Wall Street Ethics: The Good, Bad, and Ugly

An Underlying Difference

Last year, I derided GameStop's GME stock price; this year, that of Digital World Acquisition Corporation DWAC. For me, they were comparable investments. Each had become a "meme stock"--highly celebrated by retail investors and therefore trading at steep price multiples. Their valuations, it seemed, had outrun reality.

(Since my article on Digital World was published, the stock has risen further. The critical test awaits, though: how the stock behaves after its scheduled merger, when the company's institutional investors may sell their shares. Should Digital World's stock retain its value after that event, I will happily concede defeat. Quite happily, in fact, because such a result would warrant a follow-up article, and this columnist appreciates topic ideas like a kitten appreciates mice.)

However, although the two companies shared similar investment circumstances, their shareholders possessed different attitudes. Owning GameStop meant defying hedge funds. Along with profiting, GameStop's retail investors had a secondary goal of punishing Wall Streeters who had shorted the security. In contrast, Digital World's buyers have joined hands with Wall Street. They follow multiple hedge funds that pledged $1 billion toward Digital World's proposed merger.

One reason why the shareholders of GameStop and Digital World have disagreed about hedge funds is politics. GameStop's boosters opposed the rich and powerful. In contrast, as would be expected for those who plan to hold a stake in Trump Media & Technology, Digital World's supporters fervently support such a person. The first group views itself as permanent outsiders, while the second hopes very much to return to the inside.

Framing the Issue

But politics furnish only half the story. The other half is that the common view of Wall Street is fractured. Although most investors distrust the Street, they will also grant that it is not entirely wicked. They just are unclear where to draw the lines. This column makes such an attempt. Of course, as this topic is highly subjective, reasonable people can disagree.

Because investing provides no guarantees, sometimes rewarding the foolish and punishing the prudent, Wall Street's products should not be judged on outcomes. They should instead be scored on two alternative criteria. First, do the participating institutions possess the same investment opportunities as retail investors, or do they receive favors? If the playing field is level and the service honestly marketed, Wall Street need offer no apologies.

If the playing field is not level, but the Street is forthright, then the product places in the second tier of Wall Street behavior. It requires some apologies. Below that, in the third tier, lie those offerings that commit the most egregious sin, by actively deceiving their customers. Such products owe Main Street all apologies.

No Apologies

1) Mutual Funds I use the term generically, to mean all listed funds: mutual funds, exchange-traded funds, closed-end funds, even interval funds. Vanguard founder Jack Bogle castigated most such funds, and to an extent I concur. If the weakest 95% of such funds disappeared, only marketers would miss them.

On the other hand, mutual funds are not privileged. They invest in the same securities that are available to all, and, at least for equities, at the same prices. (With bonds, funds often receive slightly better prices, because of their size.) Nor are their flaws hidden. Their expenses, risks, and strategies are openly disclosed, for all to see.

2) Hedge Funds (Mostly) On this I side with Digital World's shareholders, which to judge from the emails that I received after publishing that column, would surprise them greatly. Hedge funds are widely detested, because their chieftains too often resemble C. Montgomery Burns. Nor are they particularly sound investments, by and large. They cost too much and deliver too little.

But with a couple of exceptions--shortly to be noted--hedge funds don't enjoy unusual advantages. For the most part, they purchase publicly traded securities, at publicly traded prices. And they specify their charges in advance. Don't wish to pay a jet-setting portfolio manager an annual 2% of your investment assets, plus 20% of your profits? Don't buy a hedge fund.

Some Apologies

1) High-Frequency Traders The villains of Michael Lewis' Flash Boys, high-frequency traders clearly don't deserve white hats. They prosper by receiving advance notice from stock exchanges, courtesy of data feeds that only they receive. With enough money, you or I could invest as most hedge funds do. But we certainly could not become high-frequency traders, not without acquiring proprietary information.

To their credit, though, high-frequency traders don't deceive Main Street. In fact, they don’t sell to everyday investors at all. To the extent that their activities increase the rest of the marketplace's trading expenses, rather than reduce them--a question that remains unresolved--no single shareholder is asked to foot the bill. The costs, such as they exist, are spread among all.

2) Hedge Funds (The Rest) Two varieties of hedge fund drop from the first to the second tier. One consists of funds that are granted special advantages that elude ordinary investors. For example, hedge funds that buy into special-purpose acquisition companies, or SPACs, typically receive discounted shares. Good luck getting that arrangement yourself. Similarly, activist hedge funds sometimes negotiate sweetheart deals that benefit their investors but not the company's other shareholders.

Hedge funds that use the megaphone supplied by their size and prominence to denigrate the businesses they have shorted should also offer some apologies. Unlike many, I have no quarrels with the practice of investment shorting, as a general policy. That said, short sales that are accompanied by criticism that would pass unnoticed, were the shareholder a retail investor, is an exercise of privilege.

All Apologies

1) Stock Promoters By "promoters," I mean those who endorse securities without divulging their personal interests. Offending parties might be brokerage firms seeking to unload excess merchandise; portfolio managers praising the long-term prospects of stocks that they plan to soon sell; or securities analysts recommending companies in the hopes of attracting their investment-banking contracts.

Sometimes it's tough to judge the infraction. If a fund manager is asked about one of her holdings, is she wrong to commend the company's business? No, if she is fully truthful. Yes, if her praise exceeds her beliefs. Distinguishing between those two positions is, of course, difficult for outsiders.

2) Investment Engineers Not everybody who transmogrifies (the second time I have ever used that verb in this space; I wish that I had more occasion to do so) a simple security into something complicated has sinned. Some derivatives are genuinely useful. However, many elaborate investments exist to mislead. Were they understood by the marketplace, they would not sell.

The obvious example being the lower tranches of collateralized mortgage obligations, justifiably demonized in The Big Short. Those who created such issues scorned them. Structured notes are another case. How many investors would buy a complex structured note, with a convoluted payoff scheme, if they knew that within the industry such securities are nicknamed "toxic waste"? Not many, methinks.

Wrapping Up

This column's list, of course, is only a start. Among other parties, I have neglected to address investment banks, SPAC sponsors, and brokerage firms. My aim was not to provide a thorough review of Wall Street's many roles, but instead to offer a scheme that might prove helpful in considering when to castigate the Street, and when to refrain. Feel free to disagree, and to send along your framework, should it differ.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.