Expert Networks: Elephant Trap?

According to Integrity Research, “at the end of 2007 at least 26 firms generate between $325 and $375 million in sales by providing expert network services to the buy-side.”

It’s undeniable that the demand for experts of all shapes and sizes has grown exponentially in the past couple of years, and will continue to grow as market volatility drives the need for more information upon which to base trade ideas. Since the implementation of RegFD, it has been increasingly hard for investors to ‘go to the source,’ for any useful/actionable information, so expert networks are a seemingly sensible way for hedge funds and other institutional investors to get a lay of the land without having to wait for company ‘spiel’ to be released.

But, with no real obligation to properly serve the interests of investors, the ‘experts’ – no matter how carefully ‘vetted’ by the network itself – are still not in any way, shape or form, accountable or held to the same standards as a Registered Investment Advisor (RIA). The further these networks expand, the more difficult it will be for networks - and regulators - to keep a pulse on credibility and expertise.

Because regulation of pure-play expert networks is still rather lax, the level of accountability for the experts themselves is minuscule. There has not been a major incident…yet. But if there were to be a major incident today, the information provider (expert) is not held accountable by any standards at all…which should cause investors to proceed at their own risk.

Of course hedge funds and other institutional investors are, by and large, big boys and girls, who should be able to make decisions for themselves about information they find credible and information they do not. But if one of these institutions loses millions or even billions after being mislead (purposely or not purposely) by a so-called 'expert' – who will be to blame?

More Landmines

Beyond the lack of regulatory oversight, there are two other downfalls for pure-play expert networks. The first is that these experts are not exclusive to any one network. So, in essence, these experts could be delivering the same insights to all of your competitors – or worse, in cahoots with the competition. With some hedge funds and other entities choosing to launch their own expert networks, it’s clear that many are not comfortable with the lacking exclusivity that exists in the industry.

The other downfall is that expert networks are a purely ‘pull’ model. What we mean by that is, you have to have the ideas first – there is no dialogue, or anything coming in to you. So, sure, you might wake up this morning and decide that pencil erasers are the next big thing, and you can find a whole range of experts to tell you why they are, why their not, and even put together a custom report outlining how and why – but you have to conjure the notion of pencil erasers as the next great investment all on your own.

At StreetBrains, we believe that the true value of expertise, in any realm, is for experts to offer both ‘push’ and ‘pull’ insights. StreetBrains calls this model the Actionable Information eXchange (AIX.) More specifically – after enduring our stringent vetting process, analysts are accessible and available to discuss incoming ideas, but also push out to clients fresh information and ideas they are encountering as they assess the markets. Furthermore, this information is delivered exclusively through StreetBrains research HUB, to a finite number of customers.

To learn more about the benefits of the StreetBrains AIX, click here.

We Called It

As the adage goes…

“It ain’t braggin’ if it’s true!”

StreetBrains analysts have spent the first 24 days of 2008 beefing up the benchmark for correctly calling market moves. Below are some of the items that StreetBrains independent analysts have nailed in the past few weeks.

(See how smart analysts can be when they’re able to say what they’re really seeing and hearing, rather than being muzzled by investment bankers, traders, and compliance departments?)

Steve Digilio, The Bank Notes, told us in November ’07 that ’08 would bring at least one major bank consolidation or acquisition, and 3 top bank CEO departures/ousters. 24 days in, we have already seen Countrywide acquired by Bank of America, and Jimmy Cane step down as CEO of Bear Stearns.

In September ’07, Larry Rothman of DebtVisions made the definitive call that retail was in a tailspin. To date (from his call on 9/28), the RLX has declined 13.8%.

On January 9th, 2008, Jim Sterling of the Sterling Account (who was up a whopping 44% last year on his calls) wrote a report titled “Throwing In the Sponge” where he advised the exiting of all energy stocks. He still loves many of the companies, but the stocks are going to continue to be battered for a long while out, he claims. Since January 9th, the XLE is down 7.95%.

