Rigged Chapter 15

"Tilt"

by

Ross M. Miller
Posted July 29, 2004

Our collective euphoria, brought on by a combination of the thrill of discovery and lack of sleep, was short-lived. For one thing, we were due back at Lowell in two hours. More of a letdown, however, was what Tara found when she returned to her computer. I saw her staring at the screen and saying to herself, “My . . .”

“My, what?” I said. “Did something fail to check out?”

“No, not that,” Tara said.

“Then what?”

“There’s one question that we forget to ask.”

“Yes . . .”

“Does what we’ve found explain why Ken’s Aggressive Growth fund has behaved so badly?”

“And the answer is . . .”

“Not entirely—in fact, far from it. I can attribute only somewhere between a quarter to a third of the decline in Ken’s performance to his inability to access the silos anymore. That leaves most of it unexplained. Furthermore, regardless of where Ken bought his stock or was able to dump it, he still would have solidly beaten the market before GFF came along, but not afterwards. He might not have been the top performing fund manager without the silos, but he was doing something right, at least until the time of the acquisition.”

“Even a quarter of the chips is a good start,” I said. “Now we just have to find a way to corral the rest. And we still have the portfolio database to examine. It’s all in one place and Zero should have no trouble loading what you need onto your laptop. You can take it with you over to Lowell. If yesterday is any indication, we should have lots of spare time.”

“Probably more than yesterday,” Randy said with one arm on the television. “All the markets are set to open on schedule. That’s what Sally says.”

“If she says it, it must be true.” I responded.

I had room service bring breakfast up with the final coffee delivery. We went our separate ways at seven-thirty and would reconvene an hour later for the walk over to Lowell. I don’t know what Zero and Tara did during that time, but Randy went down to swim some laps while I took a catnap. I recalled from a misadventure in the distant past that to catch any real sleep was a mistake—when I sleep, I really sleep. I was confident that caffeine along with my own natural chemicals would get me through the day. I figured that surgeons over at Mass General were rewiring people’s brains on a lot less sleep.

The walk into the financial district had a different feel from the previous day’s excursion. Randy had become obsessed with trivia, pointing out the Escheresque bricks that paved the sidewalk and the golden lobster weathervane that graced the roof of a seafood emporium. The rest of us were more inwardly focused. We let Randy’s narrative sail by us like a gull on a thermal. Before we joined up with the sea of office workers who had parked in the cheap lots that dotted the waterfront and were hoofing it in the rest of the way to work, I stopped and turned to give the group its marching orders for the day.

“First thing. Whatever you do, don’t mention ‘Rosebud.’ For that matter, don’t let Citizen Kane or Orson Welles slip into the conversation.”

“Is Peter Bogdanovich okay?” Randy asked.

“Only the context of Cybill Shepherd, Eric Stoltz, or James Gandolfini.”

“Bada bing. Six degrees of Guido the Killer Pimp.”

“Of course,” I said, “don’t let on that we’ve accessed the database. At some point, they’ll figure things out, but I hope by then it won’t matter. Also, I expect to be called away at some point to meet with Roland. I’m sure that you can manage without me.”

There were no further comments, not that I invited any. As we approached our destination, we were unfazed by the impediments to our entry—construction, smokers, and guards—and found ourselves back in the conference room with five minutes to spare.

Lloyd came by to greet us. “We’re having our pre-opening conference call down the hall, you’re all invited to join us.”

Was it possible that Lloyd was capable of being congenial? We went along with Lloyd, who casually said, “By the way, Ken’s out of town and can’t make it today, though he will be hooked into the conference call.” No surprise there.

Lloyd led us to a conference room that was identical to our usual one except that its view of the water was obstructed by a neighboring building. Everyone’s attention was focused on the speakerphone. The seats at the table were already filled and we didn’t want to sit there anyway, so we occupied chairs along the back wall of the room. As new parties joined the conference call, they identified themselves. Kenneth Paine was the last. The call began at seven minutes after the hour.

