies do not require any insight into the weighting mechanism. One can build a smart beta strategy with any stock ranking methodology that is not related to prices, from a strategy as na?ve and transaction-intensive as equal weighting to a more efficient approach such as weighting on the basis of fundamental economic scale. For example, a low volatility portfolio and its inverse, a high volatility portfolio, both outperform the market by roughly 2%?as long as they are systematically rebalanced.²??It is not the weighting method but the rebalancing operation that creates most of smart beta?s excess return. Acting in a countercyclical or contrarian fashion, smart beta strategies buy stocks that have fallen in price and sell stocks that have risen.

When I read that, I said to myself, “That is a more intense version of my portfolio rule seven:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I learned this rule from three good managers — one growth, one core, one value. ?They were all fairly rigorous in their quantitative analyses, but they all agreed, a 20% filter on target weight added ~2%/year to performance on average. ?But unlike the current “smart beta” discussion, I have been using this idea for the last 15-20 years.

The mostly equal-weighting also induces a smallcap and value tilt, which is an additional aid to performance. ?Since I concentrate by industry, the 30-40 stocks?requirement does not lead to over-diversification, as a great deal of my returns comes from choosing the right industries.

In one sense, portfolio rule seven is an acknowledgement of mental limitations, and is an exercise in humility. ?So things have been great? ?They will eventually not be so. ?As prices go up, so does fundamental risk. ?Take a little off the table. ?Raise a bit of cash.

Things have been bad? ?Look at the fundamentals. ?How badly have they deteriorated? This can take three paths:

a) Fundamentals?have deteriorated badly, or I made an initial error in judgment. ?I would not own it now, even at the current price there are much better stocks to be owned. ?Sell the position.

b) Fundamentals are the same, a little better, or haven’t deteriorated much. ?Rebalance to target weight.

c) Fundamentals are better and people are just running scared from a class of companies — not only rebalance, but make it a double-weight. ?I only do this in crises, for high-quality misunderstood companies like RGA and NWLI in the last financial crisis. ?Some of that is my insurance knowledge, but I have done it with companies in other industries.

For fundamental investors, who think like businessmen, there is value in resisting trends. ?Having an orderly way to do it is wise. ?Don’t slavishly follow me, but ask whether this fits your management style. ?This fits me, and my full set of rules. ?Modify it as you need, it is not as if there is one optimal answer.

I’ll close with an excerpt from the first article that I cited, which was its summary:

KEY POINTS

1.?????Smart beta strategies are countercyclical, periodically rebalancing out of winning stocks and into losers. They may underperform for extended periods but they ultimately tend to prevail.

2.?????Investors? procyclical behavior, selling recent losers and buying recent winners, pays for the estimated 2% per year in long-term value added by smart beta strategies.

3.?????Smart beta investing can be reasonably expected to have an edge as long as investors persist in following trends and chasing performance.

Are you willing to take the long-term view, meaning more than 3 years? ?These ideas will work. ?Focus on longer-term value, and do your analytical work. ?And if you outsource your investing, be willing to allocate more to stocks during bad times. ?To avoid really ugly scenarios, wait until the 200-day moving average has broken to the upside, of look at the 13Fs of value managers.

Do that and prosper. ?Resisting trends intelligently can make money.

On Alternative Investment Myths

Posted on 21 June 2014 by David Merkel

I think alternative investments should analyzed the same way that ordinary investments are analyzed. ?After all, I have written:?On Alternative Investments?and?Alternative Investments, Illiquidity, and Endowment Management. ?So when I read an article like this one at Militello Capital (not to pick on them, but I read it there), I say that I agree with points 1-4, and disagree with points 5-6. ?What are points 5 and 6?

5. Alternative investments are more volatile than stocks and bonds.

As a whole, private alternative investments tend to be less volatile than the stock market. Why?? Because investors tend to view alternatives as long term investments, and cannot constantly trade in and out of them.? In this day and age of high frequency trading and quantitative arbitrage (by the way, do most investors even know what this even means?), it is refreshing to know that long term investments still exist.? According to?10 Myths Surrounding Alternative Investments?by Nancy Everett and Mark Taborsky of BlackRock, ?Adding alternatives to a diversified portfolio has the potential to provide lower volatility than a portfolio composed exclusively of traditional stocks and bonds.?

