Let’s say you’ve got a friend, a friend who works as an investment banker, and he gifts you with some inside information. Not for any compensation, just because he wants you to make some bacon, and you make $1.5 million on the trade. Is that cool?
Believe it or not, it used to be. But it’s not any more. The United States Supreme Court just decided that the free gift of inside information is illegal for you to trade on.
The questions before the court was, if the person passing along the inside information isn’t paid or compensated for gifting you with it, how can that be a crime? And, if the person acting on the tip doesn’t know the tipster is breaking some fiduciary duty they have, how can the person who makes a trade on that information be committing a crime?
Those questions were answered previously by a New York Appellate Court in the negative- no, it wasn’t a crime.
So what happened?
Here’s what you need to know to stay on the right side of the new law…
Determining the Value of Inside Information
Prosecutors in California had charged one-time Chicago grocery wholesaler Bassam Yacoub Salman with one count of conspiracy to commit securities fraud and four counts of securities fraud, alleging Salman earned $1.5 million trading on inside information.
On September 1, 2011, Salman was convicted on all counts in the United States District Court for the Northern District of California.
The government said the tips Salman got originated with Maher Kara, then a Citigroup investment banker who gave the information to his brother, who in turn passed it on to his brother-in-law, Salman.
Salman appealed, to no avail. Then, another case came up on appeal that gave Salman’s attorneys hope.
In 2014, The United States Court of Appeals for the Second Circuit vacated the insider-trading convictions of two individuals on the ground that the Government had failed to present sufficient evidence that they knew the information they received had been disclosed in breach of a fiduciary duty.
…we conclude that, in order to sustain a conviction for insider trading, the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit. Moreover, we hold that the evidence was insufficient to sustain a guilty verdict against Newman and Chiasson for two reasons. First, the Government’s evidence of any personal benefit received by the alleged insiders was insufficient to establish the tipper liability from which defendants’ purported tippee liability would derive. Second, even assuming that the scant evidence offered on the issue of personal benefit was sufficient, which we conclude it was not, the Government presented no evidence that Newman and Chiasson knew that they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties. Accordingly, we reverse the convictions of Newman and Chiasson on all counts and remand with instructions to dismiss the indictment as it pertains to them with prejudice.”
While Federal securities fraud statutes don’t specifically mention insider trading, in 1983 the Supreme Court said prosecutions could be based on an insider’s breach of a duty to the company’s shareholders. The ruling, known as Dirks v. SEC, also said the insider had to receive a “personal benefit” from the disclosure.
The 2014 Todd Newman and Anthony Chiasson appeals victory in effect established new requirements for insider trading cases. First, “the Government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.” Second, those acting on a tip had to know they “were trading on information obtained from insiders in violation of those insiders’ fiduciary duties.”
Salman’s attorneys used the new benchmarks to take their case to the Supreme Court.
SCOTUS’s Ruling Toughened Insider Trading Rules
The High Court’s ruling, handed down earlier this week, affirmed Salman’s conviction, and in doing so resolved questions that had divided federal appeals courts.
The ruling, more importantly, restored prosecutorial and SEC powers lost in 2014 when the New York Appellate Court established new requirements for insider-trading cases.
The Supreme Court didn’t center on Salman’s conduct, instead it zeroed in on the tipster’s motivations.
Justice Samuel Alito wrote, “By disclosing confidential information as a gift to his brother with the expectation that he would trade on it, Maher breached his duty of trust and confidence to Citigroup and its clients.”
Essentially, the Supreme Court rejected the New York court’s suggestion that a tipster must “receive something of a “pecuniary or similarly valuable nature in exchange for a gift to family or friend.”
Preet Bharara, the U.S. Attorney for the Southern District of New York and the toughest cop on the Wall Street beat said, “The court stood up for common sense and affirmed what we have been arguing from the outset – that the law absolutely prohibits insiders from advantaging their friends and relatives at the expense of the trading public, today’s decision is a victory for fair markets and those who believe that the system should not be rigged.”
So, if you’ve got a Bad Santa trying to be good to you this Christmas and gift you with some unwrapped inside information, you might want to come up with another wish.
Banking shares across Europe are rallying, especially share prices of Italian banks.
It’s not because they’re in good shape, or netting more profits, or have great yields.
They’re rallying because the possible collapse of Italy’s Banca Monte dei Paschi di Siena and the contagion fears that come with a big bank failure, have been diverted, for now.
Investors who had shed bank shares, driving their prices into the bargain bin, are now jumping back into these same banks hoping to pick them up on the cheap.
