econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 14 October 2017

Corruption In The Financial Industry: Is It Affecting Your Investments?

by Elliott Morss, Morss Global Finance

Introduction

About half of all Americans own stocks, either individually, in pension plans, or via mutual funds/ETFs. A breakdown of their holdings appears in Table 1. Note that individual holdings are greater that their mutual funds/ETF holdings combined.


Please share this article - Go to very top of page, right hand side, for social media buttons.


Table 1. - US Individual Holdings (bil. US$)

Source: Federal Reserve, Investment Company Institute

There are many ways that “behind the scenes" activities could be hurting investors, including corruption. Corruption? Is that not being a bit extreme? Maybe not. Why else was an organization formed to promote five core principles for investment advisers:

  • Put the client’s best interests first;
  • Act with prudence, that is, with the skill, care, diligence and good judgment of a professional;
  • Do not mislead clients - provide conspicuous, full and fair disclosure of all important facts;
  • Avoid conflicts of interest;
  • Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

One might wonder why such a standard is needed. The answer is because the financial industry is rife with potential conflicts of interest and corruption. There are at least two important ways in which equity owners might be affected:

  • The execution of trades;
  • Equity choices.

Executing Trades

Equity brokers must, under federal trading rules, provide “best execution." That means in part getting the best stock prices for clients. But not all buyers are treated in the same way. And commissions from trades differ. The rules also recognize that for some trades, getting the best price is only one part of best execution. The speed, size and other costs of a trade must also be considered.

Research presented at Senate hearings show that under the guise of making subjective judgments about best execution, brokers were routinely sending orders to venues that paid the highest rebates. For example, in the last quarter of 2012 the brokerage TD Ameritrade sent all nonmarketable customer orders - those that can’t be completed immediately based on the market price - to the one exchange that paid the highest rebate. In the first quarter of 2014, it sent nonmarketable orders to two venues that paid the highest rebates.

Are these rebates really bribes? I quote Senator Carl Levin, Chairman of the Senate Permanent Subcommittee on Investigations: “It is a frankly pretty incredible coincidence" that TD Ameritrade’s judgment on best execution invariably led it to use the brokers that paid the highest rebates. Under questioning, an executive of TD Ameritrade conceded that in the trades cited by Levin, the firm had almost always used exchanges that paid the most. He also estimated that the firm made $80 million in one year from maker-taker rebates. I cite TD Ameritrade only as an example of a practice that is widespread.

In 2012, a study by Woodbine Associates estimated that rebates cost individual investors, mutual funds and pension funds as much as $5 billion a year. Of course, stocks are sent to exchanges with inferior prices for reasons other than rebates. And the study’s tally includes those losses. But the authors said that the primary reason for bad routing decisions were the rebates. Thomas W. Farley, the president of the New York Stock Exchange, has said that a system in which exchanges pay rebates to brokerage firms for orders, created “inherent" conflicts.

But how important are these rebates for the individual investor? The study mentioned above estimates that investors lost an average of four-tenths of a cent on each of the 1.4 trillion shares traded in 2011 because of orders being sent to exchanges that were not offering the best final price.

And how about other cost and benefit differentials? NerdWallet looked at this and here is what they found:

High Speed Execution

  1. Schwab - 0.12 seconds
  2. TD Ameritrade - 0.20 seconds
  3. Wells Fargo - 0.21 seconds

Percentage of Trades Price Improved

  1. Wells Fargo - 88% of trades price improved
  2. Schwab - 84% of trades price improved
  3. E-trade - 79% of trades price improved

Amount of Price Improvement

  1. Interactive Brokers - $0.0144 average price improvement
  2. Wells Fargo - $0.0049 average price improvement
  3. Scottrade - $0.0044 average price improvement

Best Value for Fast Execution

  1. Cobra Trading - $1 for 0.46 second average execution
  2. TradeKing - $4.95 for 0.30 second average execution
  3. Schwab - $8.95 for 0.12 second average execution

So what does this all mean for the individual investor? Not much. The differentials here are quite small. But you will probably do better if you invest via an ETF/Mutual Fund than as an individual investor. Because of their size, they will probably receive better executions.