6. Investors cannot access their capital if invested in alternatives.

As with most stereotypes, this one does not always apply. Yes, many alternatives are less liquid than traditional investments but the level of liquidity is dependent on the investment itself. Everett and Taborsky agree by stating ?As with all aspects of investing, there is a tradeoff between risk and expected return and liquidity is no different. When investing in less liquid assets investors should, of course, expect to be compensated for that illiquidity through improved risk-adjusted returns.? Alternatives that are illiquid also allow individuals to invest in tangible assets. Investments you can talk to.? Investments you can visit.? When?s the last time you visited your hedge-fund?

As for point 5, anything that you measure over longer time horizons will have lower annualized volatility than what is measured over short horizons. ?Whether a business is public or private does not affect the underlying volatility of the economics, though it may affect the accounting.

As for point 6, there are far more limitations in accessing capital from alternative investments than from ordinary investments. ?Alternatives are not as liquid, except when times are bullish. ?The same is true of condomiums, which indeed are fungible, but are rarely liquid, with a tight bid/ask spread.

As such, I don’t think points 5 & 6 are myths. ? They are the truth, those that argue against them are proposing myths.

The Tails of the Distribution do not Validate the Mean

Posted on 20 June 2014 by David Merkel

17 months ago I wrote a post?How to Become Super-Rich?? Now, many of my articles are timeless — they will still have value 10 years from now. ? I like to write for the long-run. ?Teaching basic principles is what this blog is about.

The surprise for me is that article is the most?popular one at my blog. ?That says something about the desires of mankind. ?Now, if you do want a chance to become super-rich, you create your own company, and focus your efforts on it exclusively. ?Diversification is not ?a goal here. ?We are swinging for the fences here.

But just as in baseball the guys who swing for the fences to hit home runs, they also tend to strike out the most. ?The same is true of businessmen. ?Many start companies, put their all into it, and end up broke. ?Many end up with marginal businesses that give them a living, but not much more. ?A few prosper and become moderately wealthy. ? A tiny amount of them create a hugely profitable company that makes them super-rich.

Anyway, after I was cold-called by Militello Capital, I reviewed articles on the blog, including one called?CRACK THE WEALTH CODE. ?I’ll quote the most relevant portion of the post:

According to?Get Rich, Stay Rich, Pass It On: The Wealth-Accumulation Secrets of America?s Richest Families?by Catherine McBreen and George Walper Jr, ?Building up a nest egg with the equity in your home is a fine thing. But what distinguishes the model for getting rich, staying rich and passing it on is its emphasis on investing in current and future income-producing real estate?. Andrew Carnegie, the wealthiest man in America during the early 20th century, said that ?90 percent of all millionaires become so through owning real estate.? If that?s not enough to peak your interest, consider this: ?The major fortunes in America have been made in land?, coined by John D. Rockefeller. What does he know?..his net worth in today?s dollars is?onlyaround $300 billion. Invest in areas you know. Real estate gives you the opportunity to visit and connect with your investment. When?s the last time you connected with your mutual fund?

Don?t forget about the second part of the winning combo: private companies. Open your eyes to entrepreneurial opportunities. McBreen and Walper advise that at least one-quarter of your investment dollars should be in enterprises that develop products and services or invent breakthrough technologies. In?10 things billionaires won?t tell you, number seven?s title, ?We didn?t get rich investing in stocks?, hits the nail on the head. Billionaires like Steve Jobs, Bill Gates, and Mark Zuckerberg made their fortunes in start-ups, says Robert Klein, founder and president of Retirement Income Center, a retirement and income planning firm in Newport Beach, California. The article confirms that ?you?re far more likely to become a billionaire in Silicon Valley than on Wall Street.?

In one sense, I agree with what they say. ?If you want to become super-rich, pursue one goal with your one company. ?Less than 1% will succeed. ?Maybe 5-10% will attain to being multi-millionaires. ?Most will muddle or fail.

Running your own business, including real estate investing, is not a magic ticket to riches. ?A lot depends on:

Solving problems people didn’t know they had.
The time period that you invest during — were financial conditions favorable for speculation?
The ability to manage a large enterprise is an uncommon skill.
The ability to be an entrepreneur is also not common. ?Most people don’t want to take that much risk.
Discipline, hard effort, taking time away from family and friends.