But getting into European banks right now is a dangerous game because nothing is certain.
European Bank Shares Are Rallying… for Now
While bank shares rallying on the prospect of another state-sponsored bailout of Monte dei Paschi, Italy’s third largest bank by assets, and the world’s oldest bank (founded in 1472), seems crazy, it’s not in the short-run.
That’s because Too Big to Fail banks have been good bets every time they crash and burn and get bailed out by their governments and central banks.
However, beyond this latest market pop, Italian banks and big European banks are a dangerous bet.
All the news lately is focused on Banca Monte dei Paschi di Siena (MPS) because it has until the end of 2016 to recapitalize itself after failing European bank stress tests this summer.
In order to meet required capital standards, the bank put together a plan to raise €5 billion of cash and sell €28 billion worth of non-performing loans (NPL).
Part of the €5 billion in cash needed to bolster MPS’ equity capital is expected to come from Qatar’s Investment Authority, the country’s sovereign wealth fund and already a beleaguered investor in MPS. Underwriters of the equity offering hope a large investment by Qatar will spur other investors to pony up fresh cash.
As of today, Qatar hasn’t stepped up with any commitment of cash, which the offering’s syndicate of underwriters says partly constitutes “adverse market conditions” that relieves the underwriters of having to raise any money.
Meanwhile, there haven’t been any takers for packages of MPS’s €28 billion worth of bad loans.
And that’s good news for investors, believe it or not.
Don’t Believe the Hype – Euro Banks Are Still a Danger
Because Italy and the European Union can’t afford to let MPS fail, it now looks like the state will lend the bank whatever it needs to stay alive and buy time to hopefully sell off bad loans and entice equity investors off the sidelines.
This isn’t the first time MPS has needed a bailout.
It was on the brink of failure and technically insolvent in 2009. It failed 2011 stress tests and needed €3.3 billion to fill a capital hole. It managed to stave off failure, but by 2013 had to borrow €4 billion from the government to keep its doors open. A €5 billion capital raise in 2014 helped pay down the government loan by €3 billion and another €3.3 billion raise in 2015 was enough to pay back the rest of its government bailout loan, keep the bank’s 25,000 workers employed and its 2000 branches open.
Obviously, MPS is failing again.
So why would anyone buy shares in the bank? Because it’s getting bailed out again?
While it’s not a “done deal” and the government hasn’t yet ponied up the money MPS needs, it has to.
Otherwise, the failure of MPS would likely immediately trigger the failure of three teetering mid-sized banks Popolare di Vicenza, Veneto Banca and Carige, and four small banks that had to be rescued last year: Banca Etruria, CariChieti, Banca delle Marche, and CariFerrara.
If the state doesn’t give MPS the cash it needs, the bank would be subject to a bail-in, where depositors who have more than €100,000 in cash at the bank can have their money taken by the bank and turned into equity shares. And some €2 billion worth of subordinated debt held mostly by savers and pensioners who bought MPS bonds for their yield could have their bonds swapped for equity.
The likelihood of a run on most Italian banks, as depositors feared their cash would be confiscated, would decimate the banking system in Italy and spread panic across Europe.
It’s entirely possible.
Especially now that Italians voted “no” on the referendum that would have changed their constitution and reduced the size of government, which triggered the resignation of Prime Minister Matteo Renzi, and sets the stage for a caretaker government and new elections that could bring populist parties into power who might let some banks fail.
The prospect of further political upheavals in Italy, as their banks teeter in the balance, doesn’t constitute a buying opportunity in the banking sector to me.
All across Europe, banks are in trouble. Collectively, European banks are sitting on €360 billion worth of non-performing loans, while the sum total of equity capital on their books is only €225 billion.
They’re in big trouble.
As a trader, it’s fine to make short-term, event-driven bets like MPS getting bailed out and other banks rallying along with MPS shares rising.
But as an investor, buying these suddenly popping European bank shares isn’t for the faint of heart.
Automated investment services, or robo-advisors, are taking over the world.
Well, not quite.
But they are getting lots of attention and attracting billions of dollars.
While I’m a huge fan of the concept of automated investing services and I believe they will get a lot better, they’re far from “there.” And they’re not for everyone.
You’ll need to keep your eyes open so you don’t get sideswiped by internal conflicts some service providers present, and don’t end up down a rabbit hole you didn’t see on the horizon.
