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Missed Opportunities For Average Investors, By Kelvin To, Founder And President Of Data Boiler Technologies

Date 26/07/2019

Kevin_To

Different phenomenon attribute to market evolutions, and a dysfunctional public stock market would in turn create new phenomena affecting ‘rights’ of different constituents. Let’s study these phenomenon or market behaviors and pin-point if ‘rights’ come from stock ownership being meaningful or not.

First, I praise discount brokerage firms, such as MEMX core members – Charles Schwab, E-Trade, Fidelity, TD Ameritrade, and Merrill Edge, for lowering online stock trading commission fees to a bare minimum in favor of their retail customers. Yet, Robinhood offers ‘FREE trading’ on their mobile app which has caused concern over the practice of accepting payment for order flow. Indeed, potential conflict of interest in routing orders to HFTs isn’t a new found matter per Klein v. TD Ameritrade. This case could have severe consequences on TD and other brokerages, including possible disgorge years of received rebates. That being said, discount brokerage has served its historic purpose to encourage American to do more stock trading.

Given that the cost of online stock trading is so little for retail investors, are Americans not savvy enough to trade and save enough for retirements? To some extent yes, while many indeed have too much debt and employment related pension benefits are their only investments. Despite pension investments aren’t limited to ETFs and target-date funds, but lousy returns and overpriced services of some active managers have disappointed a lot of people. Hence, they turned passively aggressive – procrastinate in money management, indirectly aggressive against all financial companies, expressing sullenness about market integrity. They did not realize the cumulative effect of everyone putting most of their pension money into passive investment vehicles can result in material impact on market volatility.

I envisage continuous growth in passive investments in the next decade, yet ETFs’ returns would be picked-on by equity index rebalancing arbitration. Then, some of statistical arbitrators’ profits may be snatched up by HFT snipers. Consequently, there are too many hands diluting earnings. Therefore, alpha seekers should honestly ask themselves these questions: are they more interested in the short-term speculative profits, or do they genuinely care about the long-term profit performance of the companies they invested in; does equity “ownership” offers any meaningful values to them, or they just care about receiving an accelerated income stream to meet liabilities obligations? 

Further, if prominent investment managers, like Bridgewater Associates, having substantial ETFs in its portfolio, what does that mean for alpha seeking stock pickers? It means they aren’t getting investment deals as sweet as Berkshire Hathaway (unmatched to the sheer trade size, reputation and what not of Warren Buffett). It also means they aren’t moving as nimble and fast as HFTs. Adding on top of that, discriminated market data price, special tier of payment for order flow rebates, and other nuances (e.g. interactions among  market resiliency mechanisms) would always ensure the vested interest are “more equal” than others. This reflects a ‘winner-takes-all’ market (even runner-ups and lone elite prop trader are not able to compete).

When active managers/ hedge funds/ prop traders struggle in public stock market, Venture capitals (VCs) and Private Equities (PEs) rise up as alternatives.  On a positive note, VCs and PEs are skilled at nurturing new companies, corporate restructure, and unlock asset values, etc. Their existence allows new firms, yet to meet listing requirements, to obtain funding for development. They will also allow listed companies whom no longer are able to deliver quarter-by-quarter fast pace growth to enter ‘intensive care’ / ‘rehabilitation’ through delisting process. VCs and PEs have higher funding cost than banks, but they have the advantages 

of being an informed group and often with board authorities to exert influence on management. The downside is: they are constantly looking for exit strategies after grabbing the most gains from the invested companies.

In contrast, average investors are an uninformed group that often overpay on securities purchase. They may rely on investor protection rules and resiliency mechanisms in a public market to shield them from excessive risks. Truth of the matter is: average investors have bare-minimum ‘rights’ from stock ownership, or significantly less than the rights enjoyed by PEs, VCs, or other gigantic investors.  Exchanges often side with issuers, for example allowing duo-class voting system or tenure voting that detriment to small investors. Although this might be a market reality to fight for new listings against international competition, U.S. regulators and the Exchanges can definitely do more to overhaul the controversial proxy voting process

I recall the 2009 BlackRock iShares proxy campaign that I predicted 50 out of the 178 ETFs would not pass by the first meeting date. My prediction actually did happen. Funds however are allowed to split into multiple proxy meetings. The duration was extended almost indefinitely, as a result, all 178 funds passed quorum after a year-long accumulation of sufficient votes with the management. On other incidents, some corporate managers do not like proxy advisors, hence they lobbying for rules to limit their ability in order to get easier passage on management proposals. From my experience, ISS and Glass Lewis are honorable using objective frameworks to independently recommend votes. Their rigorous approach helps maintain a bit of balance between management and main street investors.

Despite decades of investor education, many investors don’t realize their rights, don’t read the disclosures, and don’t show an interest to exercise rights that come with stock ownership. Because discount brokerage model and proxy process have been working so effectively, main street investors may inadvertently give up registered shareholder rights to become beneficial owners in exchange for inexpensive services. Overtime, such intermediaries costs came back to bite the small investors indirectly.

Sadly, the phenomenon of mistrust between management and investors seems unresolvable via proxy fight. Also, listed-companies aren’t as robust as privatized companies to approve merger/ split/ other corporate development decisions, or there lacks corporate action rule to curb “excessive shareholder payouts”. So, should money be channeled to PEs/ VCs via banking system to achieve the same economic goals? Unfortunately, the Volcker Rule’s covered fund provision limits banks’ sponsorship of PEs/ VCs to 3% in general. Regardless, adding banks in the middle would be another layer of costs. Besides, main street investors would miss out on stock appreciation opportunities when private market is overly competitive with the public market.

In the next article, I’ll discuss issues in the thinly-traded securities segment. Stay tuned.