Gotham Research proves that there’s money to be made, even in a bear market – if you’re nimble. The following 3 pairs have brought in generous returns when closed out today:

IEF/XLE – iShares Lehman 7-10 Year Treasury Bond Fund vs. Energy Select Sector SPDR Fund. Closed long IEF and short XLE spread from 9/21/07 with an advance of 26.04%.

USB/SPY – U.S. Bancorp vs. SPDR Trust Series I. Closed a long USB and short SPY spread from 1/10/08 with an advance of 17.35%.

ONB/VTI – Old National Bancorp vs. Vanguard ETF Total Stock Market. Closed a long ONB and short VTI spread from 12/12/07 with an advance of 18.46%.

Last but certainly not least, Steve Frenkel of PatternWatch, whose several CNBC appearances in the past few weeks you can find in blogs below, has also been consistently spot on in calling the Dow, S&P, Gold, and CCI Index moves. Click here to view his most recent television appearance, where he discusses the current state of the market.

Wall Street Sings the Executioner's Song

Yesterday, Sara Hansard at Investment News wrote a brief update announcing that the SEC will soon be releasing new guidance on soft dollars. Although there is no indication that the SEC plans to mandate the explicit separation of research dollars from execution dollars, it seems clear that they endorse the value this separation of services brings to investors, and will be watching carefully to be certain that firms are providing this level of transparency to their clients.

In the article, Jennifer McHugh, senior adviser to the director of the SEC’s division of investment management explains that the separation of research and execution has “had a positive result.”

Although soft dollars (or CCAs/CSAs) were not immediately embraced by most large U.S. brokerage firms, the inevitable separation of research from execution services is leading many large firms to seek opportunities to partner with independent research providers (IRPs). By doing so, these firms are hoping to keep a tight leash on their execution dollars - even if it means abandoning their own in-house research offerings for the more lucrative/less overhead option of IRP partnership.

To no one’s surprise, in-house research may once again face the internal firing squad, as their execution-focused counterparts have increasingly less success selling their commoditized research.

The New Arm Candy

While IRPs may be the new arm candy for execution providers to shop around to clients, this could potentially be a detriment to the end user. Great research will have a difficult time setting itself apart from the pack as more providers gain the ‘endorsement’ of execution firms who are looking to coattail on IRP trade ideas by securing the execution business on the back end of the trade.

For this reason, anyone using independent research will need to be very selective about research providers they choose to work with. The vetting process for finding quality research is a critical component for finding top quality ideas and insights.

Click here to learn more about StreetBrains vetting process.

Frenkel's 'Tea Leaves' Suggest Throwing in the Towel

For the second time this week, Steve Frenkel, chief technical analyst with PatternWatch - a member of StreetBrains' Actionable Information eXchange (AIX) - was invited to come on CNBC to discuss his views of the market.

In a segment titled 'Reading the Technical Tea Leaves' on today's 'Powerlunch' program, Steve got to talk about what he does best: analyzing and interpreting technical charts.

Although Frenkel's assessment of the current state of the market may not coincide with popular opinion, he certainly doesn't lack conviction in his calls (as Michelle Caruso-Cabrera points out.) And to the dismay of many investors, his calls for a vastly declining market have been spot on.

Click here to view the segment.

Gold Losing Its Luster

Yesterday, StreetBrains technical guru – Steve Frenkel of PatternWatch – was on CNBC to discuss whether or not there are still investment opportunities in Gold.

While Douglas Doyle of Blanchard & Company (which on their website boasts they are “the largest and most respected retail dealer in rare coins and precious metals in the United States”) called for Gold to reach $1150 this year (shocking prediction from a firm that specializes in precious metals), Frenkel countered that Gold technical indicators show that Gold is well on it’s way back down to $720.