There is a cost to trying to be super-rich, and most people die at that altar of greed. ?I suspect that most that succeed, did not aim to be super-rich, but pursued that task because they found it interesting. ?They were idealists who happened to be in business, and their ideals matched up with what would enable society to pursue its goals more effectively.

So does it make sense for average people to invest in private equity funds or private real estate funds because the wealthy ran their own companies and invested in commercial real estate?

No. ?First, remember that the super-wealthy were swinging for the fences. ?They were the rare success stories.

Second, note that those who invest in?private equity funds or private real estate funds are diversifying. ?As such, they are seeking more certainty, and will not gain an abnormally large return.

Third, recognize the data bias. ?Those who succeed with?private equity funds or private real estate funds, their data exists, while those who fail disappear.

There is no advantage to being public or private as a business. ?Private businesses can keep things secret, but public businesses have a lower cost of capital.

Conclusion

Just because the wealthy got that way by making big bets that most people lose, does not mean that average people should do that. ?Alternative investments like?private equity funds or private real estate funds are not an automatic road to wealth, and are less transparent than their liquid alternatives on the stock exchanges.

Average people should avoid low probability bets — they tend to impoverish, with high probability.

PS — that said, I like commercial real estate as a diversifier, but it won’t make you rich.

Avoid Illiquidity

Posted on 18 June 2014 by David Merkel

There are several reasons to avoid illiquidity in investing, and some reasons to embrace it. ? Let me go through both:

Embrace Illiquidity

You are offered a lot of extra yield for taking on a bond that you can’t easily sell, and where you are convinced that the creditor is impeccable, and there are no sneaky options that you have implicitly sold embedded in the bond to take value away from you.
An unusual opportunity arises to invest in a private company that looks a lot better than equivalent public companies and is trading at a bargain valuation with a sound management team.
You want income that will last for your lifetime, and so you take some of the money you would otherwise allocate to bonds, and buy a life annuity, giving you some protection against longevity. ?(Warning: inflation and credit risks.)
In the past, you bought a Variable Annuity with some good-looking?guarantees. ?The company approaches you to buy out your annuity at a 10-20% premium, or a 20-30% premium if you roll the money into a new variable annuity with guarantees that don’t seem to offer much. ?Either way, turn the insurance company down, and hold onto the existing variable annuity.
In all of these situations, you have to treat the money as money lost to present uses. ?If there is any significant probability that you might need the money over the term of the asset, don’t buy the illiquid asset.

Avoid Illiquidity

Often the premium yield on an illiquid bond is too low, or the provisions take value away with some level of probability that is easy to underestimate. ?Wall Street does this with structured notes.
Why am I the lucky one? ?If you are invited to invest in a private company, be skeptical. ?Do extra due diligence, because unless you bring something more than money to the table (skills, contacts), the odds increase that they are after you for your money.
Often the illiquid asset is more risky?than one would suppose. ? I am reminded of the times I was?approached to buy illiquid assets as the lead researcher for a broker-dealer that I served.
Then again, those that owned that broker-dealer put all their assets on the line, and ended up losing it all. ?They weren’t young guys with a lot of time to bounce back from the loss. ?They saw the opportunity of a lifetime, and rolled the bones. ?They lost.
We tend to underestimate how much we might need liquidity in the future. ?In the mid-2000s people encumbered?their future liquidity by buying houses at inflated prices, and using a lot of debt. ?When everything has to go right, the odds rise that everything will not go right.
And yet, there are?two more?more reason to avoid illiquidity — commissions, and inability to know what is going on.

Commissions

Illiquid assets offer the purveyor of the assets the ability to pay a significant commission to their salesmen in order to move the product. ? And by “illiquid” here, I include all financial instruments that carry a surrender charge. ?Do you want to know how much the agent made selling you an insurance product? ?On single-premium products, it is usually very close to the difference between the premium you paid, and the cash surrender value the next day.

Financial companies build their margins into their products, and shave off a portion of them to pay salesmen. ?This not only applies to insurance products, but also mutual funds with loads, private REITs, etc. ?There are many?brokers masquerading as financial advisers, who do not have to?act strictly in the best interests of the client. ?The ability to receive a commission makes them less than neutral in advising, because they can make a lot of money selling commissioned products. ?In general, it is good to avoid buying from commissioned salesmen. ?Rather, do the research, and if you need such a product, try to buy it directly.

