Investment Banks and Hedge Funds : The Wolves : Zero Sum Game part II
In the last article I introduced the concept of Make Money in the Stock Market : Zero Sum Game part I and who is really making money with your finances. There are two sides to every story. In investing, there is the buy side and the sell side. My discussion shall start with the sell side, which is a label given to investment banks. To understand why they are named as such, consider this example: a private company has owners and investors. At a certain stage, the company might be ready to go public, in which case, it will consult an investment bank. Essentially, the owners deposit the amount of ownership they want to sell in the investment bank. The investment bank sells the ownership to the open market (other investors), and gives the cash to the original owners. Of course, the bank takes a cut, depending on the size of the transaction. This is called an Initial Public Offering, or an IPO for short, and is a classic investment banking transaction.
At face value, this seems like a great deal. However, other things occur that make this less capitalistic than it could be. One of the striking problems is that studies have shown many investment banks do not compete on price. On average, an underwriting fee (the % the bank takes of capital raised) is around 7%. Instead of bidding the price down, competing banks bid on reputation, historical performance, and speed. Any one who has studied economics knows that without price competition, price does not equal marginal cost and the supplier is gaining at the expense of others. Another problem is that the IPO shares are issued to repeat customers, usually institutional investors who agree to hold the shares for a long time and buy large chunks. Investment banks are hardly concerned with/interested in appealing to the average investors for these IPOs.
Investment banks perform all sorts of other financial services. Of these, one of them is to research publicly traded companies, and publish their reports for customers. The analysts who produce these reports often times have access to the management of companies they cover. Their informational advantage compared to a regular investor is astounding. They usually are producing reports on companies that have investment banking relationships with their employers (from prior IPOs, etc). The research reports on the companies they have taken public serves as free marketing and coverage on Wall Street. This tends to support the respective stock price for a while. It is no surprise that most analysts issue Buy recs, and rarely succeed in predicting a Bear market.
Meanwhile, your average investor is paying a percentage of assets to get access to these reports, and thinks “oh this company sounds great, I’m all in!” However, prices are determined by information, and by the time this info hits these investors, the news is already reflected in the price. The result is that investors buy into overvalued stocks, never see the returns they want, and waste money on these reports. Meanwhile, had they put their money in index funds, they would have saved money and had higher returns.
To summarize, investment banks are the gateway for private companies to become public, but IPOS are largely closed off to the average investor. They have hoards of information on companies and closely held access to further information. They analyze all the stocks and mass produce their reports. The mobs of investors use these reports to make decisions, which drives the price in an adverse direction for each next investor. The end result is that the average investor has the least access to information, faces a time delay, and ends up under-performing a given index.