At the time of this posting, Gold sits at $877, down $33 from where it was yesterday just moments prior to our CNBC appearance, and down $39 from it’s $916 high (which Frenkel had previously targeted as the high).

Click here to watch the video.

The ‘Race to Zero’ Zooms On

The fact that commissions are drying up, and that brokers are competing over a half or a quarter of a penny at this point to win execution dollars, is nothing new. However, the Race to Zero will kick into high gear in 2008, as research desks get slashed at large firms (which used to be an ‘add on’ that justified higher execution pricing), and the surge in unbundling execution from research sends clients searching for best execution providers.

Brief History

With the onset of the tech era, commissions started facing their first hurdles in the 90’s. New execution providers flooded the market promoting faster and cheaper execution than ever before. Existing brokerage firms were able to implement similar technologies that also touted volume scalability that kept them in the game. As technology improves commissions become increasingly more commoditized, and thus coined was the ‘Race to Zero.

Current State of the Union

Large brokerage firms now look primarily to volume, not pricing as the key to feeding the execution beast. However, as most large brokerages look to slash their workforce, the research departments – long considered a ‘cost center’ and often referred to as the ‘red-headed stepchild' of the brokerage world – will certainly take a hit. With less research being written internally to justify higher execution pricing, unbundling research will almost evolve organically from the current issues in the market.

Mid and small executing brokers who provide research – despite their hopeful musings that the sky is not in fact falling - are facing some trouble. Many seem to have hung their hat on the idea that hedge funds want to continue to use an over-abundance of executing brokers, so that competitors won’t be able to follow their trading patterns. Based on our talks with market insiders, this notion seems rather unreasonable. We’re not suggesting that any hedge fund out there is handing his entire trade book over to one execution firm, but minimizing the number of executing brokers is not only something most have said they’re willing to do – from a cost point of view, it’s a priority.

Mid and small guys who recognize the threat on the horizon still have the opportunity to choose a business, any business – either research OR execution – not both – and have a chance at survival.

Alpha or Artifice?

A story titled “And God Created Alpha” from the January 5th edition of The Economist, knocks some fund managers off their high horses by making an important point about replicators and other tools/products being developed to mirror the returns of well-performing funds:

“…If those returns can be reproduced by a set of mechanical rules, is skill really involved?”

We’re not here to throw under the bus any fund managers who’s masterpiece-like returns have made them the idyllic poster-children for knock-offs and frauds, but investors should know that the faux-Picasso and the Canal Street Prada purse have found their way to the fund industry. The difference here is – if the returns are the same, will anyone care that it’s a fake? Probably not.

In a volatile market where hedge funds themselves are not able to generate the same volume of returns, can replicators really find their place in the market? Or will it be survival of the fittest, where only the top performing hedge funds will survive, the rest will fold, and replicators will vacuum up the dollars left behind by the vacating failed funds and go on to match the leaders?

Is there such a thing as ‘alpha’? If replicators succeed, will ‘alpha’ find itself thrown into a category with wives’ tales and urban legends? It could be a true concern down the road, but for now, replicators can’t win if they don’t have great fund performance to replicate. So, at very least, the top-performing funds won’t be closing their doors anytime soon.

However, with these new competitors trying to steal a piece of the pie, there won’t be any room for mediocre performance amongst hedge funds that have been riding the gravy train of ‘hedge fund’ allure. Where artifice substitutes for alpha, there will be abundant failure.

Securing Alpha

The surest way to ward off replicators is to outperform the indexes. Funds that find top-quality research and information to set them apart from the pack will be crucial if they are to outperform ‘synthetics’.

As The Economist story points out, “it’s certainly not a crisis yet…but it ought to be a long term worry.”

StreetBrains Top Reads for 2008

If you haven’t already immersed yourself in the following books, you’re missing out. Some are new, and some are ‘oldies but goodies’ that stand the test of time, but all are required reading for any self-professed market junkies. Enjoy!