Here’s who should seriously consider using a robo-advisor, how they should be used, and what to look out for…
Who They Could Help, Who They Could Hurt
Anybody who wants be invested in the market but doesn’t know how to start should consider opening up an account with a robo-advisor.
Anybody who is a DIY investor, who hasn’t been successful doing it yourself, and doesn’t want to pay for a full service broker should also consider opening up a robo-advisor account.
Anybody who isn’t happy with the performance of their stockbroker or wealth manager – especially in terms of how much fees and commission are eating into their returns – should consider opening up a robo-advisor account.
Robo-advisory services make investing in the markets, building a diversified portfolio, and automatically rebalancing it incredibly simple.
And simple is great if it gets individual investors off the sidelines and into the game. Or if you haven’t been successful doing what you’ve been doing and want non-biased (for the most part) advice on establishing an investment portfolio, automated services are a simple answer.
Unfortunately, under the hood, robo-advisory portfolio construction and rebalancing principles, pricing theories, and the math inherent in convening all the moving parts that make investing in general more of an art than a science, is anything but simple.
I’ve written a lot about what’s under the hood of these services, but you don’t have to understand everything about what’s under the hood (the complex math, for example). You just have to know what to do when the investment car that’s being auto-driven for you looks like its heading for a brick wall.
A False Sense of Security
First of all, would you get into a driverless car today and just fall asleep, or read, or talk on your smartphone as if the technology had been perfected? Of course you wouldn’t.
Just because your investment portfolio has been automatically created for you doesn’t mean you shouldn’t know exactly what’s in there and where the ride’s taking you.
Automated doesn’t mean blind. You should always know what’s in your portfolio and how each of the positions are doing, whether they’re making money or losing money and what your account balance is doing relative to the market.
The problem with robo-advisory services, and it’s a giant problem, is that a lot of investors aren’t going to pay attention to what’s in their portfolios and how they’re doing.
That’s no different than investors buying mutual funds and expecting that’s mutual fund managers will just make them money with their picks and rebalancing strategies.
Don’t go in blind just because you think technology is somehow foolproof. It’s not.
The good news is that 99% of the time robo-advisors will have you in ETFs. They use ETFs because there are so many of them that allow investors to invest in different indexes, different markets, different industry groups and sub-groups and different asset classes, that being diversified has never been easier.
The bad news is, as I’ve warned you about, when there’s a market crash it almost doesn’t matter what you’re invested in, because indexes and markets and different asset class become highly correlated, they all usually go down.
If you’re in an auto-driven car and you see it heading for a wall, hopefully you’d be able to do something about it, like yank the wheel or hit the brakes.
You can yank the wheel of your robo investment portfolio by changing your investment parameters online, and you can hit the brakes by selling your portfolio.
The point is, ETFs aren’t the be-all-end-all of diversification, partly because of structural problems inherent in all ETFs, which I wrote about here (and you definitely need to read).
But if you know what’s in your portfolio and see a crash coming, you can sell some of your ETFs or easily buy put options on them to hedge your entire portfolio.
While that might get a little expensive, it wouldn’t be at all if it saved your account from getting crushed in the next crash.
Of course, you don’t have to do any hedging or sell any positions if you have a long-term holding timeframe for your investment portfolio. You can always hope that over time the markets will heal themselves and get back on bull track.
Pitfalls, Conflicts, and Legal Issues
Robo-advisory services are no different than any other investment track you can run on. There are always going to be corrections and crashes and you’re always going to be exposed to losses. It’s just a matter of how comfortable you are sticking with the investment program you’re following, or how you proactively defend your investment capital if you see trouble ahead.
Speaking of trouble… robo-advisory services aren’t always conflict-free. Their status (acting in the capacity of a Registered Investment Advisor) doesn’t mean you have the same rights you might think you have if you were exposed to inordinate losses due to the fault of a human advisor.
As far as conflicts, they’re out there.
For example, some service providers receive compensation for offering third-party ETFs on their platforms. Some providers may be market-makers and traders in the underlying stocks held by ETFs. And service providers can be “authorized participants” who actually create and redeem the ETFs their services put you into. That gives them a lot of power over pricing and also a huge head start in selling underlying securities that make up an ETF if they know there’s going to be a lot of investor liquidation of ETFs.
Selling the underlying securities that make up an ETF portfolio can put more pressure on the ETF price and cause a negative feedback loop. That can happen on a massive scale with ETFs, which is a structural problem inherent in the ETF universe.
If something goes terribly wrong with your robo-advisory account, don’t think that just because the service provider had to have an RIA set up through which it offers automated investment services that you’re protected by the laws that govern RIAs.
