Is Wall Street Crooked?

April 19, 2014

Michael Lewis’ latest best-seller, Flash Boys, highlights the dark (pool) underbelly of America’s largest casino, the stock market.

First, a brief history of recent revelations of Wall Street shenanigans that cut into your pipeline to corporate profits. This isn't a history of individual frauds and schemes from Bre-X to ZZZZ Best. Flash Boys isn't about a devastating Madoff-esque Ponzi scheme. It's more about how Wall Street as an industry can maim a portfolio with a thousand cuts, the razor of focus this time being sophisticated front running computer schemes.

Recent revelations of Wall Street deceit include:

General initial public offering (IPO) crookedness - After the great dot-com fall, numerous stories came out (always after the fact…) of investment banker shenanigans including, but not limited to: 1) making buy recommendations on stocks the firm was underwriting, regardless of, and often in inverse proportion to, actual investment potential; 2) layering the market with buys ("ladders") to boost an IPO to all-but-guaranteed profits for friends who got in at lower prices; 3) essentially requiring bribes for IPO access in the form of higher commission rates; 4) fixing commissions at high levels with minimal firm underwriting risk to warrant it

Playing favorites – While “Regulation FD or Fair Disclosure” seeks to end  this, Wall Street has historically received market-moving news before the rest of us, and buy and sell accordingly. 

Late Trading Mutual Funds – We’ve written before about how Wall Street (including mutual fund companies) has allowed favored clients (like hedge funds) to trade in and out of their mutual funds after the close of the market at stale prices. This practice virtually guarantees profits at the direct expense of longer-term shareholders, either by watering down the benefit of the up market, or intensifying the downside, in addition to increasing trading costs for fund shareholders. 

To the casual observer, late trading might seem harmless, but imagine you owned $10,000 in a tech stock. After the market closes, a great earnings report is released, and you find out your broker allowed someone else to buy $1,000 of your stock from you at the low price before the good news was reflected in the stock price.

Insider Trading – An ongoing problem that shaves profits from large groups of outsiders for the benefit of insiders. Very hard to stop, even with existing rules and regulations. Often seen as a victimless crime, since victims are hard to identify, and often, like many of these schemes, the thief steals a small amount from many people. 

One way to conceptualize the damage from insider trading is to imagine you like XYZ Biotech, which is trading at $60 a share. You'd like to buy it at a lower price in advance of an important drug trial result You put in a limit order to buy at $55, good until the day before the news is to break. 

Meanwhile, a hedge fund bribes one of the biotech's executives to give them the results a few days early. The news is bad, so the hedge fund sells all of its shares early and then borrows more to sell short, driving the price down and triggering your buy order at $55 – a trade that would never have happened had the insider not sold aggressively on the inside news driving down the stock price. The stock opens at $30 on the day the results are released. You lose, insider wins.

Spreads - Although the difference between a stock’s buy and sell price has greatly decreased in recent years, spreads still cost investors a fortune, especially in the bond market and broker-sold investment market for CDs and other thinly-traded, engineered investment products and options. 

Even today with the old fashioned pricing of 1/8ths and 1/4ths gone, a retail investor can buy a Goldman Sachs Equity Index-Linked Note tied to the Dow for $10,000 and immediately lose $1,000 if they sell it the next day, even with no change in the Dow. That same investor can’t buy more at $9,000. The asking price would remain $10,000.

The Lewis book deals with skimming via high tech front running. Front running has been around forever. Say Fidelity needs to by $500 million of a stock for a large fund. A broker learns of the big upcoming trade and buys the stock for themselves before Fidelity’s orders are placed. They knew Fidelity’s order would push up the stock’s price, guaranteeing them a profit when they sold. This sort of front running is being replaced by the legal supercomputer systems that can identify big trades while they’re happening, and automatically buy or sell securities at lightning speed to take advantage. 

The good news is that the profits of corporate America are so great that even with a little skim, stocks are still the best game in town. Real Estate comes with taxes, insurance costs, and high fixed commission to buy and sell. And bank CDs? The bank pays you near nothing, then pays near nothing for FDIC insurance so you're happy earning nothing, then makes very low-risk loans (usually…) at several percentage points higher than you're earning. 

But what can you do as an investor to minimize Wall Street’s cut? Most of the above skims profit off others trading in one way or another. In general, the ones we mentioned that are older than the Flash Boys problem hurt the smaller investor more. That said, the less you trade, or the less the fund you own trades, the better off you'll probably be. In addition, the lower fees you pay, the less money is going to the middle men.

Our proprietary mutual fund rating system, free online portfolios, and managed accounts seek to minimize Wall Street’s drag by using a mix of low-fee, low-turnover index and actively managed funds. Our fund rating system rewards actively managed funds with higher ratings for being small, cheap, and having low turnover – all features that minimize playing the patsy in Wall Street’s games. 

Flash Boys gives us yet another reason why you’d rather invest in a fund that trades less frequently and in smaller batches. You can’t out-trade the house. You can’t remove the middle men entirely, and I’m not sure you'd want to, anyway. But be aware of the ways Wall Street shears, and try to let them do it off other sheep.