Sunday, April 26, 2009

Did Two and 20 Sink Wall Street?

The thing about human nature is that someone's always sizing you up.

On Wall Street, if your neighbor is making more money than you, you want to know why. And if there's an opportunity for you to tap into the riches yourself, you're sure to follow his lead, because if you don't, someone else will. (By Wall Street, we mean the different firms participating in the capital markets.)

Call it common greed or animal spirits: it's what makes Wall Street move. It's the water cooler chatter of who gets paid what – inside and outside a firm.

Until the late 90s, big sell-side firms drove Wall Street compensation. You got rich by working your way up the ladder to managing director or partner – less so the latter as the sell-side's partnership model broke down.

From 1997 to 2003, market volatility leapt upward and stayed there – first on the Asian currency crisis and then on three consecutive down years in the equity markets. Traditional investment banking franchises produced less and less revenue over this time.

This period also marked the end of one of the greatest bull market runs in history. For nearly 20 years, most securities you purchased increased in value (if not immediately, then over time), and long-only investment strategies flourished.

In 2000, this trend reversed. Investments went down in value, not up. Consecutive down markets paved the way for successful short-selling.

The primary difference between the longs and the shorts? Fees. While the longs charged management fees of about 130 basis points (as of 2000), investors in shorts paid not only another 70 basis points, but also 20% of annual gains. (Many long-onlys do charge loads, but these are one-time fees paid at purchase or redemption.)

For $100 million under management, a long would take home a management fee of $1.3 million, and the short $2 million, regardless of performance. If both return 10%, the long still would retain $1.3 million, but the short would gain another $2 million, taking 20% of the $10 million gain.

The sell-side's traditional revenue engines sputtered, but the shorts – the two-and-20s – got wealthy, and a sharp discrepancy opened between the sell-side and the buy-side.

Not to be outdone, big sell-side firms transformed themselves into huge hedge funds. Proprietary trading desks chased the same performance as their stand alone competitors. To keep traders from jumping ship, managers paid out big bonuses, which got bigger as the two-and-20s earned more.

After 2002, low-cost borrowing boosted returns, and the two-and-20 mentality stuck. In fact, some funds were able to increase performance fees up to 50%.

In the end, Wall Street lost control, and the house of cards collapsed. Will fees downshift as a result? Will the water cooler conversation change?

Time will tell, but as long as there's a lead steer, expect that others will follow.

That's just how human nature works.

Tuesday, April 21, 2009

From Bell Curves to Comparative Effectiveness

What's good for you, may not be good for me. That proposition works in groups of two, but what about three or more? The breakdown of what's good – and what's not – could be skewed across few or several.

From a business perspective, the value in addressing more than one customer is in achieving scale. The bigger the scale, the better the probability of appealing to large numbers of people.

Statistically, a large group translates into a well defined bell-shaped distribution curve, at the mean of which businesses point goods and services.

As long as there's value to be had, new businesses will form and push deeper into the tails, targeting bell curves inside bell curves. And as long as this process continues, more and more customers will get what they want or need.

The drug industry defines scale in terms of patient populations. Big populations mean better opportunities for leveraging the billion dollar cost of product development. Patent law provides pricing protection for a defined period of time.

Recent advancements in pharmacogenomics, the study of how variations in the human genome affect a person's response to medication, are now upsetting this balance. Where previously a drugmaker would point to the mean of the biggest possible bell curve, it can now aim tailor-made products at the tail and throughout.

Pharmacogenomics would be the perfect vehicle to mine the entire curve, except for the economics. Personalized medicine comes at a significant cost, both in product development and in testing and administration. For widescale use to occur, payers would need to realize material social benefits, such as in quantifiably healthier, more productive workforces.

At its core – and a key platform of health care reform – is comparative effectiveness: side-by-side clinical assessment of medical treatments. Often, the FDA approves medications that target the same indications, but it never evaluates one versus another, for example, the way Consumer Reports might do for a class of automobiles. Physicians, therefore, rely on aftermarket studies (typically funded by the drugmakers themselves) and their own instincts for prescribing.

Beyond just issues in science and economics, politics also factors into comparative effectiveness, in particular as a question of public or private oversight. Typical questions include:
  • Who should set the agenda?
  • How do you measure it?
  • Who measures it?
  • Who decides which intervention to measure?
Eventually, stakeholder risk will determine how far comparative effectiveness takes root – specifically, the cost of a negative outcome, and who bears this – whether the drugmaker, provider, payer or patient.

