Pointing out the Obvious

I wrote this for the 1-2 Knockout blog, but it is reposted here, enjoy:

Pointing out the Obvious

Over the course of the past year, I've spoken with a large number for brokers/financial advisors at my firm, and while I attempt to give them the benefit of the doubt, often I am left disappointed by their ignorance of most things finance (especially things that don't add to their bottom line). Just the other day, I spoke to a financial advisor (intentionally lower-case, btw) who asked if I knew if we published any research on Bear Stearns, so he could read it and advise his client(s). Besides the fact that this genius lacked the ambition to literally make 4 mouse clicks to navigate the intranet site to exactly where he wanted to be, I found this situation to be exemplar of far larger issues at hand. On the surface, this points out what for many in the Financial community is already a foregone conclusion, that retail brokers are wholly unqualified to offer any sort of financial advise.

Historically, financial advisors and brokers have offered various investment products such as equities, 'straight' fixed-income (corporate, preferred, muni, etc), annuities, and insurance. While I strongly doubt the ability of any financial advisor to value such a simple product as an annuity, Brokerage firms generally provide various planning tools allowing their advisors to simplify this process and explain returns, risks, etc to their clients when selling these traditional products. However, today (and this is not new, by any means), advisors routinely sell clients on various structured equity and fixed-income products that are far more complicated to value and understand than traditional investment products. Somehow (and this is another issue altogether) advisors are able to pass their NASD (FINRA) licensing exams, yet in my experience more often than not, do not understand these structured products in which they are investing their clients money. How many brokers and advisors are going to read a prospectus for a leveraged principle-protected structured note tied to the value of a basket of currencies with an embedded call option on them? Further, how many could say, model the cash flows or even sketch a chart of the payoff profile of such a security, let alone discuss the specific economic conditions which could affect such an investment?

I'm curious as to what liability a Firm has in such cases. Admittedly, I'm no Lawyer, but it seems to be the case that arguably the only protection Brokerage Firms have in this respect is the ignorance and indifference of their clients. Essentially, Brokers are playing the waiting game, betting on the probability that clients won't lose enough money due to (or at least in part to) 'bad' advice (in quotes, as that is clearly a relative term) so as to compel clients to take legal action. Its a liability management policy based almost solely on a hope and a prayer, that future returns will be similar to historic performance, and that nothing 'really bad' will happen.

What we're seeing now though is this lax liability management coming back to hurt the Brokers. Recently, UBS was served with a class-action lawsuit over the marketing of Auction Rate Securities (see WSJ: UBS Sued over ARS). A detailed explanation of these securities is beyond the scope of this post, but essentially they were sold to clients as almost-cash investments which could be redeemed for cash on a weekly (although monthly, and longer-term reset periods exist) basis, while earning an attractive return relative to other liquid cash-like investments (e.g. money market funds). I'm sure the fine print somewhere includes language that the selling Firm in no way guarantees the success of the auctions (i.e. no guaranteed liquidity), but when considered with the actual pitch these products were sold upon, I doubt that this will offer Firms much protection against lawsuits.

What we see now is that for some years, the success of these auctions and the liquidity they enabled - a critical selling point for ARS - was due to the underwriting/offering Banks and Brokerages propping up the auctions on their own account. In the past few months, as these same Banks/Brokers have reallocated capital due to credit market conditions and losses, they have ceased to support many, if not all of these periodic auctions for their clients. Thus, clients who were essentially promised liquidity have none (or some, if they're lucky) and their 'cash' is completely useless to them. As if this wasn't bad enough, Brokers are adding insult to injury and, in their great benevolence, charging clients interest to take out loans using the ARS as collateral. This seems to be the epitome of usurious, bullying behavior and breach of fiduciary duty at best, and criminal at worst (although thats a claim for the lawyers er, courts to decide).

Only time will tell how this class action and subsequent ones that are sure to be filed against other Brokers will play out, but I imagine that it will not work out very well for the Brokers/Banks. I also don't want to focus solely on this issue, since it is simply one example which shines light on the potentially enormous legal liability of ignorant and unqualified brokers and sales policies/procedures/literature which do not accurately explain investment products in their entirety.

Taken further, one could even question why in this day and age, what purpose brokers and financial advisors actually serve, when one could just as easily open an Ameritrade/etrade/etc account and do the work oneself. The reason for the continued existence of the profession though is not due to their specilization and expertise in providing financial advise, but for the same reasons why virtually every other brokerage type business (e.g. realty) exist: laziness and indifference. People don't want to be bothered with the minutiae of managing their finances, of doing due diligence and research on their investments and potential investments. The problem though, is if the advisor can't do that, then why are they trusted to do so, and so handsomely remunerated for services not performed?

Lichtenstein vs. Germany: Slippery Slopes Abound

So for those of you who (apparently, like most of the blogosphere) have glazed over this little fiasco, check out the WSJ's solid summary of the situation here.

