Understand How the Wall Street Game is Played

Many people claim that Wall Street is a rigged game, where salesmen are more concerned with their profits than yours. Two of the most common examples are mutual funds and stock research.

Numerous studies conclude that mutual funds outperform their ETF cousins, because managers cannot outperform the market after fees. Because markets are efficient. Efficient market research aside, what is the purpose of a mutual fund? Fund companies maintain mutual funds to gain as much revenues as possible, Of course the fund company is more interested in making money than being optimal for your portfolio.

Why Mutual Funds Underperform

Investors display a curious psychology that reviles losses more than it likes profits. A losing fund will shed assets much quicker than a fund that beats the market. True investment greats that have periods of lagging the market but long term outperformance will see money flows into the fund after good runs and out flows in other times. The best way to keep growing assets is to never underperform by more than your peers. So with funds in the same Morningstar style box, you see herding behavior in and out of the same stocks. You won't deviate greatly from the market return, but that is not the point.

If you take away the benchmarks and the herding investors, what happens? Hedge funds have no benchmarks (just an absolute return mandate) and investors generally can only get out quarterly, instead of daily. They beat the market handily on a risk adjusted basis, but a large portion of their aggregate outperformance is gobbled up by high fees. One solution is Alphaclone, which is a service by which you get invest in hedge fund positions without paying the fees. Or you can choose a mutual fund that doesn't have asset gathering as it's main focus. Examples include Hussman Funds and GMO.

Stock Research

Everyone knows that stock analysts have an aversion to sell ratings. The fact is that sell ratings don't make much money. Banks and investment banks want to get other business from the rated companies, including bond and equity issuance deals. The end result is that a firm must be quite bad to get a sell rating. Hold ratings exist for when an analyst is cautious about future stock performance, but doesn't want to issue a sell rating. In my opinion, the best types of ratings systems are the "peer perform/underperform/outperform" systems. But the best system is not to rely on Wall Street stock research at all. Check out the percentage of sell ratings:

Notice that they stayed at 5% throughout the crisis. Analyst ratings are generally a lagging indicator, telling you more about the recent past than the future.

Wall Street has many problems with it, but when you understand that they are in the business of making money more than helping investors, it will help your portfolio.