Only after the risk equation is sorted can a rapid parsing of the bell curve take place.

Monday, April 20, 2009

Wall Street May Be Changing, But Trading Activity Isn't

Despite Wall Street's shrinkage, trading – its core focus over the past decade – is busier than ever. The best measure of this is the market turnover rate: the volume of shares traded against the total number listed.

A 100% turnover, for example, would mean that market participants buy and sell the entire market over a one-year period. Since 1960, the average turnover rate has increased every decade, from 17% to 114%.

As of March, it was 160%, equal to an eight month holding period.

Why so manic? Two reasons: first, technology advancements make it easier not only to transact, but also to access investment information. Second, during extreme market movements (up and down), shareholders tend to react uniformly, adding or withdrawing funds. These flows can profoundly affect how investment managers put the money to work. Redemptions, in forcing money away, can be particularly disruptive to investment strategy.

An important consequence has been a rebalancing of market participants. Consider the table below, which compares 2004 US equity ownership with 2008.



As a percentage of total – and relative to everyone else – the biggest declines occurred in households and private pension funds, at 334 and 143 basis points each.

Three entities have more than made up the difference: ETFs (a 196 basis point increase), foreign investors (+188) and the federal government (+124 – all in Q4 2008).

Turnover activity, however, is not uniform across participants. Mutual funds (in aggregate) buy and sell about 50% of their portfolios in a year. ETF rates are often much lower, because they're passive index trackers. (The trading levels in ETF shares can be quite high, however.) Insurance companies and pension funds also utilize similar long-term timeframes.

A smaller concentration of participants has driven the rising trading levels. Enter alternative investment groups: hedge funds and proprietary trading desks. No other entities have used technology more effectively to produce investment returns. And no one has had the same sensitivity to money flows.

While there is lots of talk of Wall Street changing, trading activity suggests forces in play for several years now are continuing.

Wednesday, April 15, 2009

Changing Consumer Behavior in Health Care Begins with Engagement

Why is it so difficult to change consumer behavior?

Why, for example, can't employers get smokers to quit, or physicians convince overweight patients to exercise and diet?

And why does it take a negative event for the patient to begin considering a lifestyle change? (Even then, nothing is guaranteed as medication adherence statistics indicate.)

For folks like Mayor Bloomberg of New York, the solution to behavior change is 'I know better than you, so I'm going to control what you do.' Decree would seem the surest way except that most people don't want rules imposed on them.

But if we look to other consumer industries such as retail or entertainment, behavior modification occurs much more easily. The reason is engagement: how a person identifies and interacts with a product or service.

One of the strongest examples of user engagement is in software development. Open source projects involve hundreds – often thousands – of contributors, nearly 100% of whom see no monetary compensation whatsoever. Yet, many devote several hours a week of their spare time to writing code.

What keeps them to it is often nothing more than peer recognition or the satisfaction of having contributed directly to a high-use product.

The open source software movement and health care both share a broad scale, complexity and problem-solving needs. They're massively different, however, in organization. For code writers, open source projects break down into discernible teams. For consumers, patients and all stakeholders for that matter, health care offers few mechanisms for engagement.

Open source software doesn't work because of some sort of mythical altruism. Instead, it's the collective output of multiple self-interested parties. The end result is a user's product, not something developed for users.

Health care functions much differently. Decisions are made in the best interest of someone else, often with zero transparency and irrespective of consumer or stakeholder input.

Until engagement can occur and collaborative processes take root, don’t bet on big returns from behavioral modification efforts.

Sunday, April 12, 2009

Consumerism and Health Care Reform

Agree or disagree?
  1. I trust myself to make the right decisions about my own well-being.
  2. I trust others to do the same.
  3. When I purchase a good or service, I don't just consider price, I think about whether it's a good value.
  4. Value is something I determine for myself, not what others determine for me.
  5. My purchasing decisions depend largely on my own understanding of different information sources – sometimes friends, sometimes my own research.
  6. Wasteful spending means a lot more to me if it's money I've spent from my own pocket.
  7. I consider insurance protection as my responsibility, not as a right.
  8. My biggest fear about a negative economic event is loss of control.
  9. Given the choice, I would always pick a defined contribution program over a pension plan.
  10. Despite recent market performance, I'm still confident of my ability to manage this defined contribution program for long-term gain.
If you agree with most of these statements, then you likely see consumer choice as a viable economic tool. What happens, though, if you apply this to health care? Does this mean you would accept more consumer control in health care decision-making? And if you're ten for ten is the answer necessarily an automatic 'Yes'?

