Like any street, Wall Street has two sides. If retail investors are on the sell side (sold at the offer) then large institutions are on the buy side (bought at the bid.) For them, stock is an investment that must achieve certain returns in the face of various macroeconomic factors.
Generally, buy-side refers to professional money managers, each of which is contractually bound to act as a fiduciary for the people who pay him.

The issue is sometimes confused because investment banks also have buy-side parts to them, which manage money for others. In an effort to stop any leaks and clear up any confusion, investment bank managers create a legal device called a Chinese Wall.  The "Wall"  is a series of policies which aim to prevent information exchange between those selling to the public and those buying for institutions.

Buy-side institutions include:

• Mutual funds
• Pension funds
• Hedge funds
• Institutional firms
• Sovereign wealth funds

The Buy-Side Silence

Who speaks does not know, who knows does not speak - Lao Tzu

Any buy-side analyst can get as much information as any retail investor on a given company. Using only that information would violate prudent standards, however. Institutions know the potential for abuse with sell-side literature and duty to investigate with due diligence any such claims. For some managers, that means reviewing publicly available accounting reports and then analyzing them in a specific, proprietary way.

Other managers will actually visit the companies and talk to employees on a plant tour. These tire kickers think they can get a better idea of whether or not to invest by actually looking over the place. In either case, the buy-side analyst gathers information in order to create his own vision of the future. In effect, the management team of an actively managed fund tries to predict the future. There is no advantage to investing if you don’t know “just a little more.”  The vision they create remains private; no one shares it with the world.

When Advertising Masquerades as Information

Whenever you hear of an upgrade, downgrade or price target, you’re listening to an advertisement. The buy-side keeps its opinions to itself, because it has a duty to do so. Its members have paid for the research they produce. The public has no right to it.

Buy-Side Meets Sell-Side

It used to be that large institutions and small investors were consigned to meet in one place: The New York Stock Exchange. Trading also took place on “the curb” (the AMEX) as well as in Philadelphia. However, New York offered a central location for those with the greatest liquidity needs. Buy-side managers used to place large orders with specialists on the New York Stock Exchange (NYSE) and these firms would gradually execute the orders throughout the course of one or several days. In cases where large blocks of stock needed to change hands, a sudden market order would upset the price to the disadvantage of the institution.

Greater information exchange over the internet and even television made large trades too visible to speculators. Today, your simple online trading platform (which you can get for free from a discount broker) will show you where the liquidity in many issues lies. You can see large blocks of stock offered for sale or you can see prices at which buyers will take thousands of shares. This information makes buy-side managers very uncomfortable, as it should. A smart speculator who sees where liquidity lies or detects changes can insert his own order and make a buy more expensive or a sell less profitable for an institutional manager.

Now, buy-side institutions make their trades away from the prying eyes of speculators in “Dark Liquidity Pools.” This mysterious sounding phrase refers to a series of electronic trades that can take place in small bits on many exchanges across the world without giving anyone a clue that a particular fund is divesting or investing in a company. Contrast this with the orders that retail investors use, and you’ll see that any edge you might have as an individual will be particularly hard won and entirely non-existent if you do not take into account the way that these sophisticated managers work. The moral of the story is simply this: If you engage in retail trading, and you buy a stock from someone, you should ask yourself what that person knew that made him want to sell it to you.

Index investing allows investors to put their money to work with some of the lowest costs in the industry. If low fees for financial services concern you the most, this may be the starting point for your future planning.
New investment products in the last decade allow individuals with relatively smaller portfolios to use ETF’s in order to gain out-sized diversification in a variety of indices. The financial press has widely publicized that typical management fees for index funds are under 20 bips (0.2 percent) which makes them some of the lowest fee choices available. The popular thinking equates greater returns on investment with lowered fees for services.

Other advantages include the fact that shares of the ETF’s trade all day long. This contrasts with many mutual funds whose shares are marked to market once daily, at the close. Sophisticated accredited investors may even short the ETF’s or buy and sell options contracts on them. This flexibility and wide range of choices makes them preferable to mutual fund shares for some purposes.