Not Knowing What Is Going On

There are some that try to turn a bug into a feature — in this case, some argue that the illiquid asset has no volatility, while its liquid equivalents are more volatile. ?Private REITs are an example here: the asset gets reported at the same price period after period, giving an illusion of stability. ?Public REITs bounce around, but they can be tapped for liquidity easily… brokerage commissions are low. ?Some private REITs take losses and they come as a negative surprise as you find ?large part of your capital missing, and your income reduced.

What I Prefer

In general, I favor liquid investments unless there is a compelling reason to go illiquid. ?I have two private equity investments, both of which are doing very well, but most of my net worth is tied up in my equity investing, which has done well. ?I like the ability to make changes as time goes along; there is value to being able to look forward, and adjust.

No one knows the future, but having some slack capital available to invest, like Buffett with his “elephant gun,” allows for intelligent investing when liquidity is scarce, and yet you have some. ?Many wealthy people run a liquidity “barbell.” ?They have a concentrated interest in one company, and balance that out by holding very safe cash equivalents.

So, in closing, avoid illiquidity, unless you don’t need the money, and the reward is very, very high for making that fixed commitment.

A Brief Note on Dividend-Paying Common Stocks

Posted on 16 June 201416 June 2014 by David Merkel

The equity strategy that I have run for the last 13+years always has a slightly higher yield than the S&P 500. ?But I never look for dividends. ?It’s not a factor in my process. ?That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend paying common stocks as a means of obtaining income. ?They also add REITs, MLPs, BDCs, and an assortment of other things that trade like stocks and have yield. ?I don’t think this is a safe way to get yield, at least not now. ?Here’s why:

1) Think of the 1970s, when I was a teenager. ?Not only were interest rates higher, and?inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely. ?During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it.

2) There have been many flameouts in REITs, especially mortgage REITs. ?I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher. ?They got crushed in the early-90s by Greenspan’s hyper-easy monetary policy. ?In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also got crushed in 2008-9. ?But Equity REITs have their times of trouble as well — they tend to be bull market babies. ?When commercial real estate is doing well, they do extra well. ?When it goes badly, extra badly for the REITs because of all the leverage.

3) I mentioned 1994. ?In 1994, as rates rose, dividend paying stocks underperformed. ?The value manager that Provident Mutual used at that time was an absolute yield manager. ?In other words, that manager only bought stocks that had a yield higher than a fixed threshold. ?At that point, the threshold was 4% or so. ?From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era. ?In 1994, the?performance was abysmal. ?The manager?was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly, because there is little left over to reinvest into new business. ?It is akin to owning a bond disguised as a stock. ?Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business. ?With Equity REITs, the latter strategy has generally been more successful. ?Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs, and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much. ?During crises, that really bites them.

(This wasn’t as short as I thought it would be. ?Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit. ?If we have a severe recession, be aware that dividends do get cut. ?Do not rely on stocks for income. ?Bonds are designed for income and return of principal. ?Stocks are designed for gains or losses depending upon the underlying business performance. ?They aren’t income vehicles, but performance vehicles.

The Value That Investment Advisers Deliver

Posted on 14 June 201415 June 2014 by David Merkel

I got cold-called this last week while I was away on business. ?I googled the phone number, and found that it came from Melitello Capital. ?I went through their site, and read most of their articles.

It’s an interesting firm, though I have no interest in working with them. ?The article I would like to comment on tonight is “HOW DOES AN RIA JUSTIFY ITS 1% FEE?”

I will explain why a 1% fee?can be justified. ?Now, I am an old school RIA [Registered Investment Adviser]. ?I only manage assets. ?I don’t allocate across asset classes. ?I don’t manage taxes in entire (though I help). ?I don’t structure the means to escape estate taxes. I don’t set up insurance schemes to minimize taxes; I could do it, but it would be boring. ?I could make a lot more money than I do, but I make enough, and I really like the challenge of outperforming the market.

RIAs offer value to clients in a large number of ways:

Reducing income taxes
Holding the hands of clients during the manic and panic periods of the market. ?Discourage them from taking more risk when the market is hot, and encourage them to take more risk, or at least, don’t leave when the market is panicking.
Hedging risks, whether it is a collar on a large single stock position, or a macro hedge.
Aiding in covering insurance needs.
Setting up financial plans.
Structuring estates, such that everything goes where the client wants, and estate taxes are minimized.
Asset allocation, including regular rebalancing.
And more… free advice on other issues, entertainment, bragging rights, etc.
Putting everything together in one neat package.
Oh, and in a few cases, alpha. ?(that’s my game)

Now, is that worth 1% on assets? ?Point 2 alone is worth more than 1%, so yes. ?Those who have read me for years know that people get greedy and panic. ?If you can avoid that, you are doing well, very well.

