Saturday, March 21, 2015

Proprietary positions, front running & being a pig

“Bulls make money, bears make money, pigs get slaughtered”
- Old adage

Imagine a sales representative trying to sell you a latest stock which he or she claims is going to run up in the coming months. You are told about the wonders of this company and how bright the future is. Now at this point if I told you that his bank holds a large position on it and is on the other side of the trade would you buy it? It would probably surprise you to know that even professional investors at a hedge fund or at mutual funds sometimes fall prey to this situation. These large positions are taken by a portfolio manager within the bank working on a 'prop desk'. After the sub-prime crisis several banks shut down these portfolio management desks and focussed on their core business but you can be sure that something akin to this will be back within the decade.

Every time the brokerage arm of an investment bank is selling you something how do you know they are not selling out their own position? On the flip side how would you know if the brokerage arm was telling you to sell when they were buying for their own proprietary desk?

There is supposed to be regulation in most countries that suggests this to not be allowed. Proprietary desks are on the other side of the ‘Chinese wall’. But do you believe it? Proprietary desks often have the highest paid traders on the firm's payroll on them. They typically yield lots of power within the institution.

Front running is when your brokers respect your investment decision so much that when you tell them to buy something for your they go ahead and buy it for themselves first. With small amounts of capital this may not be a big deal but when funds are buying large percentages of a company then this becomes a very big deal - a big enough deal to be illegal in most countries. Several people I know who trade for hedge funds say that they don’t want large investment banks like Goldman as they have a significant proprietary trading business. This has lead to many a fund to trade with smaller firms. The internet world has democratized the business of stock trading and made it a technology play from an old boys club.

One way to stay away from this problem is to research whether the bank has a position in the company via filings, but filings are only quarterly and they maybe at the start of an operation. Also they could be invested via various legal entities so it may not show up on filings. Some jurisdictions require large financial institutions to club their holdings in their reports. But why not just stay away from buying anything that is being suggested by a large brokerage or investment bank?