“Let the Buyer Beware”

is the first lesson any investor should learn. The SEC complaint against Goldman Sachs with regards to a synthetic CDO deal is only the latest reminder of why this old Latin phrase still has instructive powers today.

But, don’t expect much commentary on Caveat Emptor in the coming weeks. Why? Because it is human to get a guilty pleasure from watching the misfortune of others. The Germans even have a proper term for it: Schadenfreude.

One cannot blame the financial media (newspaper, magazine, television, blog) for feasting over every little detail. This story has only just begun. As Professor Bill Black points out in a series of YouTube videos, there were over a thousand criminal convictions in the wake of the Savings & Loan Crisis that wiped out an entire segment of the US financial industry in the late 1980’s. The most stunning statistic to date is that there have been no convictions in the wake of the much bigger and more widespread Global Financial Crisis despite the widely reported fraud that occurred at many levels of the subprime and Alt-A mortgage origination process. Now that the SEC has fired an opening shot at the biggest target on Wall Street, State Attorney Generals will jump on the band wagon. Unlike SEC officials, AGs need to run for reelection. Pursuing the alleged perpetrators of the crisis that has pushed millions of homeowners into negative equity and driven the underemployment rate to 16% will prove popular amongst the voters for several years to come.

Sure, it is fun to watch the mighty fall (or at least get in deep trouble). But, if you want to become a better investor, you need to tear your eyes away from the media circus and learn an important lesson from this affair. The lesson is that “Wall Street” or if you prefer, the sellers of financial products, are not necessarily on your side.

That statement needs to be looked at very carefully. It does not mean that the sellers of financial products are always out to cheat you. It does not mean that all financial markets are a zero sum game where every winner must have a loser on the other side of each transaction. However, it does mean that the firms and the employees of the firms who sell you financial products have priorities that may not always align with yours. It’s called agency conflict.

How does this conflict arise? We need to divide it into two batches:

In the olden days when brokerages and fund managers primarily made their money from selling products and gathering assets, the agency conflict largely arose because financial professionals were compensated by moving product. While the vast majority of investment professionals enter the business to help their clients make money, compensation systems are not set up with that goal in mind. That conflict between the need to make money for the firm and the hope of making money for the client was largely but imperfectly bridged by prospectuses, disclosure, regulation and professional standards. The theory was that transparency should allow investors to make informed choices. In practice, greed and laziness (and sometimes darker motivations) overcame good intentions from time to time.

More recently, however, the large investment banks have come to depend more and more on proprietary trading to pay the bills. This has set up a more serious agency conflict because it is now in the bank’s direct and immediate financial interest to trade against its clients. The relationship runs the risk of turning into that of the casino owner and his customers. And, where prime brokerage relationships allow the “house” to peek at the customer’s cards before placing its bets, the odds appear to be unfairly stacked in favor of the “house”.

Will new regulations fix the problem? Agency problems exist wherever there is a market. Unless the new regulations do away with markets, the answer is no.

What can an investor do?

That brings us back to the title of this article. The lesson of this “train wreck” is that investors must constantly strive to make themselves aware of what is really going on. Investors must not abdicate responsibility for their investment decisions whether for reasons of laziness or greed. The investor must be aware of the risks involved both at the individual asset level and in the portfolio as a whole.

We think the best way to achieve this is to develop a systematic approach to investing. A systematic approach should include at the very least a robust and unemotional investment screening process and a regular review mechanism. The investment screening process is critical to choosing investments based on rational criteria rather than the latest rumor, hot tip or “gut feel”. The review process is equally important because markets are cyclical and even the best investments go down sometimes.

The Fund King System is designed as an asset selection system with a built in review process by investment professionals who have dealt with agency conflicts for several decades. Unlike less independent research operations, we do not have a financial interest in the recommendations of the Fund King System. The system works with your investment universe to unemotionally select assets that have the most likely chance for outperformance in the medium term. Because it refreshes on a weekly basis, mistakes (and there will be mistakes) are caught before they do too much damage to your portfolio. Your assets are regularly redeployed away from underperforming assets and towards those with the best prospect of performing. At the end of the day, that is what investing is all about…positioning your assets so that they can work hard for you.

How does that help you with agency conflict? When you are in control of the asset selection and review process, the Financial Industry’s role is reduced to that of a product and execution services provider. Agency conflicts still exist but the opportunity for abuse is reduced.

If you would like to learn more about how the System works, there is information on this website or you can contact us directly with any specific questions you might have.

Filed under: Market Comment

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