The wide range of indices represented by ETF’s allow investors or trustees to overweight certain areas which may be more relevant to beneficiaries in a customized manner. A charity involved in food distribution my overweight food related commodities while a company involved in delivery of heavy equipment might overweight energy and transportation issues.

ETF Transaction costs may be significant

The downside to ETF’s is that trading costs may be significant. If you wish to receive monthly income and to re-balance, you’ll need to liquidate shares on the open market regularly. This increases costs to a much greater degree than alternatives which have zero trading costs and zero fees for cash redemption. Individuals may need larger portfolios with less frequent distributions and re-balancing in order to fully realize the cost savings of the lower management fees. In order to take advantage of the great diversification available with ETF’s, a retirement account of at least $2,500,000 starts to make this method economically feasible.

ETF returns under-perform their benchmark

Investors who chase ETF returns make the same mistake that any market timer makes. The design of these instruments allows for out-sized diversification, not out-sized profits. In fact, to the degree that the managers successfully execute the purpose of the fund, they are guaranteed to under-perform their benchmark over each period, simply because of the fee structure and the fact that the underlying assets must conform to the benchmark yields and returns.

The simplistic investment policy statement of ETF’s allows for these low fees. For a given benchmark, the selection of underlying stocks makes the manager’s job easier. One of the largest and most popular index ETF’s is the Dow Jones Industrial Fund (Symbol: DIA) or Diamonds. In order to create shares in this fund, the managers at State Street Bank and Trust Company purchase shares in each of the stocks in the Dow Jones 30 Industrial Index on a capitalization weighted basis. As of this writing, there is somewhat more than 9 billion dollars in the trust and more shares may be created or liquidated in units of 50,000 shares. The procedural details can be found here.

The purpose of the trust is to provide investment results, before expenses that correspond to the price and yield performance of the Dow Jones Index. The managers don’t make any judgments about the individual stock components or any economic, financial or market considerations. They simply make sure that at the end of the day the trust holds enough shares of each individual stock so that one share of the DIA represents an interest in the thirty stocks.

While the Dow Jones Industrial Average may be the most reported index, hundreds of other indices support the diversification needs of individual and institutional investors. The long history of these benchmarks makes for simpler calculations of risk and covariance for professional asset allocators.

Using index funds like ETF's allows for a stringent design of diversification. The investment policy statement of the funds demands that all of the equities in the particular index must be held without regard to valuation or any performance prediction. Thus, the fund follows the performance and yield of the given index very carefully. When an expert designs a diversification plan, she first looks to which investments form a group in some natural way. The first major cut is to distinguish stocks from bonds. Every investor can say why those two are different; it comes down to whether or not the investor owns some of the company or lends some of his money to the company.

This difference makes the two asset classes behave differently when things change in the macro economy. As interest rates rise, some stock prices may go down as the value of bonds comparatively increases. The opposite may happen if interest rates go lower. If you own a combination of stocks and bonds, the individual components will fluctuate, but the total value of your holdings will change less. While it's great to have a bifurcated plan of diversification, an expert can do much better than that.

Logical Groupings Help Create Sub Asset Classes

She looks for logical groupings among stocks that would make them behave in similar manners. Consider that transport, delivery and perhaps car manufacturers behave similarly, although the last may not always move in a pattern similar to the first two.

Contrast those groupings with energy stocks and consumer staples. When energy is expensive, transports and delivery services pay more for gas and report lower profits. Energy companies do well as they achieve pricing power.

Given that this type of thinking underlies good diversification, then the next step is to find out how many distinct groupings one can find that fulfill the criterion that the components move together for some logical reason and that the groups may move in directions opposite to each other given the same conditions. The companies that put together ETF's generally take that into account in order to design and market an ETF.

Good Sub-Asset Groups Have Long Histories

The long history of a properly constructed sub-asset group makes for quite an attractive feature to our expert advisor. With years of daily data, the numbers for performance, yield and covariance in relation to other groups allow her to construct apparently stable behavior profiles. From these profiles, she can decide what percentage of your funds to allocate to each group in order to both capture equity risk premium and to increase safety through diversification.

