April 27, 2016
What we’re reading this week
T Rowe Price’s Diversified Small-Cap Growth Fund has outperformed 93% of its peers over the past five years by returning an average of 10% annually. Before you get too excited, by contrast, IWM, a small-cap index fund, has returned an average of 9.28% over the same timeframe. The buzz over at T. Rowe stems from the fund manager’s methods. Sudhir Nanda, the fund manager, uses a computer to make investment choices. Computers that trade on an algorithm are nothing new but Sudhir Nanda believes that they will one day have a more prominent place in retail investing. He states, “Having a human is still important. Humans aren’t going to be completely replaced, but they will be mostly replaced.” Many firms have turned to computers to replace asset managers but in today’s marketplace, having humans pick stocks is still the norm. Fundamentally, I agree with outsourcing investment selection to an emotionless computer. Individuals investing on their own have achieved sub-par returns and it has been well documented. When you examine the ways that computers have aided in our daily lives it is clear that we are very bad at predicting what computers will do in the future. 20 years ago no one would have believed that computers would be capable of vacuuming our floors, loading dishwashers, or driving cars. Two of those things can already be done by computers and the third is close to being a reality. There are certain things that computers will never do. When it comes to complex decisions and emotional decisions, research suggests humans will never let a computer make choices for them. I am not referring to investing, but rather to financial planning. I do believe that computers can make most people’s investment decisions for them but as a financial planner I don’t see technology replacing people. Unless we enter into some kind of terminator situation, then all bets are off.
The Seventh Circuit Court recently reversed a ruling against David Weimert, previously convicted of federal wire fraud. Essentially, Weimert negotiated a deal between a buyer and his own firm for assets held by said firm, AnchorBank. During negotiations he convinced the buyer that AnchorBank wanted him to have a stake in the deal. He then turned around and convinced AnchorBank that the buyer wanted him to have a stake in the deal. The deal went through but when his deception was exposed he was fired and subsequently sued. The reversal came about because the court decided, “it is not unusual for parties to conceal from others their true goals, values, priorities, or reserve prices in a proposed transaction.” They chalked his dishonesty up to “negotiation” and left it at that. From the court documents,” To take a simple example based on price, suppose a seller is willing to accept $28,000 for a new car listed for sale at $32,000. A buyer is actually willing to pay $32,000, but he first offers $28,000. When that offer is rejected and the seller demands $32,000, the buyer responds: “I won’t pay more than $29,000.” The seller replies: “I’ll take $31,000 but not a penny less.” After another round of offers and demands, each one falsely labeled “my final offer,” the parties ultimately agree on a price of $30,000. Each side has gained from deliberately false misrepresentations about its negotiating position. Each has affected the other side’s decisions. If the transaction involves interstate wires, has each committed wire fraud, each defrauding the other of $2,000? Of course not.” The question here is, how much dishonesty is ok when dealing with financial instruments? Obviously, no dishonesty is ok at AnchorBank, they let him go. AnchorBank also gained from the transaction as the deal came in a third higher than expected. But was the customer harmed? All final terms of the deal were fully disclosed to both the buyer and the seller and both had the opportunity to renegotiate before signing. According to the courts, it’s ok to lie sometimes. There have been several cases in the past year or so where bond traders and their respective firms have been less than honest. Edward Jones was ordered to pay $20 million for overcharging their customers. Wells Fargo was sued for misrepresenting a client during underwriting. There are others and the similarities stem from financial harm coming to one or more of the parties involved. If no harm was done, was there a crime? Additionally, if we take our cue from the court, is lying a key aspect of negotiating?
The End of Too Big to Fail?
The head of the Federal Deposit Insurance Corporation gave a speech on April 21st in which he stated, “In my view, we are at a point today that if a systemically important financial institution in the United States were to experience severe distress, it would be resolved in an orderly way under either bankruptcy or the public Orderly Liquidation Authority.” This is coming on the tails of the New York Times headline, “Regulators Warn Top 5 Banks They Are Still Too Big to Fail.” The Times is of course referring to the Federal Reserve and the FDIC’s criticisms of the “living wills” provided by the nation’s largest 8 banks. Regulators citied the banks’ increased size since the 2008 crisis and stated that the existing agreements could “pose serious adverse effects to the financial stability of the United States.” So who is right, the head of the FDIC or the rest of the FDIC? Ultimately, I think it means they are both right. I don’t agree with the Time’s interpretation that rejection of the living wills is an adherence to “too big to fail.” Part of Dodd-Frank legislation included an “Orderly Liquidation Authority” process that can be put into place should a large baking institution become insolvent. Living wills for banks are the regulators’ process for pushing banks to review their risks and develop new systems and processes. It makes the banks better. Obviously, the banks in question didn’t meet the standards of the Federal Reserve and the FDIC. Regardless of the living will, it is clear, from the head of the FDIC, that banks should not expect to bailed out the same way they were in the financial crisis.
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