Look, it’s easy to trash talk your competition. ?Some registered investment advisers are worth their ~1% fee, and some not. ?It depends on the package of services that they deliver — alpha, taxes, insurance, legal help, asset allocation (tsst… be wary of the efficient frontier. ?It does not exist.).

In general, if the investment advisers themselves do not give in to panic and greed, they are worth a 1%/year fee. ?So seek out advisers that do not give in to market pressure.

Note: this is unpopular, because that means hanging onto advisers that underperform during hot markets. ?In the long run you will do better following advice like this– after all, they dissed Buffett in 1999, and my Mom told me I was a fuddy-duddy. ?(Note: when a parent tells you that you are behind the times, it stings. ?It does not mean that you are wrong.)

I am not telling you to invest with me; that is not what my blog is about. ?I am saying that there is value in separate accounts with RIAs. ?And, be choosy. ?Lower fees are better, subject to the same levels of competence.

Self-Regulation in the Financial Markets: My Thoughts

Posted on 13 June 201413 June 2014 by David Merkel

Self-regulation: let’s think about a person. ?Can he regulate his own life on his own? ?Of course he can. ?But will he?

The same is true of markets. SROs can be?effective if the culture is good, and people are willing to take actions against friends. ?But an SRO can also develop a culture that has a blind eye toward offenses, until the media embarrasses them. ?The same can be true of regulators, though. ?They can be “in bed” with the industry if the wrong culture exists in the regulatory body.

2) The trouble with financial companies and products is that they make promises, whether sharp or?vague, about the future. ?That leads some people to commit money today to those products, which may be bad or good. ?When done across a whole economy, that can lead to booms and busts. ?That is a great reason to regulate the promises made by financial firms.

3) But how do you regulate? ?Do you have a sharp separation between the regulators and the regulated, which can make regulation adversarial, or do you introduce a third party, the SRO? ?The SRO is a kind of middleman, who executes the will of the regulator, but takes into account the special conditions in each market, and talks with the regulator about where they might be wrong in what they would ordinarily do.

4) SROs have specialized knowledge, drawing from the firms they regulate. ?Well, regulators could have the also, if they hired the best, and paid them what they could earn in the private sector. ?My but the regulated would be baffled if they faced the “stone wall” of their equals in dealing with regulators.

But our government is chintzy where it should be bold. ?Aside from idealistic investors like me, (and I have applied to various government positions without the decency of a reply) it is difficult to attract top talent without paying top dollar. ?And as such, they have not gotten top talent. ?Academics are not top talent. ?They don’t really know how the markets work. ?They know how their models of the markets work.

Ideally, you need investors who understand the academic research, like me. ?If you have regulators with that strength of knowledge, you could regulate well.

5) Many of the speakers today talked about mining big data to get results. ?I will tell you that the only way to get those results is to hire talented programmers, then train them in the markets. ?Waste time teaching them; they’re bright, they will learn. ?Then after the initial training, propose the first project. ?You will create a cadre of clever programmers that can sniff out problems. ?Pamper them, and you will have a fantastic corps for sniffing out financial irregularities.

The guy from the National Futures Association emphasized the idea that mandatory membership in the association as a requirement to do business was paramount for an SRO and I can see that. ?The SRO then has the “death penalty” hanging over the heads of those they regulate. ?That said, consider this: the CFA Institute may dream of the day when all involved in investing *must* hold a?CFA Charter.

I have no doubt that this would be a good thing. ?Ethics codes are good for the industry, and to kick out bad apples would be a good thing.

6) When there are more than two?parties in any economic arrangement, regulation gets tough. ?It becomes difficult to separate the various interests, and come up with the right division of duties toward the ultimate consumer.

7) On Rules-based vs Principles-based regulation, in the American context, I lean toward rules-based. ?Rules-based has the advantage of comparability. ?Let the analysts make their adjustments, and let the companies provide the data to do so. ?But provide a consistent set of rules that all need to comply with first.