This same quality of asset classes may also create a false sense of security among amateur purchasers of ETF's. Normally, when a mutual fund opens its doors, it can only report its performance since inception. That should make perfect sense. An index fund, however, can report the performance of the underlying index since its composition is entirely composed of that index. The performance figures for ETF's do not reflect the same kind of performance that a history of an active fund shows.

When a particular sector of the economy outperforms the others, the creation of an ETF around that grouping makes for easier sales to those who want to enjoy the gains without the labor of picking stocks in the outperforming area. Marketing efforts for these funds become easier as the trend continues and everyone wants to jump on board. Thus, a new index ETF may report stellar performance just as the sector or group it's composed of heads for a fall.

Prudent Practice Avoids Trendy ETF's

Sometimes though, the temptation to produce a product that people will buy may lead to products which don't suit the Prudent model particularly well. A fund which holds physical silver and gold may accurately represent the precious metals as an asset class, but a fund which uses rolling futures contracts and buys or sells based on robust technical indicators doesn't represent the type of diversifier one seeks in a prudent investing plan.

Avoid ETF Equity Overlap

Overlap represents a significant danger to a good diversification plan. Most index ETF's hold equities on a cap-weighted basis. That means there will be more shares of expensive companies in the fund than shares of lower prices, less capitalized companies.

Consider the American behemoth General Electric (GE.) It's one of the largest companies in the world. How would you classify it? Large cap, domestic, durable goods provider? Do you know that a large share of its business comes from its financing arm, so part of GE behaves like a bank?

GE could be a large portion of several different ETF's. That means that a number of the parts in your portfolio you had counted on to act differently may end up acting the same way because of the elephant in the room. In order to be sure that your diversification is effective, an expert should perform a thorough drill down to check for this kind of overlap.

In both bull and bear markets, popular media advise strongly that lower fees guarantee a larger return. After all, if you avoid a 1% fee, then you have 1% more money for yourself. John Bogle, founder of Vanguard funds, advocates that individual investors pare away most all fees and “take what the market gives them.”

Prudent experts know that fees can impede return. On the other hand, the expert has a positive duty to make sure that each part of the trust operates smoothly and that often requires delegation. In order to delegate, the advisor must be sure that the service you get adds value to your overall portfolio, either in terms of safety or return. Additionally, he needs to be sure that the fees each expert delegate charges reasonable and customary fees for the services he delivers.

Most importantly, a Prudent Fiduciary may not have a set opinion about fees or commissions, but instead must investigate which of these are necessary and reasonable.

Actual Benefits, not Manner of Compensation Guide Decisions

As an example, it may not be worthwhile for a CFP advisor to spend an hour or two on life insurance planning for a 40 year old with a spouse and two children when the same work can be done at no additional cost by a competent insurance agent. Incurring a fee over and above a commission on that issue simply does not make sense. The client requires competent planning, and if there was a prejudice about fee only issues, then the cost of the service would be greater than it needed to be.

Perhaps the hottest button for investors is the question of mutual fund and advisor fees. With the availability of very inexpensive ETF’s (Exchange Traded Funds,) some would think that mutual funds are a thing of the past. If no one can choose stocks consistently in such a way as to outperform the market, then paying for these services makes no sense. And the popular press is filled with quotes about managers who can’t beat the market net of fees. In light of the fact that individuals and institutions pay billions of dollars per year to portfolio managers, a Prudent expert must examine this statement carefully. On closer examination, the common thinking about stock pickers may be a bit of journalistic sophistry.

Skilled Managers May Reduce Risk

Those who subscribe to the strong form of the Efficient Market Hypothesis must believe that no manger can gain an advantage in choosing stocks at any time. Each price at every time is perfectly correct because of the accumulated wisdom of “the market.” Those who believe the weak form of the EMH may allow that some managers have skill, but that a given investor could not tell whether a particular manger was lucky or skilled.

In fact, it may be that paying a portfolio expert to choose certain stocks over others is money well spent. A Fiduciary Expert knows and uses various means to determine if indeed the managers are worth their fees.