Equity Choices

I am a regular reader of Pensions & Investments. The periodical is full of money manager promos. They all use numerous descriptors/principles that they claim govern their investments like “The Wellness Effect", “Pure Value", “Diversity", and “ESG Investing." You rarely if ever hear them discuss the reasons behind their purchases of individual stocks along with what did not work and why. As a case in point, consider how pension funds operate and decide what to buy.

The first thing a fund does is create a committee to decide what to invest in. It hires a consultant to help it determine who should invest their money. This approach might appear a bit cumbersome. It is. But it accomplishes a key task: it removes the direct responsibility for the investments from the pension fund committee.

So pension committees hire consultants to help them decide who manages their monies. One would be hard-pressed to devise a more inviting scheme for corruption:

  • The consultants could bribe pension committee members to agree with them;
  • The consultants could get paid by potential fund managers to hire them;
  • Potential fund managers could pay committee members to hire them.

In most cases, these bribes are not discovered. But they do happen. For example, consider what happened at the California Public Employees’ Retirement System (CalPERS), the second largest US pension fund. In January 2015, Alfred J.R. Villalobos, a former CalPERS board member committed suicide. Villalobos faced trial on federal corruption and bribery charges for allegedly earning about $50 million as a middleman in winning CalPERS investments for private equity managers.

And Villalobos was not alone at CalPERS. Federico Buenrostro Jr., Chairman of the CalPERS pension board along with pension fund board members Charles Valdes and Kurato Shimada - strong-armed a benefits firm to pay more than $4 million in fees to Villalobos. Buenrostro pleaded guilty to a conspiracy charge and admitted that he took more than $250,000 in cash and other bribes from Villalobos. Buenrostro was sentenced to 4 1/2 years in prison.

Unbundling Commissions and Research Costs

Gretchen Morgenson recently wrote a piece highlighting regulatory changes taking place in Europe. First, a little background. Big institutional investors buy investment research from brokerage firms. This sounds odd. One would think these large investors would do their own research rather than pay brokerage houses for it. And of course, such an arrangement offers up a wide range of potential conflicts of interest: brokers write positive research in hopes of generating commissions. On top of this, payment for these research services is bundled into the commissions charged by brokers.

The European rule change will require the charges for research and transactions to be unbundled. They will require payments in hard dollars for both research and trade executions.

There are several problems with the research/commissions bundling. Investors do not know what they are paying for. In addition, the bundling ties an investor to a firm regardless of how well or poorly it executes an investor’s trades. One would hope that small firms generating good research would be hired. But under the current setup, they will not. The new rule will make it possible to monitor best execution and encourage the creation of high-quality independent research companies. Tyler Gellasch, executive director of the Healthy Markets Association, a nonprofit organization focused on improving the integrity of the nation’s financial markets says:

“Separately shopping for research and trading will significantly reduce investors’ costs. That directly translates to higher returns and more money for retirees and college savings funds."

The US does not appear to be following the European lead. Lobbyists for the securities industry oppose the change. Their argument: broker-dealers that publish analysts’ reports would have to register as investment advisers. And this would subject them to an additional regulatory burden. This sounds like complete nonsense: rules are in place for investment advisers and that is what broker-dealers are when they do research reports.

Conclusion

What should the individual investor draw out of this? Table 1 indicates US investors hold $12 trillion directly in equities, or more than their holdings of mutual funds and ETFs combined. Picking individual stocks is a risky business. You are probably better off and safer if you invest via mutual funds and ETFs. And keep an eye on how your pension monies are being invested.

I conclude with a quote from Warren Buffett:

“Over the years, I’ve often been asked for investment advice, and in the process of answering I’ve learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund. To their credit, my friends who possess only modest means have usually followed my suggestion."

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Investing Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.




Econintersect Investing








search_box
Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.







Keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government





























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2017 Econintersect LLC - all rights reserved