While the Journal does a very good job explaining the facts surrounding the controversy, they don't take it out a step further to consider the implications of, and myriad questions raised by German investigators' actions.

Is it now not only commonplace, but a widespread and acceptable method of obtaining information in an investigation to blatantly pay employees to steal from their employers? Are the tactics employed by German investigators against firms essentially owned by another sovereign nation right, in the legal, ethical, or even pragmatic sense of the word? Taking this one step further, I cannot help but wonder as to how widespread such practices are, and to what extent or magnitude they are practiced. The next question really though, is where does it end? One could very easily make the argument that such tactics amount to the very same espionage practiced by the KGB or CIA during the cold war, if not worse, since the perpetrators are open about their espionage, and yet still completely unapologetic, as if Germans are rubbing it in Lichtenstein's face.

I'm not exactly an expert in Euro-zone or Lichtenstein law, but there are many things going on here that suggests the truth of the matter might be more complicated than it seems on the surface. If all is as the Journal would have us believe, one might imagine Lichtenstein banks having more recourse against the employees who stole client data and attempted (sometimes successfully) to blackmail the Banks.

Any readers out there familiar with extradition or employment law in Eastern Europe?

Welcome Back to the Blog!

So, admittedly its been quite a while since my last post (although I've racked up quite an impressive inventory of drafts), but I'm back, rip roarin' and ready to go!

A Few things you'll be seeing in greater detail in the near future:

• My reaction to the WSJ article today (2/6/08) mentioning Disney's relatively miserable quarterly results, buoyed by solid results in the Cable & Networks division. While I haven't read through the 10-q, I expect ESPN (and its sub networks) had ALOT to do with it. I still have more research to do, but lets just say I am OFFICIALLY calling for Disney to investigate a carve-out or spin off ESPN from the rest of the Company.

• A discussion of human nature in corporate environments, namely (mid-level) managers' propensity to act not in the best interests of the company or its shareholders, but in such ways that actually damage those interests. Lets just say I've spent some time 'in the trenches' this past year, and its given me the opportunity to see dysfunction the likes of which I had previously thought impossible. I will also seek to discuss methods of dealing with this.
  

• Many of my reactions to the undulations of the Equity and Credit markets, and the Economy in general, with special focus on the underlying causes of our current predicament.
  

• Various investing strategies , some relatively original, others not so much.

• Aaaaand, last but certainly not least, my reaction to news, events, and the writings and rantings of others (especially so-called "experts").

So, I look forward to hearing from you, engaging in (semi) intelligent debate, and of course, bringing you new and unique perspectives in Business, Technology, and Innovation!

Getting Real with Hedge Fund Regulation

For the Government to get in the ring and try to further regulate hedge funds would be like me trying to referee a Cricket game. I could probably go in there and just assume this and that is right or wrong, but I'd be interefering with the game, with the competition. And just as in Cricket, that is how the free market operates. Sometimes you win, sometimes you lose, but you'll never be punished by the Ref changing the rules in the middle of the game.

Ok so here's the deal:

Hedge Funds, PE, and other alternative investment pools SHOULD NOT be subject to increased public regulation and disclosure requirements, especially now that the minimum requirements for investment in these funds has increased. The main concern raised by politicians and other would-be intervention artists seems to be the risk exposure these funds bring to public capital, namely in the form of pension and endowments, both of which have been and continue to be major investors in these funds.

Assuming this is the true reason these politicos are pushing for increased regulation, to me, is absolutely ridiculous. If the real concern is that public pension, etc money is exposed to "risky" investments such as hedge funds, than the obvious conclusion is that the pension and endowments themselves should be limited in the amount (or more accurately proportion) of their capital they allocate to such investments. Such an approach precisely attacks the apparent problem (to what extent alternative investments are any more/less risky than any other class is beyond the scope of this post), and is in-line with the free market philosophy implicit to functional and efficient markets.

Generally speaking, do I believe that hedge funds should be further regulated? Not necessarily. While assets in hedge funds and other alternative investments has reached incredible highs, and the number of failed hedge funds continues to increase, I don't believe that increasing the regulatory burden on these funds will have any meaningful positive impact on the economy, their investors, or any other significant constituency (besides maybe self-serving government types perhaps). If an investor, whether individual or instutitional decides to invest in a particular asset, in this case hedge funds, the critical fact to remember is caveat emptor, buyer beware. Just as with investing in any asset, solid dilligence should be conducted, and a portfolio should be sufficiently diversified according to the investment vehicle's/individual's risk profile. Right now, there is a staggering amount of money searching market-beating returns, and I believe that some otherwise intelligent managers and investors have been increasingly jumping into investments without their usual dilligence and caution. In such a scenario, you can't feel sorry for sophisticated investors getting the short end of the stick because of their short-sightedness.

I can't stress enough the fact that investors need to be vigilant when investing in hedge funds. Ask questions. Demand transparancy and accountability. (Some) hedge funds take on substantial amounts of risk. Uncooperative management simply won't help the matter, and could even be taken as a sign that the investment strategy(ies) employed wouldn't stand up to scrutiny if they were shared with investors.