Most services tell you that your robo-advisor is and will act as an independent contractor, that it is not an employee of the client and has no other relationship with the client. The service is just a service, and the robo-advisor can’t be said to be acting in the best interest of the client because the client is supposedly acting in his or her own best interest by setting the parameters when they open their account.
Don’t get me wrong, I like robo-advisory services if they gets folks involved in investing.
They’re just not all there yet, and may never be. That’s why you still have to know what’s in your portfolio and how it’s doing, and more importantly, take responsibility and action when it comes to your money.
Stay tuned. In the coming months, I’m going to show you how we can improve upon robo-advisory strategies and techniques… and even how we can use them to profit.
Today, I’m tackling what the real problems are with robo-advisory services – who should use them, and how not to get crushed when they go haywire.
Depending on what theories and math robo-advisors are wired for, they construct a “personalized” portfolio based on forms you fill out online, and they automatically rebalance your portfolio when threshold weightings of positions in your portfolio get out of balance.
And that’s precisely where the issues begin…
Ghosts in the Machine
The first problem with these services starts there, in their construction of portfolios.
They are personalized- but only to the degree that you fit into a model that fits thousands or hundreds of thousands of other hopeful investors. So, don’t count on your portfolio being different to the point where you believe it’s immune from what anyone (or everyone) else might suffer through if markets blow up.
Generally, you’re put into “passive” low-cost indexed ETFs. Investors plowing in larger sums at some services, like Wealthfront, can have a combination of individual securities and one or two “completion ETFs” to track an index.
If you’re investing 100% in U.S. equities and expect robots to diversify you, they will… but they won’t.
The bottom line is, no matter how robots break up your funds- whether they put you in several big index ETFs tracking the likes of the S&P 500, the Dow Jones Industrials, or the Nasdaq- you’re essentially correlated to the market.
Robots can put you into large-cap ETFs, small-cap ETFs, growth ETFs, value-oriented ETFs, into ETFs indexed to divided sectors or industries, or smaller subsets of equities based on fundamentals, dividends, almost any subset of stocks based on almost any theme. There are lots of indexed “products.”
But you’re still correlated to the market.
It may matter what indexes you’re in on the upside, in the short run. It won’t really matter in the long run if you’re well diversified across all these indexes and groups. You’re being indexed enough, diversified enough, to essentially just follow the general market.
On the downside it matters, because correlation is what it is: a phenomenon, whereby most equities breakdown when faced with widespread selling by individuals, hedge funds, and mutual funds. It matters especially in the short-run, regardless of how “uncorrelated” to each other these equities are supposed to be.
Then there are the ETFs. That’s what you’re mostly invested in with robo-advisory services.
If you don’t remember what happened to ETFs last August, you need to be reminded here and never forget.
Because ETFs are composed of actual stocks, or futures, other assets, or derivatives for that matter, they are priced based on the sum of their parts. Last August, before markets opened, futures prices were down sharply. Everyone knew stocks would likely selloff hard at the open. And… they did.
The problem with ETFs suddenly surfaced. How can you open trading in a security if the price of that security (an ETF), is based on other stocks that aren’t open, or opening, and have no prices? You can’t really. If you do, you’re just guessing.
So while lots of ETFs weren’t opened for trading, the constituent stocks that they’re made of were going down.
What happens to your portfolio if your robots can’t sell your ETFs while the stocks that make them up are going down?
You could be devastated.
The Faults in Correlation
Now, we’re back to correlation. If stocks are going down and some investors can’t sell what they want to sell, they’ll sell whatever they have to, including other asset classes.
That’s cross-asset correlation. Everything gets sold and sometimes there are no safe harbors. Usually when there’s panic selling, the Treasury bond market becomes a safe harbor and prices of bonds rise.
Maybe your robot will have you in a small T-bond position. You’ll at least have that.
Robo-advisor advocates would argue it would be unlikely an investor would be 100% in just U.S. equities based on their models. But their models are based on investor inputs. And if an investor wants all equities, and all-American equities, they’ll get that.
As far as cross-asset diversification, especially achieved by mean-variance analysis (a favorite of most robo-advisors), Mark Broadie, Professor of Business at Columbia University, has demonstrated through simulations that “the error maximization property of mean-variance analysis becomes more pronounced as the number of asset classes increases.”
In other words, you’re more prone to larger standard deviation moves on both the upside and downside the more diversified you are in different asset classes.