8 ) Finally, on derivatives. ?Regulate them as insurance, and let the states deal with it. ?Require insurable interest such that only bona fide hedgers can initiate trades. ?Speculators should not be allowed to trade with each other; that is gambling. ?If we did this, the derivatives market would shrink dramatically, and no one would be hurt.

That is what I would do, and Wall Street would fight it, tooth and nail.

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 3)

Posted on 12 June 201413 June 2014 by David Merkel

US System of Self-Regulation through SROs: Strengths and Areas for Reform?

Questions

What are the most substantial/significant contributions of the current SRO system in the United States?
What areas present the greatest need for reform?
How can the private versus ?state actor? functions of non-exchange SROs be reconciled?

David Blass
Chief Counsel, Division of Trading and Markets
US Securities and Exchange Commission

Trading markets division oversees oversees rules, rule changes, etc. ?Promulgate rules, exposes to the public. ?Dodd-Frank gives strict deadlines now, which if exceeded leads to proceedings, which now means further time to evaluate, decide, and additional public exposure.

Lynnette Kelly
Executive Director
Municipal Securities Rulemaking Board (MSRB)

Created in 1975 to deal with egregious conduct. ?Regulates the muni market. ?Writes rules and others enforce. ?SEC regulates on anti-fraud. ?Protect muni issuers since Dodd-Frank. ?Provides data to other regulators.

Daniel J. Roth
President and CEO
National Futures Association

SRO deals with Futures & Swaps — interacts with the CFTC. ?NFA is to CFTC as FINRA is to the SEC regarding crafting of regulations.

Moderated by: Cheryl L. Evans, CFA Institute

DM Note: attendance down to about 50 at this point.

Q to LK: ?How does MSRB “protect issuers?”

LK: Qualified professionals are held to a higher standard. ?[DM: note Poway School District…]

Q: What do you look for in an SRO?

DJR: Mandatory membership is needed, which makes expulsion end the business of the one thrown out.

LK: Collection of data is important. ?Led the way on “pay to play” issues. ?Argues that the muni market is the most transparent bond market after Treasuries. ?[DM: I doubt that.]

DB: Authority, Deep Knowledge, Sanctions help make for a good SRO.

Q: How can SROs aid regulators with data issues?

DB: we are data hungry in order to classify market participants. ?MIDAS — more timely analysis of market trading data.

LK: Aids in collecting analyzing data. ?Analyzes trade data daily. ?Responds to requests from law enforcement and regulators. ?They have allocated a lot more time and money getting analyses together.

DJR:?Drawing together all of the data is tough, but when you do it, you uncover anomalies. ?Constantly developing new systems. ?Have to have human intervention, computers aren’t enough.

Q to DB: How are you increasing your analyses of data at the SEC?

DB: lots of ways, one example is churning.

Q: Conflict challenges, how do you deal with them?

DJR: Create a system of checks and balances. ?34 people on his board, public director are the largest bloc. ?Diverse interest also sometimes checks matters.

LK: We are audited. ?Staff is independent of the board. ?Directors must be competent & ethical.

Q to LK: How do you provide interpretative guidance?

LK: they try to interact quietly with the regulators to resolve differences of opinion.

DB: FINRA is in the same place regarding the SEC. ?FINRA has to enforce SEC securities rules.

Q: What the data sharing rules regarding agencies and SROs?

DJR: CFTC has full access to our data. ?We notify other affiliated regulators/SROs.

LK: Formal rules w/FINRA, IRS, banking regulators, etc., law enforcement via subpoenas.

Q to LK: Additional financial information on new issues?

LK: No authority over financial issuers, more frequent disclosure would be better. ?We make our systems easy for?issuers to upload data. ?FOIA requests can be made as well on issuers. ?Munis are not high quality liquid securities.

Q: Thoughts on principles-based rules and regulations?

DB: perennial issue, we will never be fully one way or another. ?Market participants request rules to guide them when principles are issued.

LK concurs.

DJR says that principles-based rules allow them to be tougher. ?Market participants have a rule: they complain. ?(laughter from audience)

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 2)

Posted on 12 June 2014 by David Merkel

Exchange SROs: Meeting the Needs of Investors and the Financial Marketplace

Questions:

How do exchange SROs contribute to the effective functioning of the securities markets?
How has the role of exchanges changed since they were first designated as SROs, and have these changes affected their ability to function effectively in that role?
Do recent breakdowns in exchange oversight functions indicate a need for an overhaul of structure/functions or point to ?fatal flaws? in the current system?
Are conflicts in the current system of demutualized exchanges resolvable or inherent in the system?
What needs to be done to reinforce the integrity of the system and increase investor protections?
How does increased competition from broker/dealer internalization networks and foreign trading markets affect exchanges under the constraints of the current self-regulatory system?

