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IPOs, Wall Street, and the Crumbling of Chinese Walls Medium

IPOs, Wall Street, and the Crumbling of Chinese Walls

December 15, 2015

Over a decade ago, 10 of the largest Wall Street firms paid $1.4 billion to settle a government lawsuit. The charge? Duping investors during the stock market bubble of the late 1990s. The Wall Street Journal reported: the [settlement] centers on civil charges that the Wall Street firms routinely issued overly optimistic stock research to investors in order to curry favor with corporate clients and win their lucrative investment-banking business.

Going back to 1933, The Glass-Steagall Act was passed in order to prohibit commercial banks from owning securities brokerage firmsto prevent conflicts of interest. However, the 70 years that followed saw the slow, piecemeal deterioration of these regulations through loopholes and legislative reform.

In 1998, Citicorpa bank holding companywanted to merge with Travelers Groupan insurer. For that to be legal, Congress granted them an exception to what remained of Glass-Steagall, and the Bank Holding Company Act of 1956. Less than a year later, Congress passed the Gramm-Leach-Bliley Act, which overturned large parts of both acts, including the Glass-Steagall prohibition, against simultaneous service by any officer, director, or employee of a securities firm as an officer, director, or employee of any member bank. The explicit prohibition against fully merging the operations of a bank and brokerage disappeared.

President Roosevelt signing the Glass-Steagall Act

The Dark Side of Deregulation

During the dot-com boom, Wall Street banks took advantage of the loose regulatory climate. Because of their firms loyalties, and their sometimes personal commission-based payment structure, research analysts had been directly pressured to publish positive analyses of companies, they personally believed to be poor investments.

In fact, some analysts actually owned pre-IPO shares of the companies they were analyzing and thus stood to gain a great deal if the stocks were successful. If they convinced enough of the public to invest, they could artificially drive the stocks price up. If they sold their shares in that bubble, they could disproportionately profit off of a bad investment.

The Sarbanes-Oxley Act of 2002 came in the wake of these realizations. While it did not reinstate Glass-Steagall-like prohibitions, it tried to require firms strengthen the Chinese wall between analystswho are supposed to be objectiveand everyone else in the firm, including the investment bankers. But this wall might not be particularly effective at preventing conflicts of interest and abuses of power. According to several studies, analysts who are affiliated with firms that underwrite IPOs are significantly more likely to rate those companies favorably, especially if the stocks do poorly in the secondary market and are in need of a boost. And those ratings influence investor behavior.

Some investors have based successful investment strategies on betting that analyst research remains biasedweve seen this first hand at Instavest. Heres a brief summary of that approach (more details in the sections below):

Despite the best efforts of regulators, Investopedias Lisa Smith wrote in 2013, the Chinese wall has proven ineffective at thwarting intentional information-sharing between various parts of financial services organizations. Every little niche that can be exploited is exploited (much of it too complex for the average investor to understand).

Investing in a Conflict of Interest

That skepticism, it seems, is warranted. To anybody aware of the structure of this system, the remaining potential for conflicts of interest is obvious. The SEC even has a page warning against following analyses that come from the same firms that underwrite an IPO. The analysts firm may be underwriting the offering, they caution. If so, the firm has a substantial interestboth financial and with respect to its reputationin assuring that the offering is successful.

The fact is, if the lending branch of a firm underwrites an IPO, the investment securities branch is more likely to provide a positive analysis of that company. Those ratings influence investor behavior, even when the firms relationship with to the stock as underwriter is exposed.

After an IPO, theres a 25 day period known as the Quiet Period during which the underwriting firm cannot publish reports about the company. The report tends to be positive, investor Don Dion says, which tends to make the stock go up.

One of Dions investments on Instavesthe bought shares October 12, and sold them October 14. You can see Dons analysis here.

As a 2006 University of Florida study found, firms with lower sales generally receive higher target price ratios and are more likely to receive a strong buy recommendation. The researchers called this a booster shot, which analysts sometimes give to companies they are affiliated with to counteract negative performance. (Analysts assigned stocks that were above their offer price a target price ratio of 1.46, and stocks that were not a target price ratio of 1.82.) This booster shot phenomenon has been found in multiple other studies.

The Upside is Meaningful

Dion buys shares of a stock about five days before its quiet period ends. Then, he sells on the day the report is released. The five day lag is because his strategy is common enough that it drives the price up in the few days before the quiet period ends. Were not the only ones who have figured this out, Dion says.

Of his trades of this kind on Instavest, Dion made an average of 2.3% on his buy price. He did this 8 times on the platform this year, though he says hes implemented it more elsewhere. This is the phenomenon Dion is betting onWhile 2.3% may seem relatively small, his compound returns have been 9.55% over 127 days. If he is able to continue replicating the strategy, that would result in annual returns of 29.97%.

Chart shows compounded returns using actual trade data from investor Don Dion on Instavest (see endnote for details)

Weve been doing this for 4 years, Dion says. We typically see a positive return 2/3 of the time. He says that returns average around 24%. He pays attention to other factors, too, that he thinks make a difference. According to Dion, prestigious investment banks like Morgan Stanley or Goldman Sachs are more likely to produce a bump than a no-name firm. And a stock is also more likely to bump if its already above its initial valuation.

It might come as a surprise that this mini bubble phenomenon, which stems from an apparent conflict of interest that shouldnt exist, is reliable enough for an investment strategy. But Dion is nonplussed. He discovered this strategy by reading academic research on how it theoretically should work, and why. Then, he got in touch with the researchers, and decided to run an experiment with his own money.

Its not a controversial thing, Dion says. But you gotta have the money to do it, and you gotta do it right.

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