The quality of sell-side research has declined due to compromised analysts and the rise of ETFs.
Investors can find opportunities in specialty finance sectors by understanding trends and operations.
Hedge funds need to adapt to the changing landscape and prioritize objective analysis to survive.
Deep dives
Importance of Access to Management
Sell-side analysts used to provide access to company management as a valuable resource. However, this has changed in recent years, as sell-side analysts have become compromised by investment banking fees and the need to maintain relationships. Fundamental investing has taken a backseat to immediate returns and the influence of ETFs. As a result, buy-side managers have become less reliant on sell-side ideas and are more selective in using sell-side research as a tool rather than a necessity.
The Issue of Lower Quality Research
The quality of sell-side research has declined significantly due to various factors. The rise of ETFs and passive investing has led to a non-fundamental tape, where stock prices are driven more by ETF flows than company fundamentals. Many sell-side analysts are compromised by the need to access management and generate investment banking fees. This has resulted in a lack of objective and independent analysis. Hedge funds have also become more dependent on brokers for capital and lending, further compromising their independence and objectivity.
The Role of Financial Services in Alpha Generation
Financial services, especially within specialty finance, have been a fertile ground for finding alpha and gaining an edge. Non-deposit funded institutions in particular offer unique opportunities, as they rely on securitization markets and have specific underwriting standards. By understanding the trends and operations within these sectors, investors can anticipate future developments and identify potential winners and losers. Financial services also offer opportunities for long and short positions, focusing on company-specific factors rather than broad industry trends. However, it is important to cap the size of the fund to maintain flexibility and agility in trading smaller and mid-cap names.
Future Outlook for Hedge Funds
Hedge funds will need to adapt to the changing landscape and accept lower fees. Longer lock-up periods may become more common to give investments a longer time frame to play out. As fundamental investing regains importance, hedge funds that prioritize objective analysis and independent research will be better positioned to survive. However, a major market correction or a reevaluation of market structure may be necessary to restore the importance of fundamentals in investing.
The Importance of Cash Flow and Valuation in Investments
Cash flow is the most important component to consider when evaluating a company. It provides a sign of the company's health and can indicate whether it can sustain itself. Along with cash flow, valuation plays a crucial role in investment decision-making. While metrics like price-to-earnings ratios (PE ratios) are considered, it's important to understand that valuation is subjective and can be influenced by various factors. Therefore, it is crucial to not solely rely on valuation metrics, but also to assess the long-term value and potential of a company.
The Intersection of Wall Street and Bail Bonds
The podcast episode touches upon an interesting personal connection in the lives of the speaker and their friend, who is a highly successful bail bondsman. While the two worlds may seem unrelated, there are instances where they intersect, such as when financial crimes involving market manipulation or insider trading occur. The speaker shares an anecdote about a hedge fund manager seeking help from the bail bondsman. This story showcases that even in seemingly different spheres, there can be connections and overlaps that influence each other's worlds.
My guest this week is Danny Moses, who was directly in the middle of the biggest trades in market history, chronicled by Michael Lewis in his book the Big Short. Danny was the head trader on the Frontpoint team led by Steve Eisman, which was one of a small group of firms that figured out, in real time, the dire situation with mortgage-backed securities during the financial crisis, and how to build a portfolio to bet against the U.S. housing market. We cover his part in the Big Short story, but also lots of other interesting ground, including the state of sell-side research and financial markets. I love conversations with traders because they live and breathe market risk. You’ll be able to see why quickly in this great conversation with Danny Moses.