So while the press may lead you to believe that the only way to invest is through the use of very low cost measures, it’s worth remembering that some valuable services are worth paying for.

You answer your telephone only to hear your brother-in-law telling you that you have to drop everything and listen to this. He has a line on The Next New Thing. Gasoline from seawater!

Sure, it was spoken of in whispers during World War II, but now scientists have perfected the process and you can get in at the bottom. This is your chance. Oil prices are higher than ever, aren't they? In fact, the stock is selling for just $0.37 on the OTC:BB market. Should you buy 10,000 shares, just to be sure you don’t miss out? You can see your mind racing to figure out how you could raise that extra cash quickly.

You think about what happened with Microsoft, that company that was started in someone’s garage. Didn't that idea sound just as ridiculous back then? The same company whose stock options made multimillionaires out of secretaries. Now your palms are sweating and you wonder if tomorrow isn’t too late to buy some of this stock. What’s a Prudent Investor to do? On the one hand, the idea is patently ridiculous. On the other hand…. What if?

Missed Opportunities May be Costly

On the performance side, one of the risks to a prudently managed portfolio is that it will fail to capture the Equity Risk Premium of the world capital markets. (See: The Wealth Factor: What Every Portfolio Needs to Succeed.) In short, the purpose of prudent investing is to make sure that you are able to benefit from the earnings of as many good companies around the world as possible. It’s true that many of the strongest and most sustainable ones are here in the US, but there are some great candidates in other countries. You don’t want to ignore any good opportunities.

Imagine how poorly an investor would do if he was so “conservative” that he refused to have own shares in any company which was not established enough to pay dividends. His reasoning: If it isn’t safe enough and established enough to be making good money, I don’t want any of it.

With that kind of an attitude, he’ll miss a great deal of growth over any given decade. Indeed most of the universe of small cap and micro cap stocks do not pay dividends. Companies grow like oak trees if they are successful and they almost all start small. There is a risk in bringing any new idea to market and investors take that risk everyday. The price they pay to participate in that opportunity is relatively small since the shares have lower prices. That makes up for the fact that plenty of companies go bankrupt. Most go honestly and quietly, unlike Enron. But failure is still a fact of life in business and a risk that must be taken in a prudent portfolio.

So how do you handle the opportunity of a lifetime at less than the cost of a cup of coffee in the old days, when it didn’t cost $3?

First, you need to take a breath. This isn’t the first world shattering idea that has come about and it won’t be the last. Back in the 1600’s in England, shares in a company whose purpose was “To make a profit, the secret means by which are not to be disclosed,” were sold and even became expensive before the company simply folded in the crash of the South Sea Bubble.

Good Companies Prove Themselves

Let’s say, for the sake of argument, that you have been presented with an idea for a stock whose meteoric price rise will surpass Google or Taser. You’ll have to agree that somewhere between being sold for $0.37 and $1,200 per share it’s going to cross the $5.00 mark. For most institutional investors, that’s what puts it on the radar screen. Many mutual funds have investment policy statements that prohibit them from investing in companies with share values under $5.00. On the other hand, once that barrier is breached, you may see lots of accumulation in the stock if the idea looks good and if the company appears viable.

You might even be lucky enough to have an active manager who sees this opportunity early and grabs it for the fund that you own. But even if you miss that early stage, you’ll have ample opportunity to catch the value as the company’s revolutionary product becomes more and more mainstream and hence profitable.

So what about all that profit you missed form $0.37 to $5.00? That’s more than a ten bagger! How could you let that go?

It’s simple and here’s the reasoning: If this new idea is viable, the company will be in demand. Its shares will get listed on a major exchange. That’s a major goal for the investors and for the CEO of any company. Listing on a major exchange means millions for them. Of the thousands of stocks on the OTC:BB about 6 get listed each year. So while that stock for under fifty cents sounds great, in order to reduce your risk of rolling craps, you’d have to spread your investments around hundreds if not thousands of other “great ideas.”