The fact of the matter is, that it is up to investors to manage their risk, not the government. Blowups, crashes, and unexpected events happen, but with a well-diversified portfolio and other risk-management techniques, investors in hedge funds and other alternative assets do not need the government to get involved, at least not by regulating the funds themselves. If public money is the concern, restrict the public pension/endowment pools, attack the problem at its source. End of story.

Strategy Session: Preemptive Solution to a Potential MySpace Mistake

After my last post (which you probably should read before continuing here) I realized that while I pointed out a very relevant issue which could determine the future of social networking, I didn't do much to point out anything even resembling a solution.

Firstly, lets assume that MySpace fully executes its announced plan to rid profile pages of copy-protected music (no plans yet to systematically remove other media, "yet" being the operative word). As I pointed out, this action will not be without consequence, as a significant percentage of users currently have such music embedded in their profiles. With that in mind, I think the key strategy issue for MySpace is to limit this fallout, and the best way of going about doing that is to provide users with an alternative.

And, lucky for MySpace, the best alternative not only serves to keep the users happy, but could substantially boost profits in the process.

Ideally MySpace will arrange a deal with at least one major record company (or, dare I suggest, ITunes) to provide users with a pre-selected, and targeted choice of music which could be legally embedded into profile pages. Depending on how the deal is structured, this could be a potentially lucrative strategy. The record companies would likely pay a pretty penny to get exclusive access to provide the soundtrack to the lives of the massive MySpace population. A population which, I should point out, is extremely important to the record companies' continued existence.

Imagine the promotional and marketing opportunities such an arrangement would present, for example, allowing MySpace users to embed yet-to-be released or remixed songs in their profile before the album is available for sale to the general public. This would also be an incredibly savvy means to promote new or up-and-coming artists to a massive audience. These promotions could and would likely also be coupled with strategically placed banner ads (i.e. that display in the profiles of users who chose to embed the song). This is just one example of a strategy record companies could use in my proposed scheme, and there are numerous others that could be adopted. One thing to keep in mind though, is that the arrangement would have to give the users (at least the perception) that they have a large and broad enough library from which to chose songs. Arrogantly assuming users will simply take whatever song(s) a label is pushing upon them would be a very ineffective move.


As I've laid this out, I think it is clear that MySpace is at a fork in road, with one path leading to virtually assured disaster, and the other to the land of milk & honey (and profits). Only time will tell which one they choose, but unless they plan on bringing me on as a consultant, don't be surprised if they go after copy-protected music without much thought as to the consequences of their actions (or equally as likely, grossly underestimating the reaction to their actions).

Biting the Hand That Feeds You - Misadventures with Myspace

This week, News Corp's MySpace unit revealed plans to implement an "audio-fingerprinting" technology developed by Gracenote (venerable keeper of the Compact Disc Database aka CDDB) in an effort to block users from uploading copyrighted material. see article in NY Times

My first reaction was to applaud MySpace's adoption of a potentially great technology which I first started followin a few years back.

However, my second was one of astonishment.

For those of you who've been able to avoid MySpace or who are otherwise clueless about the company/website, check out the picture below:



The above is a screenshot of the profile page that a friend of mine's band maintains. You'll notice about 1/2 way down the page on the right side the little media player feature. Take a good look at it, because a large number of MySpace's members use the same (or similar) tool to insert music and movies into their profile pages. What kind of music and movies do you think these millions of members are putting in their profiles?

Yup, the copyrighted kind!

While I don't have access to MySpace's data, conducting a quick informal ad-hoc survey of a number of friends profiles I visited, more than a few of them have music or some other form of copyrighted media in their profile pages. Most of the time users simply embed a popular song(s) or video in their profile using MySpace's media player or a 3rd party tool.

Now with this copyright vigilantism, MySpace risks alienating (read: really pissing off) the same users who made MySpace the premier social networking site it is today. One would think that MySpace would learn from the Facebook faux pas earlier this year when the rival social networking site opened up its doors to basically anyone. Clearly, the installed base of these sites is not to be messed with.

While only the future will tell, I predict a significant protest to come from the MySpace membership, and possibly (although inprobable) a relatively large fallout from this disruptive decision.

Lack of Posts, Facebook still in Play

I'd like to appologize to all those normally enlightened by the Blog for not having posted or anything since June.

For compliance reasons, my job more-or-less prohibits me from commenting on any company, regardless of whether I have any material non-public knowledge.

Likely this will be my last post in which I mention a specific company for some time, so here goes:

Facebook's still in play, as I had originally suggested back in April (see the "Disney's LoJack for Kids" post), and all signs point to them getting a price well within my estimated range of $900-$1,300 million. I am fairly certain also that one of the commonly suggested "strategic" buyers will step up to the plate if for no other reason than being left behind while a competitor swoops in for the kill.

Fear is one helluva motivator.