How Wall Street Leverages Your Money to Make Their Money

While I love capital markets and what they have done for our nation, I loathe the means by which most investors feel like they must access said capital markets.  Too many people think '40 Act Funds (mutual funds and exchange-traded funds) are the most efficient way to gain exposure.  However, 94% of these funds underperform average (source: SPIVA U.S. Scorecard).  Conversely, others think the best means of accessing "Wall Street" is to invest through a brokerage account at a Wall Street firm.  The following will detail how misguided these approaches can be by detailing how Wall Street firms game Wall Street investors.

Free-riding

To explain this issue, I'll use a personal story from my investing experience.

It was October 8, 2008.  A pretty hectic time in the markets.  Fortunately, I was in cash or even net-short in my margin accounts as markets collapsed.  So I was free from the fog that impacted so many investors.  Earlier in the year, I had liquidated my Master Limited Partnership (MLPs) exposure but continued to follow the space.  Back then, MLPs were not as ubiquitous as they are today.  There were only a couple '40 Act Funds in the space and the biggest was the Tortoise Energy Infrastructure Fund (TYG).  TYG invested in maybe a dozen different MLPs and charged 1.5% for "their management".  Rather than buy the fund, I just bought its 10 biggest holdings and saved my clients the extra expense. 

But I tracked TYG using it as my proxy for the space.  And on this morning, TYG opened trading 50% below where it had closed the day before.  I looked at its top ten holdings and saw them only trading 10 - 12% below the prior day's close.  (Quick tutorial: TYG is a closed-end fund that can trade above or below its true value or NAV, unlike a mutual fund or ETF which has a market maker that keeps its price inline with its fair value.)  My quick math told me that it must be trading at a 40% discount to NAV.  So I bought a block trade that I intended to allocate to my clients. 

Now here is where we need to pay attention.  At the time, I used Fidelity Investments as my custodian.  And here is how block trades work at Fidelity and most every custodian I know of except Interactive Brokers.  The trade is placed in a "master" account owned by the advisor and, subsequently, the shares are allocated to the client accounts.  So, say I have 10 clients and I want each to have 100 shares of TYG, I would buy 1000 shares in my account, and then I would instruct the custodian to allocate 100 shares into each client account.  Sounds pretty straight forward, right?

But here is the issue - there can be a significant time lapse between when the trade is made and when the allocation is provided.  I bought TYG at around 9:30 am CST.  But I didn't have to send my allocation to the custodian, Fidelity, until well after the market closes at 3:00 pm CST.  Anyone who was around in 2008, or in 2020 for that matter, knows that a lot can happen between 9:30 am CST and 3:00 pm CST.  And in this case, a lot did happen.  The stock nearly doubled by the close.  My intraday gains were well into the six-figures.   

When I bought the stock at 9:30, I fully intended to allocate shares on a pro-rata basis to all my clients.  But no one else in the world knew that.  Only me and my Heavenly Father.  And had it not been for the latter, here is what I could have done.  I could have easily a) sold the shares and booked the entire profit into my own account or b) allocate all or a disproportionate number of shares to my own account.  Either way, nobody on earth could have proven what my intentions were that morning.  It is the perfect crime.  And one that I believe is perpetuated every single day by nearly every single Wall Street firm.

I have to be honest.  I sat there with my finger on the mouse button hovering over the send button for quite some time.  The gains in this one trade dwarfed my salary for that year.  But in a moment of either weakness or strength, I don't really know, I sent the allocation for all my clients.  But I am afraid, too many persons with this opportunity do not.  

Today, we use Interactive Brokers for our clearing firm and our trades are allocated in real-time making it virtually impossible to free-ride our clients for our own gain.  But I promise you, if are invested in mutual funds or separately managed accounts at a big Wall Street firm, today, or tomorrow or the next day, someone will have the ability to free-ride your account and I imagine they will.    

Front-running

Front-running is the act of buying and or selling the firm's own account and subsequently buying or selling the same security with client funds to push the price further in the firm's favor.  For example, say a firm manages $10B in AUM for their clients and the manager has his own $1M account.  A 5% allocation in a $10B fund would be $500M.  Buying and selling a $500M position will certainly move the price of any stock, especially a small-cap or mid-cap name.  If the manager buys in his account first, then the subsequently purchases it in the fund, it would certainly have a positive impact on the price of his original position.  And in the day of momentum traders, the impact could be compounded by attracting additional assets once momentum is established. 

On the way up, this can be problematic.  But when stocks are declining, it can have a far more negative impact.  Any person studying capital markets for any length of time knows that stocks tend to fall much faster than they rise.

When stocks start to decline, there often isn't much time to get out.  When the manager can sell his or her positions first and then dump his or her fund's positions, it gives the manager a huge advantage.  Goldman Sachs famously did this in the winter of 2007 dumping all their mortgage exposure before selling their clients' positions. 

Pump and Dump

 

Another favorite Wall Street scheme is the ol' Pump and Dump.  This is where they talk up or talk down a security in their favor before making a trade.  How does JP Morgan Chase record revenue and profits in the worst stock market in 12 years?  Goldman Sachs is notorious for some horrendous calls on oil that I track on this site.  Did they really think oil was going to $200 in the summer of '07, or to $30 just six months later?  Any time GS makes a call on oil, its a pretty safe bet to fade is as they are merely "talking up their book" and taking the exact opposite side of the trade they are recommending (See some old posts outlining this outright deception by one of our nation's largest financial firms). 

If our clients subscribe to IB's data, they will get analysts updates with "upgrades" and "downgrades" for the stocks we own.  And it only takes tracking these for a short time to figure out the stock almost invariably moves opposite of the call made by the firms making the call.  A sure sign they are pumping and dumping (or they need to find a new job).