Your best chance at capturing the equity risk premium across the world markets is not to speculate in low cost bargains. If you limit your choices initially through the use of a professionally designed investment policy statement, then you’ll significantly reduce your risk and conserve your capital.

Portfolio management serves two purposes; a manager or advisor needs to control risk and work to capture returns. An expert prudently diversifies the portfolio to protect against systematic risk. A good advisor will go to great lengths working to decrease the vagaries of market prices. Market volatility harms those making periodic withdrawals from their accounts. Volatility can as easily aid them, when prices move higher, but safety considerations deal with the downside risk.

Buy and Hold is not the Answer

Academic research over the last half century, as well as recent experience shows us that there may be no ultimate buy and hold strategy. The “solid names” in the stock market can as easily respond to macroeconomic factors as any other stocks. The idea that one could construct a finite portfolio that would last into perpetuity dates from the beginning of the last century, before expertise in portfolio management and asset allocation began.

Earnings power is the second half of portfolio management. Anyone can get some information, like earnings per share number or price to earnings ratio. Not everyone can properly evaluate more esoteric issues like retained earnings and diluted earnings per share. In order to properly evaluate the purchase of a company, these details should be examined for every individual even when the individual must delegate the task.

Dividends May not be a Key to Value

Dividends, a cash back form of earnings may or may not provide more value than stocks which do not pay them. In the early 20th century, transaction prices for any stock trade often represented 6% of the total transaction in trading and spread costs. Someone who wanted retirement income or income for pensioners could avoid those costs if he could find a stock that turned out cash dividends. The income requirement for the portfolio might be had in its entirety or at least augmented by income that was transaction cost free.

Even today, some investors chase high dividend stock issues like Canadian Investment Trusts or try to find the highest interest rate with New Zealand Bonds both of which purport to deliver up to 13% in cash dividends. While investments such as these cannot be categorically denied, the Prudent investor will asses the inherent risk of the return stream before purchasing any. Further, a portfolio with proper asset allocation will have a relatively lower number of such issues compared to the total portfolio value.

Part of the reason that Dividend Reinvestment Programs (DRIPS) have waxed and waned in popularity is the transaction free nature of the reinvestment. Few investors in these programs have a large enough portfolio to properly diversify against the risks they invariably take by over-weighting only dividend reinvestable stocks in order to participate in the program.

Objective, unbiased advice is the ideal that investors seek when consulting an expert for retirement planning. The popular press insists that only a person compensated through a fee-only agreement can provide such advice. Ironically, this misconception is itself a form of biased and subjective thinking. In fact, for retirees with less than $750,000, fee-only planning may incur more expense and more volatility than products which pay planners through a commission schedule.

The only way to determine which choice is the best for your situation is to examine both paths and make an informed decision based on numbers instead of prejudice.

If you seek objective advice, then you need an impartial assessment that exhausts all of your options. A prudent expert will dispassionately examine the vast universe of investment products in order to find those which will help you attain your objectives and reduce your risk through diversification. In order to examine all of your options, none can be eliminated out of hand. That paring process comes later.

Fiduciary Planning Takes a Holistic View

Since 1994, prudent investor law eliminated the entire concept of an "unsuitable investment." Now, in order to preserve wealth, more specifically spending power, an expert has to push beyond considering a small universe of perhaps 3 - 4,000 stocks and expand her thinking to include some of the following instruments:

• Global Stocks (Across all markets, foreign and domestic)
• Mutual Funds
• Pooled money, such as Annuity sub-accounts
• REIT's (Real estate investment Trusts)
• ETF's
• Government Bonds (Domestic and Foreign)
• Corporate Bonds (Domestic and Foreign)
• Options
• Futures Contracts
• Life Insurance Policies linked to Market Returns
• Short Term and Long Term Money Market instruments
• More arcane instruments, like Warrants, Limited Partnerships and Hedge Funds.

Rather than asking if these are suitable, the advisor needs to evaluate each in terms of various risks and possible rewards, always keeping in mind that the reasoning must be documented and reasonable. Risk in these instruments entails more than just looking at volatility.