Over the coming weeks, the health care debate will intensify. The White House is keeping to its goal of signing reform legislation by the summer break.

While most of us would think of ourselves as true consumers, we would also agree that health care is different than most services. Does, for example, being gravely ill – or caring for someone who is – change our outlook? Should it?

The debate will expose a deep philosophical divide on the role of consumerism, whether we can trust ourselves as individuals to make our own decisions. Although political opponents would seem to advocate consumer choice in their respective plans, they separate on what the consumer can actually achieve, and how the public-private model supports or contradicts this as an economic force.

Health care today is employer-based and Medicare-priced: it's privately paid for but priced in a two-tier system, with government paying below-market rates at one level and commercial plans above-market rates at another level. Consumers might have certain choices, but these are limited, in contrast to the rest of the economy where consumerism exists as understood above.

For consumers to establish value in the way they do elsewhere, the public option would have to diminish, or vanish altogether, so that a more balanced marketplace could exist.

True reform, therefore, means replacing the current hybrid model with one that's fully private (or fully public, as some would intend), which is why debate is ultimately a referendum on consumerism as a force of change.

Any other legislation would be reform in name, and advance the status quo, either slightly more or slightly less.

Friday, April 10, 2009

Billing Codes and the Medical Home Model

Billing codes are to health care what tickets are to horse racing. No ticket, no payout.

Unless the provider knows someone will pay, he's unlikely to perform a service – at least more than once. Makes sense. As magnanimous as we'd all like to be, we can only do what we do so long as someone is paying for it.

In health care, billing codes identify each procedure that a doctor performs, whether surgery, drug administration or the routine physical exam. Insurance companies use these codes for reimbursement. If they can't assign a code, then they won't pay.

A provider, therefore, tends not to explore alternative practices unless there's another revenue stream he can tap into. This means stepping outside the reimbursement system, and requires either a patient population paying out of pocket, or employers "carving out" programs from their health plans and paying directly for them.

While the coding process might allow for more control and standardization, it also impedes innovation. Take, for example, the medical home concept. Generally pertaining to primary care, the medical home targets physician-coordinated care – a bundled, rather than unbundled, approach. Most important, it represents a potential boon to a broken profession.

Despite its promise, uptake has been slow, mostly because the current fee-for-service system makes it difficult for code-making committees to get their arms around a model that is more art than science, even though many folks argue it would produce better outcomes than current practices. Medicare and various commercial insurers are experimenting with different models, but typically this is happening within the traditional reimbursement framework.

So, for a concept that's been around over 40 years, it may take another generation before the system itself can change to allow for proper implementation – proper in terms of its intent, rather than how the unbundled system would transform it.

In the meantime, look to the non-reimbursement world for examples of effective uptake.

Tuesday, April 7, 2009

Tale of Two Tapes

The TED spread and VIX index are two of the market's most important risk gauges. The first reflects banks' willingness to lend to each other. The second shows investors' expectation of up and down movement in the S&P 500. The former measures credit risk, and the latter equity risk.

Both peaked in October 2008: the TED spread at 4.6 and the VIX at 80. Prior to August 2007 (the onset of the financial crisis), the two measures had averaged about 0.4 and 14, respectively.

From this peak, credit risk moderated considerably more than equity risk, a 75% versus 50% decline. The TED spread now is about twice pre-crisis levels, while the VIX is nearly three times higher.

The charts below – dating back to 2006 – illustrate this movement: the TED spread in the top one, and the VIX index in the bottom one.






So, what gives? Well, it seems to come down to just that: government giving is supporting big lenders deemed too-big-to-fail. The rest of the market, meanwhile, must fend for itself.

In normal times, market participants would have already arbitraged this price differential, especially one so big in extremely liquid markets. A hedge fund, for example, might sell a bank index against the broader market.

But they haven't (or haven't been able to), which is all the more striking since this differential has existed – unchanged – since January.

At best, the gap suggests a fundamental instability in the capital markets. At worst, it would indicate a new market order of severely uneven competition and inefficient pricing.

Either way, government intervention is elevating the cost of capital. The effect could either be long or short in duration.