NEW CONKERS3 FEATURE : The Analytical Surveyor

Analytical Surveyor has worked for over 40 years in the City and West End of London as a real estate investment manager, an equity analyst, a multi-manager, a fund manager and as a researcher and strategist. In his area of expertise, he is highly regarded and currently works as a consultant.
There is an enormous amount of academic research that provides insights into the functioning of investment markets. Rarely will this help with stock selection, but much of it will help in understand how and why the market functions the way it does. The Analytical Surveyor trawls through the work that is available in the public domain and summarises the work into useable notes for investors.

The edge that institutional investors have:

As substantial fee-paying clients, institutions have access to a vast resource in terms of their brokers’ investment market research.  Although broker cost-cutting and the growth of Chinese Walls has limited both the quality and quantity of it in recent years, and it is shrinking since the introduction of MIFID II, it still is timelier and typically has greater depth than the research available to private investors.

But this is not the only advantage that institutional investors enjoy.  A recent Harvard Business School Finance Working Paper[1] identifies the network of relationships between brokers and institutional investors that shape the information diffusion in the stock market.  In particular, the paper, using sophisticated statistical and mathematical analysis, provides an explanation as to why large ‘central brokers’ offer an advantage to institutions in formulating their trades.

The analysis shows that that trades channelled through central brokers earn significantly positive abnormal returns, outperforming those made through the peripheral brokers (what we might regard as second or third-tier brokers), even when the same stock is traded by the same manager in the same timeframe.  The main reason for this, it is argued is that by observing a larger and more informed order flow, central brokers can learn faster from the transactions they execute.  In other words, when an informed trader submits an order through a broker, the broker can then exploit its informational rent by disseminating this information to other clients, who would then earn higher returns by imitating the informed trader strategy.

This dissemination, the paper suggests, might not be driven by random meetings between traders, but rather be conveyed by brokers who gather the information through their trade intermediation and then disseminate it to their clients.

Further, it is argued that institutions are willing to be used as a trade leader on occasions, as they will then be able to be trade followers on other occasions, a form of symbiotic relationship. By disseminating the information to their best clients, brokers are also making sure that prices incorporate the information faster, ensuring an early realisation of the outperformance expectation.

The results of this are not minor.  The authors of the paper constructed monthly portfolios based on brokers’ ‘centrality’ and compute the monthly returns of the high-minus-low centrality portfolio and regress them on common risk factors such as the Market excess return, Small minus big, High Minus Low and the momentum factor.  They find that this portfolio generates a significant alpha of about forty basis points per month: i.e. about 5% points p.a. outperformance.

This is a comprehensive analysis of the subject and, in part, helps explain why private investors have difficulty in outperforming large institutional investors.  It also illustrates how important it is to have a large informal or formal network of contacts which can provide intelligence on market activity.  Good research is not sufficient.

[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2997501  The Relevance of Broker Networks for Information Diffusion in the Stock Market, Marco Di Maggio, Francesco Franzoni, Amir Kermani, and Carlo Sommavilla


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