American citizens are rightly upset when they learn that government agencies have been systematically (and secretly) collecting, storing and looking for patterns of possible terrorism in phone calls and emails.
They are angered that federal economic data and other indicators have been leaked seconds early, just enough time for high-speed trading firms to profit from advance warning.
But they have been oblivious to the big data problems going on with their mutual funds.
Make that Big Data — in capital letters — where huge amounts of information are collected, then used to learn things about their subjects that could not have been detected with smaller amounts of information or with less-sophisticated analytical methods.
There is little doubt that in the modern data-management world, everything a fund does, can and will be used against it by some sharpie armed with analytical tools and algorithmic forecasting abilities.
It’s all perfectly legal, just shady; and because there is no way to quantify what fund investors are losing to the process, the entire practice is going mostly ignored.
Most fund-industry types don’t want to discuss it, preferring to keep this a dirty little secret.
It shouldn’t be, so let’s put on the hip waders and step into the murky underworld of mutual-fund disclosure practices.
First and foremost, as a shareholder, you should recognize that a fund’s trading record is your intellectual property.
You are paying management to execute trades on your behalf; most fund managers are leery of disclosing any information that could affect how efficiently they trade, so you would think management safeguards all portfolio records against any potential misuse.
As a result, you most likely believe that the funds you own report their holdings — which easily can be reverse-engineered to show transaction trends — every quarter, as required for nearly a decade now by the Securities and Exchange Commission.
But many funds report their holdings more frequently than that, often giving their details — with active investment themes redacted — to data firms such as Morningstar and Lipper on a monthly basis.
The purported benefit to more-regular disclosures is that it helps research firms evaluate and categorize funds, which is good for shareholders.
There are other pluses to disclosure. Many managers — famous names like PIMCO’s Bill Gross among them — will tell you they want the market knowing what they are doing, so that they can push securities in the direction the fund’s action is hoping for.
The funds also typically give those updated portfolios to their top clients, pension funds and institutional money managers.
And if the management company runs exchange-traded funds or separately managed accounts based on the same underlying portfolio as its traditional mutual funds, then it is disclosing the portfolios daily.
The beyond-the-regulatory-requirement disclosures, however, provide extra fodder for Big Data, and the research firms are selling that material to hedge funds, institutions and anyone willing to pay the freight.
In describing a product called “full holdings data for institutional investors,” for example, Morningstar documents say the research “provides the most up-to-date portfolios available and makes waiting for SEC filings from EDGAR (the commission’s online document depository) unnecessary.”
That phrase should raise the hairs on the back of the necks of shareholders and regulators alike. As a general rule, fair disclosure requires everyone gets their data at the same time.
Even here, however, nothing illegal is going on.
Truthfully, EDGAR data is like turning on a fire hose; making them useful typically requires someone to take the feed from the SEC and aggregate the information, and someone is going to get paid for the job.
Moreover, the concern that most fund managers and regulators have is about front-running, where data is used to jump in front of trades made by a specific fund, and there is no real evidence that Big Data helps anyone get that kind of edge over an individual issue or manager.
But there is a lot of work in academia on the benefits of tracking institutional investors and fund flows and cash flows.
And hedge-fund managers aren’t paying hundreds of thousands of dollars for this kind of research unless they think it will bring tens of millions in advantages.
In short, if you can tell where managers, on the aggregate, are going, you can ride the crest of the waves they create.
You don’t necessarily skin any one fund, but in a zero-sum game where a trader can guess where a security is going, they get their edge and everyone who follows them into a security pays a higher price than they would have if Big Data had not lighted the path.
Ultimately, the issue requires regulators to re-examine how fund data is distributed, the same way the federal government is looking at how it releases economic indicators to make sure the playing field is even.
Next week, we’ll look at how disclosure rules need to change to make it so that funds aren’t disadvantaged by the information they distribute.
Said one fund manager who uses quantitative data to both manage his funds and to track fund flows, but who did not want to be named for fear of damaging his reputation with ratings firms: “Funds are in a weird place, when we give out information in ways we think is good for shareholders and the fund, but then have that information against us. That’s not how this is supposed to work.”
That’s precisely why changing the fund-disclosure system to reflect the Big Data age is necessary.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at [email protected] or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright 2013, MarketWatch