Expert Advisors Ask Hard Questions

• Does it help to capture equity risk premium across the span of the investment life?
• Does it work towards reducing the overall volatility of the portfolio, or does it require other investments to help mitigate its extreme volatility?
• If it’s a managed product, can we evaluate the manager without relying solely on performance measured against the SP500?
• If it’s contractual, what are the business risks as well as the value of the guarantees or terms?

It’s not unusual for a particularly diligent advisor to use pools and other instruments to devise a portfolio of literally hundreds of stocks in order to provide the income and protection that someone would need for a 30 or 40 year retirement.

In case of a trust, the “risk tolerance” of the beneficiary is not a consideration. Certainly, market behavior will not change based on a widower’s opinion of the economy nor will the market behave particularly politely if many nervous investors participate. The risk tolerance issue involves the purpose of the portfolio, usually lifetime income and not how someone will feel as she spends it.

Conservative Investors May Violate Prudent Standards

Most conservative investors, guided by a subjective and unique feeling of what should be done with their funds, will exhibit a diversification bias. They will tend to select investments with similar characteristics even as they think they are diversifying. The bias shows up as a preference for Blue Chip or Large Cap Domestic stocks, national chauvinism and value (or growth) orientation.

Impartiality in regard to investments is one of five major differences between a prudent and a conservative investor.

Most of the people we speak with consider themselves conservative investors. You probably do too. And if you were asked if you were also a prudent investor, you might answer "yes," and see no difference.

But the difference is huge. And ignoring the difference can be hazardous to your wealth.

"Conservative" is a Feeling; "Prudence" is Objective

Calling oneself conservative is a generally subjective opinion. It has a fluid definition that basically says, "I'm trying to be careful." On the other hand, prudent investing refers to a technical term whereby your investments, estate plan, spending plan and goals are all aligned according to the Uniform Prudent Investor Act. One major difference is that the prudent standard is objective, while each conservative investor has ideas of his own. prudent portfolios have more structure to them and have definite similarities among them, because they follow the rules of law. In our experience of looking at hundreds of various portfolios over the years, all belonging to conservative investors, no two ever seemed alike.

Conservative and Prudent Investors Want Safety Differently

In a casual conversation, both Conservative and prudent investors will agree on the importance of safety. The conservative will initially think he is risk averse, but he takes more risk than the prudent investor. When the subject of taking on aggressive stock positions or "risky investments," comes up, a sometimes heated disagreement will arise.

Before we talk about how prudent investors like institutional pension funds manage risky assets, let's address the way most conservative investors handle them: They don't.

A conservative investor, because he wants to preserve principal at all costs, usually shies away from what his gut tells him is "too risky."

Prudent Investors Seek to Capture Return Safely

If you want to be a prudent investor you have to think harder than that. A prudent fiduciary will calculate an optimum choice of which stocks to buy and how much money should go into each stock. To figure out this optimum mix, he will need to know the covariance of every investment with every other investment. An expert keeps track of these many covariances in a large table of numbers, called a covariance matrix.

You need to capture equity premium everywhere you can find it, and then figure out how to reduce the risk at the same time.You'll reduce the risk by finding out how each investment relates to every other one in terms of its return over time. In shorthand, you'll determine the covariance of the investments with each other.

Your total investment portfolio should have a lot of different investments to consider. The key to prudent risk reduction is to determine how the investments may correlate with each other over time. Some stocks, like Berkshire Hathaway A and Berkshire Hathaway B, have perfect correlation. There's no point in owning both. Lately, there have been a number of Exchange Traded Funds that have almost perfectly negative correlation with a particular index. Those are more interesting and we hope to have a discussion about those posted soon. Effectively, those funds can cancel all or part of the risk across a wide variety of investments.Everyone knows that to be safe your investment portfolio should be "diversified."

Diversification has Measurable Parameters

Diversification is a technical term which means you have a variety of investments that don't correlate with each other very well.

How do you choose among possible different investments? You could just throw twenty darts at a stock market page and buy the same dollar value of the twenty stocks that you hit. Journalists and some pundits would tell you that this would not be a bad choice.

Unfortunately for the casual investor, "not bad" is not good enough.