Swimming With Sharks: Part 2

A few weeks ago I took a focused look at a major segment of the more traditional type of player in today’s changed market structure – the bottom up portfolio manager. I called the posting "Swimming With Sharks: Part 1. In this week’s posting the focus is on a segment of the new players in the game – hedge fund managers, specifically equity managers.

This player is at the epicenter of the risk on/risk off craze that has become a staple of how the new financial market structure functions. In contrast to the more traditional type, this equity oriented institutional investor by and large has two distinct features: thematic oriented investing over a short time horizon. The thematic approach is a bit of a misnomer from that which is practiced by longer term, more traditional investor types in that the longer term types are seeking to identify trends and themes that will likely play out over a longer time horizon (as in years, sometimes decades). For example, one such longer-term thematic type is in the global infrastructure area (water resources, power, roads, bridges, etc.). In this area, time is on the side of those interested in how trillions of dollars will be spent and earned. In contrast, the much shorter-term hedge equity hedge fund manager is a thematic investor in the sense that he/she is looking for what is hot not years or decades from now but RIGHT NOW. This approach is then manifested in a risk on (buy stocks)/risk off (sell stocks) mentality. At the same time, another segment of the new player space is the high frequency trader.

This creature of financial innovation may have many reasons to justify why what it does facilitates a more efficient market (price discovery and narrowing of price spreads are parts of their justification mantra), but the impact on the markets is fairly clear: they exacerbate whatever short term trend sweeps over the markets. For example, what today’s equity markets often experience is a risk on (or risk off) trade started by the equity hedge fund manager for any number of “thematic” reasons which then are exacerbated by the high frequency trader. Let the feeding frenzy begin!

What is often lost in all this is the fact that as the feeding frenzy (or digestive purge in market declines) occurs the much slower to act and react individual investor watches in bewilderment as price movements surge and purge their way to exhaustion as short term money spasms on price. And in that process, this much slower to act and react individual investor feels that the game is somehow changed to something largely unrecognizable. Hence, the major common sense explanatory reason for the exodus of the individual investor over the past several decades.

Public Policy Implications

As noted in Swimming With Sharks: Part 1, what happens in the real economy matter to our bottom-up portfolio manager and our economist only when it can be measured and quantified within the framework of their methodologies. But when it comes to the short-term crowd, their methodology bears little resemblance to their longer term, more traditional brethren. Stampedes in and out of the casino called the stock market by placing bets based not on the longer term fundamentals of the companies in question but on whether hot money flows into or out of the theme du jour, which price movements are then exacerbated by those seeking to turn pennies per trade based on speed into millions based on volume is a central feature of today’s financial markets. If one were to view the two together you see one driving the car at the margin while the other is along for the short-term joy ride.

In and of itself, the impact of such in-the-moment “investing” to longer-term price directions is debatable. But what appears to be not debatable is the impact on the much slower non-professional individual investor – an essential part of the capital raising function of the financial markets via direct individual stock positions and a staple of such segments of the institutional investor market such as mutual funds: they have largely walked away from the craps table.

How this all plays out is anyone’s guess. But to deny key elements of what is described above is to deny an essential part of how the financial markets function today. And for those seeking to understand today’s global equity markets is to remove from one’s toolbox the ability to understand just how this game is played, which is just another way of saying knowledge is power.