Panel

Roberta Karmel
Centennial Professor of Law, Brooklyn Law School
Former Commissioner of the US Securities and Exchange Commission

The change from fixed commissions was significant. ?NASD traders had preferential rates trading with one another. ?Existing SROs continued on. ?Expulsion was a threat. ?Exchange listing standards were a significant protection.

Many markets, and profit seeking exchanges have changed matters. ?Sarbox and Dodd-Frank have affected matters ?with listing requirements. ?JOBS act has opened up listing standards, and perhaps not in a good way. ?SEC was happy to see the monopoly of the NYSE broken, but there have been unanticipated secondary effects. ?We need to ask what kind of regulation we need now in the present environment.

Richard G. Ketchum
Chairman and CEO,?Financial Industry Regulatory Authority

Mentions MS was the first Chair of FINRA. ?Merger of NASD and NYSE Reg. ?FINRA has an enhanced majority of public governors. ?No way for industry to capture FINRA. ?Oversees all bond and equity trading. ?Exchange SROs can delegate to FINRA, but they must oversee what FINRA does for them.

Mary Schapiro
Vice Chairman of the Advisory Board, Promontory Financial Group
Former Chairman of the US Securities and Exchange Commission
Former CEO of the Financial Industry Regulatory Authority (FINRA)
Former Chairman of the Commodity Futures Trading Commission

SROs are cost-effective and flexible, with deep expertise. ?Examine participants, Surveill markets, etc. ?New tech, markets, exchanges as profit-seeking entities are new challenges. ?Conflicts of interest have grown along with HFT.

Moderated by: Andrew N. Vollmer, University of Virginia School of Law

Q: Does the current system work well? What areas do we need to change?

MS: It’s working well. ?Vigilence is needed. ?Well-functioning SROs are an aid to regulators. ?Easier for an SRO to address an issue with stakeholders.

RK: Wants the SEC to have a bigger budget, merge the CFTC into the SEC. ?SROs are necessary now because the system won’t work without them. ?Fragmentation of?trading makes self-regulation less effective.

ANV asks RGK to reply.

RGK says FINRA aids regulators. ?FINRA brings knowledge, focus and access. ?Government regulators are more confrontational, FINRA can get more done. ?Exchanges are the only ones enforcing listing?standards.

MS concurs that listing standards are needed.

Q: Have we lost some of the benefits of SROs with the delegation of authority to FINRA?

RGK: has worked with SROs his whole life. ?Comments how things were often worse in the past, not all things are worse today.

MS:?Concurs with RGK.

RK: There has been loss, much of it through the destruction of exchange-based trading. ?2008 meltdown — few firms did anything to stop the crisis. ?Everyone acted in their own interest.

Q: Aside from listing standards, what other?things should the exchange SROs do?

MS: Exchanges will always be responsible for aspects of investor protection.

RK: Exchanges will always have an interest in the integrity of their markets.

RGK: Comments that exchanges should watch over the quality of products traded [DM: think of leveraged and inverse ETFs, ETNs, penny stocks, promoted stocks, etc.]

Q: What about efficiency at the SRO level?

MS: Competition and efficiency don’t always work well together. ?SEC and CFTC should be merged.

RK:?SEC and CFTC should be merged. ?Need more than one regulator, though. ?Did not work in the UK. ?FSOC a disaster, a non-solution.

RGK: We interact with everyone. ?No opinion on whether the?SEC and CFTC should be merged.

Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections (Part 1)

Posted on 12 June 2014 by David Merkel

I’m at the?Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections Conference hosted by the CFA Institute and the DC Society. ?I will be making occasional posts on this today, in the form of summary notes.

Jim Allen, CFA
Head, Capital Markets Policy ? Americas

CFA Institute ? already self-regulated.? Aids in flexibility of regulation.? De facto standards of investment performance measurement ? GIPS [Global Investment Performance Standards].

