Hedge funds are sometimes perceived as efficient vehicles for redirecting investor capital into the pockets of traders. This is a little unfair, since there is a longer and better established mechanism for the redirection of shareholder capital into the pockets of traders, and it's called an investment bank. The investment entry levels are lower, too. One share of Merrill Lynch, for example, can be had for roughly $55. And there's no lock-up or any real problem with liquidity. Recent performance has been surprisingly robust: Merrill Lynch stock, for example, which can be fairly viewed as a proxy for the investment banking business not least because it remains the world's largest stockbroker, has generated total returns for shareholders of 33% since January 2000. This looks especially good relative to the broader S&P 500 index, which has lost 10% over the same period. Merrill has, however, lagged the CSFB/Tremont hedge fund index, which has generated total returns of 43% since 2000 (and still they say hedge funds don't work).
The shareholder returns from investment banks have been surprising, not least given the tone of equity markets since the bear arrived in 2000. Goldman Sachs called the top of the market, essentially, by finally getting its IPO away in May 1999. They may have been ten months too early, but nobody's perfect. But if the brightest investment banking minds on the planet are sellers, is there much merit in being on the other side of the trade? Surprisingly again, there was: shareholders in Goldman Sachs since May 1999 have subsequently enjoyed total returns of 64%.
But one still gets the lingering feeling that the best days for the industry might be behind it. A combination of a wrenching bear market and Eliot Spitzer have driven a coach and horses through the industry's compliance budgets. Indeed, the cost of compliance has arguably replaced equity research as an economically valueless barrier to entry into the sector. The days of the simple and profitable carry trade are melting away. The bond market rally is entering its terminal phase of absolute insanity, accompanied by some disturbing wobbles in poorer quality credit, having outlived the 18-year equity bull market by some five years and counting. Whoever is aggressively buying government debt at current levels may or may not be desirous of losing money, but they possibly require immediate hospitalisation. Enthusiasm for equity markets (particularly outside North America) remains depressed. The collapse of the age of deference, combined with new technology and the collapse of people's advisory portfolios, has given rise to a general feeling of disenchantment and scepticism with regard to sell side advice in all its forms. Technology is also systematically taking a sockful of wet sand to trading margins and equity commissions. And hedge funds no longer skulk on the periphery of the market.
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Hedge funds and funds thereof have, perhaps not before time, become mainstream investment vehicles. This is almost certainly good news, on balance, for investors, and good news for the best prime brokers, but it carries mixed blessings for middle and lower tier investment banks who, beyond the ultimately inefficient tool of short term bribes, have no realistic way of competing in the war for talent. But the market for investment banking shares is distorted by the amounts of them doled out in lieu of real money to employees - which can be viewed as either an inducement or a penalty, but is certainly the latter for diluted external shareholders. (Separately, we have written about what looks like growing incestuousness between the banks and the hedge funds, which in conjunction with leverage is likely to lead to big dislocations in thin markets whenever everyone tries to bolt for the exit.) And as Bloomberg's Michael Lewis suggested, as far back as September 1998,
'When historians of everyday life look back on 20th Century American capitalism they will be astonished by the role played by our stockbrokers. Certainly, it will be hard for them to explain to their readers the willingness of a prosperous American to hand his life savings over to a more or less perfect stranger in the mistaken belief that a) their interests are identical and b) the stranger has some special insight into the stock market. The reader will regard us with the same awe that we now regard those brave and seemingly mad souls who rode in wagon trains and fought Indians simply to get to California.'
Admittedly Michael Lewis was referring to stockbroking and investment banks fulfil other functions, such as bilking corporate clients into what are statistically likely to be unnecessary and value-destructive mergers and acquisitions ('murders and assassinations' as Bret Easton Ellis called them) only to pop back again a few years later to unwind them and extract more fees in the process.
Relative to other industries, investment banks also have cyclical vulnerability built in, in that their assets go up and down in the lift all day. (This recalls the Dilbert cartoon whereby the boss has to admit that while employees used to be the company's most valuable asset, they've subsequently been superceded by carbon paper.) The Wall Street Journal reports that Morgan Stanley has reacted to ongoing poaching of its staff by curtailing trading activity with competitors. This may or may not strike an objective observer as childish or pugnacious, but it does point to a culture with an ingrained and somewhat anachronistic sense of machismo and individual vanity (add litigation to compliance costs then). Put to one side the fact that the collective noun for full-service investment banks is a conflict of interests.
The slow death of the stock brokerage business has been, pace Michael Lewis, reported before. The genius of American capitalism (notwithstanding the progress made by Deutsche Bank and UBS, there are few genuinely top tier foreign investment banking colossi) has surely been constant reinvention in line with market evolution. But the competitive threats cited above are hardly trivial. On the basis that US equity markets are in for a prolonged period of below average returns - hardly a contentious scenario - the rationale for owning brokerage stocks per se is hardly robust, particularly given the nascent but growing trend for investors and pension savers to self-direct their portfolios.
The inevitable sweep of digital technologies also has to encroach on Wall Street's bread and butter activities - given the size of the vested interests, it's just taking longer than expected, but the barriers to entry are eroding by the day. Deutsche Bank executives have publicly voiced concerns before about what they see as the competitive threat from 'near-banks' and 'non-banks'. In the light of such a confused but fundamentally volatile earnings environment, where so many asset classes now look essentially overvalued, and where senior investment bank employees effectively secure the first claim on corporate revenues, we don't own brokerage or investment banking stocks and in the interests of capital preservation we're not about to start now.
Tim PricSenior Investment StrategisAnsbacher & Co Ltd
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