And, you know now that matters more on the downside, because that’s when the big moves – the “fat tails” wreck all normal distribution-based models… which all of the robo-advisors are based on.
You don’t have to worry about much on the upside. Your robo-service will make you money, but being as indexed as you’ll be, don’t expect to outperform the market.
On the downside… good luck. You’ll get creamed along with everyone else when markets tank, maybe worse if the ETF market implodes from structural issues.
That’s in the short-term. If you’re a long-term investor you’ll be told to sit back and let the markets come back and lift you up when the correction or panic passes.
While this is historically true, what if you need to take money out in the short-term? What if you don’t have a long investing horizon? What if you were just trying to maximize your investment portfolio before moving more into bonds?
Portfolio construction is a problem, diversification is a problem, ETFs are a problem, correlation is a problem, the normal distribution math used is a problem – there are lots of problems with robo-advisory services.
If you’re an investing beginner and having a portfolio automatically constructed and rebalanced for you gets you into the market, I’m all for it. Go with it.
But, understand the pitfalls in blindly expecting a robot to understand you, the markets, and protect you from serious harm in the short-term, or the long-term. I only advise you use a robo-advisor if you manage that account and plan your contingent moves into the future and be ready to execute them when you have to.
There are so many things we can learn about investing from automated investment services, otherwise known as robo-advisors, that it staggers the mind.
After all, they’re computer-driven platforms imbued with advanced Sharpe, mean variance, and Modern Portfolio Theory that produce “efficient frontier” portfolios, and whose proprietary algorithms rebalance your portfolio based on threshold continuums and your personal dreams and goals.
Oh yeah, they’re complicated.
But there’s one lesson (one you were never taught) you can learn from taking a good, long look at how these robo-advisory services construct and rebalance your personal portfolio.
Because as we’re driven toward a future programmed by algorithms and dominated by Fintech innovations, it’s important to stop and take stock of some of the basic assumptions that will inform that future.
As you’ll see, there’s one fundamental assumption – upon which millions of portfolios have been built – that’s simply dead wrong.
Automated investment services – more commonly known as robo-advisory accounts – are relatively simple to understand, on the surface at least.
We talked about this last week – robo-advisories were created by millennials in response to the dot-com collapse, the financial crisis, and traditional fee-based advisory services.
But all is not what it seems. And if you dare dig into how they actually work, you’d be surprised how complex they are.
Today, I want to show you how these services actually automate portfolio selection and perform rebalancing acts, and help you understand some of the complex portfolio management theories providers have to use.
Because what you don’t know can really hurt you – and you should know how your money is being managed.
I’ve been telling you for most of 2016 that financial technology, or Fintech, is changing the investing and trading landscape.
One of the most profound Fintech disruptors is the creation of automated investment services, more commonly known as “robo-advisors.”
The idea of automating investment services was the brainchild of a handful of millennial-focused Fintech entrepreneurs, most of whom are millennials themselves.
With their general aversion to traditional fee-based advisory services, their experience of living through the tech-wreck of 2000 and the 2008 market shellacking, their comfort and trust in computers and technology, millennials (the generation born or coming of age between 1982 and 2000) were presumed to be the perfect audience for robo-advisory services.
Sure enough, assets under management by robots (and their human helpers) exploded into the billions this year.
But millennials aren’t the only group who are enamored with these low cost, automated investment services. They’re catching on with lots of investors.
If you’re not one of those investors, today, I’m going show you how robo-advisors work and what they cost, as well as the pitfalls associated with this newfangled investing horizon.
The stock market was supposed to have a major beef with Donald Trump’s election.
Now that Mr. Trump is the president-elect, everyone’s asking “Where’s the beef?”
That famous quip comes from a 1984 Wendy’s commercial assailing claims that Big Macs and Whoppers had meatier patties. That same year, Walter Mondale used it to mock Gary Hart’s proposed agenda, and later used it against Ronald Reagan, who eventually won a second term.
The answer today, as far as stocks are concerned, is there looks to be a lot of red meat in the economic future president-elect Trump’s proposing.
And as U.S. investors start to get it, they’re rotating into select stocks instead of shedding positions as everyone expected.
It’s too early to tell what investors are or aren’t going to fully embrace, since we don’t know who president-elect Trump will surround himself with and what exactly his agenda will be.
But that doesn’t mean investors should stand by with their wait-and-see glasses on.
There’s one opportunity in our future that’s a no-brainer – because it’s the central pillar of Donald Trump’s economic plan.