Wednesday, March 18, 2015

Financial intermediaries & the principal agent problem on Dalal Street

 "Stay away from anything that an investment bank is selling. Their bread and butter depends on their sales skills not their investment skills."

- Rephrased Buffet saying

    Financial intermediaries are typically compensated in a manner that drives their interest contrary to investors. Let’s think about how most financial intermediaries make money:
  • Proprietary positions - Would you like to buy something the bank wants to sell from its own portfolio?
  • Investment banking fees - If you know that the bank was paid 6% of IPO proceeds then you essentially at least loose 6%, and because the bank puts its best salesmen at IPOs you can be sure that its not just 6%.
  • Brokerage fees - Doesn't take a rocket scientist to figure out that a broker wants you to trade in and out as often as possible irrespective of the return.
  • Research coverage - If a company promises an investment bank its market offering or other business isn't it more likely to give it a high rating on research? If not why don't sell side research analysts clearly state their investment performance.
  • Leverage given to investors - The bank makes money on money lent to you. Wouldn't they want to lend as much as possible as long as they know they can liquidate your portfolio fast enough to not loose the entire capital?
  • Sales commission for distributing financial products - If you know that 1% of the mutual fund you buy goes to the broker and then there are entry, exit loads and several fees. Would you still buy it?
  • Asset management (Mutual funds, hedge funds, etc.) - If you are being pitched a fund and that is the only fund that the asset manager runs and it has a great track record maybe you could consider it. If the asset manager runs 20 funds of which 2 are outperforming the market how does that tell you that the asset manager is generating alpha?
  • New financial products - This is the highest risk and most fun. I am going to cover how people have been fooled in the past - even sophisticated investors and asset managers by financial products innovation. As a rule of thumb financial products innovation is designed to increase the EPS of the innovating investment bank not your net worth.
The primary principle that I am trying to drive home is that never buy any equity that is being sold by Wall Street or Dalal Street or any bank or financial intermediary. These institutions are selling machines. They run through several training programs that try to sell you several financial products which might sound excellent to you but when you do the analysis they might not sound as good. Now I am not saying you ignore what your trust broker of the last 2 decades says or that you cannot find a good and honest broker. But before you bring the broker into your circle of trust please evaluate the value of the ideas presented forth in an unbiased manner. I will run through each of these scenarios to describe how they are not very good for investors in the next few articles.