Mavericks at Work: Why the Most Original Minds in Business Win
by William C. Taylor, Polly G. LaBarre

Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning
by Katherine Burton

The Predictors
by Thomas A. Bass

Blood on the Street: The Sensational Inside Story of How Wall Street Analysts Duped a Generation of Investors
by Charles Gasparino

(an oldie but goodie…or a great re-read!)
Liar's Poker: Rising Through the Wreckage on Wall Street
by Michael Lewis

The Coffee Trader
by David Liss

Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score
by Andy Kessler

My Life as a Quant: Reflections on Physics and Finance
by Emanuel Derman

The Last Tycoons: The Secret History of Lazard Freres & Co.
by William D. Cohan

The Dark Genius of Wall Street: The Misunderstood Life of Jay Gould, King of the Robber Barons
by Edward J. Renehan

Wall Street Analysts Avoid the “B” word

If you were off drinking egg nog martinis in Saint-Tropez in late December, you may have missed “Settling for ‘Hold’” - a very informative piece of commentary from Bloomberg’s David Wilson. (click here for full story.)

Wilson first relies on Bloomberg’s own database of research to present his case. Most notably, he points out:

• Just 43 percent of the calls made [in December were] buy ratings or equivalents, including ``overweight,'' ``outperform'' and ``accumulate,'' according to data compiled by Bloomberg. The percentage is the lowest since these numbers were first tallied a decade ago.


• Sell ratings and comparable calls have amounted to 5.7 percent. That's less than half the peak reached in July 2003, when brokerage firms were reeling from then-New York Attorney General Eliot Spitzer's investigation of Wall Street research.


• Analysts are retreating into the relative safety of ``hold'' recommendations, telling investors who own shares to keep them and those who don't to avoid buying them. The number of ratings in this category surpassed 50 percent for the first time in October and rose to 52 percent this month.

Wilson goes on to make an important point. He says, “Analysts' growing reluctance to say ``buy'' on companies, including securities firms, is understandable. U.S. stocks more than doubled, as measured by the Standard & Poor's 500 Index, in the five years ended Oct. 9. They have since gone through a so - called correction, or a more than 10 percent loss.”

We agree that collectively, it is understandable that analysts have been reluctant to say ‘buy’ and that the overall sentiment of the market led the ‘abundance of ‘hold’ calls. However, we also think that the reluctance of analysts to seek out new ‘buys’ sheds light on the fundamental problems inherent in the Wall Street research model.

When analysts are siloed off to exclusively cover specific companies, they are pigeon-holed into making some sort of call on those names, rather than seeking out new names that are more primed for investment. If the sector the analyst covers doesn’t do well, their position may become obsolete within their firm. This is precisely the problem – an analyst who is on the front lines is most qualified to see trouble in the sector or company he covers. He should be rewarded for identifying coming problems and threats - not punished by his firm, or stonewalled by a company he downgrades. The model is inherently flawed.

We’re not suggesting we have the solution for fixing the way research is handled, but we do believe that the industry is long overdue for an overhaul. The current model is not scalable, and does not lend itself to improving the quality of research.

A Ray of Hope

One encouraging sign reflected in Wilson’s story was uncovered in research conducted by Greenwich Associates:

Stock recommendations dropped to 8 percent of commissions from 18 percent during the period, the Greenwich, Connecticut-based research and consulting firm found.

This finding suggests that good information and new insights and ideas – not straight stock recommendations - are gaining ground as the benchmark for quality research. This is not particularly helpful to research desks at large brokerage firms, where stock recommendations will continue to govern coverage until ‘the powers that be’ come to their senses – but for independent analysts and research firms, like StreetBrains, this shift can be capitalized upon immediately by increasing the information channel, and scaling back on stock recommendations.

In our experience, PMs are plenty qualified to pick stocks, and don’t really need many recommendations from outside sources. What they do appreciate are new insights and valuable information upon which to base those picks.