Keynote talk

Has spent much of her life heading self-regulatory organizations [SROs].? She thinks SROs lever the effectiveness of government in regulating finance.? Congress does not appropriate the proper amount of money to regulate finance on its own.? Employee levels in the government regulators have not grown.

Regulating RIAs ? only 9% examined in 2013 managing $55 Trillion of assets.? SROs are not a second choice solution.? There is more expertise, tech knowledge, etc.

The Future of Self-Regulatory Organizations

Cited this article: Top 10 Characteristics of Effective Self-Regulatory Organizations

DM note: There are about 60 people here in this room adequate to hold about 150.

First Panel

Global Overview: Role of Self-Regulation in Increasingly Interconnected and Complex Markets

Topics

What are the benefits of an effective self-regulatory system in the securities markets?
What challenges does the self-regulatory system face in light of the complexity of financial products and trading mechanisms (algorithmic trading, dark pools, etc.), and what resources are needed in response?
How does the use of ?front-line? regulators in certain market sectors contribute to more effective regulation?
What is the future for self-regulation? How do the experiences differ between emerging markets and those that are more established?

Chris Brummer
Professor of Law — Georgetown University Law Center
No intro talk.
Amarilis Sardenberg
Chair of the Board?– BM&FBOVESPA Market Supervision

Government Bond ? Central Bank

OTC Bond, Securities, and Derivatives ? all under one regulator.? Each has its own SRO.? Her securities SRO audits brokers and custodians.? All trades tracked by beneficial owner; makes tracking manipulation easier.
Susan Wolburgh Jenah
President and CEO –Investment Industry Regulatory Organization of Canada [IROC]

Heads a national SRO in Canada.? Provinces have financial regulatory authority.? This is somewhat similar to insurance regulation in the US.? SROs have greater authority in Canada.? Audited regularly, and the results are made public.? Thinks they hold to the Top 10 Characteristics of Effective Self-Regulatory Organizations pretty well.

Moderated by: Jim Allen, CFA, CFA Institute

Q: Challenges of SROs?

CB: 2 ? points: 1) Globalization ? financial trade can go on anywhere ? affects regulation.? Coordination is helpful, the US cannot dictate international rules.? Soft principles have dominated over negotiating hard principles.

2) Disintermediation of financial services firms eliminates gatekeeping functions of financial firms.? Bitcoin, Crowdfunding, Dark pools, etc.? (DM: I would have said derivatives or money market funds?)

SWJ: Changes have been huge ? explosion of exchanges in Canada and the US. ?High frequency trading [HFT] is highly controversial ? and it is a data-intensive task to investigate what is right or wrong.

AS: Coordination of policy is important.? A little surprised at arbitrage trades.

Q: What to do about attacks from hackers?

SWJ: Big issue, the investment banks are big targets.? Smaller firms lag on resources.? We try to educate on the issue, create best practices, policies, etc.? Their SRO hires hackers to test their systems.

AS: Similar answer to SWJ, adds that the exchanges have their own efforts.

CB: Capture the right data, analyze it.

Q: Regulatory arbitrage, how to reduce?

CB: Cites: The Danger of Divergence: Transatlantic Financial Reform & the G20 Agenda

Different regulators move at different speeds, and face local challenges.? Different cultures affect implementation.

SWJ: Businesses move faster than regulators.? Are provincial securities regulators able to adapt more rapidly than a national regulator? [DM: If they cooperate, I think it can work.]

AS: There are so many trades going across borders that it is very difficult to police.? Post-trade settlement is tough ? harmonizing settlement standards has a long way to go.

Q: How do you avoid industry capture?

SWJ: IROC does not advocate, it only regulates.? Purity of purpose is important.? Board is 7 independent, 7 industry and the Chair.? Nominating Committee composed of the independent directors plus Chair.? Everything public and transparent.

AS: Her exchange SRO is established by statute, and has clear authority and goals as a result.? Board of 11, 8 must be independent.

Q: Not many SROs in banking, as finance goes more global, how will SROs fare?

CB: Harmonization of data collection would help.? Difficult to harmonize all regulation under one roof.? Federal Reserve doing some of this. [DM: not really]? Long history of SROs in finance and other areas, like accounting.? Independent majority on SRO boards need with an independent source of revenues.

SWJ: There is an academic paper to be written here.? [DM: Panic of 1907, Great Depression help explain it.]

AS: Not many exchange based SROs: US, Canada, Brazil, Columbia…