Most of the call concerned what the Fed would do at its next meeting. I found this to be a curious obsession given that the meeting in question was weeks away. The remainder of the call focused on specific stocks held by Lowell’s funds. Everything proceeded as if the stock market had never skipped a beat. Except for Consolidated Information Systems, that is. As the obvious scapegoat for the unplanned market holiday, it had already dropped fifteen percent in pre-opening trade. Rumor had it that it might lose its contract with the stock exchanges to one of its competitors, all of whose stocks were trading higher. It was clear from context that only Ken’s fund owned Consolidated shares.

The conference call ended a minute or two before the nine-thirty opening bell. We filed back to the other conference room to await Lloyd and his minions. Zero wandered off in the direction of Karen’s office and Tara got out her laptop computer to try to find a way to make sense of what was going on.

“I’d like you to start things off today,” I said to Randy, who seemed amused at the prospect.

“Really. What should I ask them?”

“Anything. As long as it has absolutely nothing to do with what we talked about earlier.”

“Anything?”

“The more anything, the better.”

“I see,” he said, “you want me to fluff them.”

“If you want to put it that way, yes.”

I was counting on Randy for two things. First, if Randy was doing the talking, I could concentrate all of my attention on the moods and reactions of Lloyd, Harvey, and the others. Second, I was confident that Randy would confuse and annoy them. He was good at that sort of thing.

It was not until well after ten o’clock that the day’s proceedings began. Lloyd brought the same crew that kicked things off the day before. Zero entered with Karen and loudly said, “I’ve got the password now.”

I sat quietly and let Randy take over.

“I found the part of the conference call where you were discussing the Fed to be quite intriguing,” Randy began. “Have you ever considered constructing a model of how the Fed makes its decisions?” Randy spoke slowly as if he were intentionally drawing out every word to obfuscate further what it was that he might or might not be saying.

Lars fielded this question. “If you’re talking about computer models, we don’t have that capability in house. We focus more on industries and individual stocks. We do, however, subscribe to a newsletter written by the leading Fed watcher to help stay on top of things. I think that he has a computer model that he uses to determine what the market will do under several possible scenarios.”

“But does he model the Fed itself—the thought processes of the individual board members and Chairman Greenspoon—and how they shape each decision?”

“No,” Lloyd interjected, “I doubt that he does. And Alan Greenspan is the Fed chairman’s name. I don’t know of anyone who does.”

I began to wonder if Randy would suggest that Lowell invest in an animatronic re-creation of the Federal Reserve Board, but his attention span was short enough that he had already moved to the next topic.

“I’ve also been thinking about market research,” Randy said. “I see that Richard Warren isn’t back here today, but perhaps you can answer my question without him. I’m wondering if rather than waiting for your customers to tell you which new funds to offer, might you not have some way of anticipating their needs? That could give you a big jump on the other investment managers.”

Great. Randy was telling them how to run their business.

“No,” said Lloyd, who had rolled his eyes upon hearing this, “I don’t really see how we can do that.”

Randy then explained how they could do it. While I thought that Randy had a number of good points, no one from Lowell did.

“That’s all very interesting, Randy, but there are several reasons that it just won’t work.” Harvey said with his fingers arched against the table.

“I’m sure that the two of you can talk things over during a break.” I said, using the standard GFF technique for halting an unwanted discussion in its tracks. “I’ve got some questions of my own.”

I could feel the relief in the room when I gave Randy the hook. I looked directly at Lloyd as I asked, “How do you reconcile your investment strategy with the theory of efficient markets?”

As I had hoped, Lloyd looked bewildered before responding, “Reconcile? In what way?” He then laughed nervously and said, “I didn’t think we’d be getting a pop quiz today.” The Lowell contingent minus Helen laughed along.

I glared back at Lloyd and saw him flinch. “Okay, I’ll spell it out. If the stock market is efficient—I recognize that’s a very big if—there is no way that you or anyone can beat the market over the long haul. Winners and losers in the markets are determined at random and, over time, any random winners will be offset by a corresponding number of random losers. Could it be that the success of your Aggressive Growth fund is just a statistical fluke and its recent performance is merely randomness come home to roost?”

Lloyd clearly had a pat answer for this question. “Let me assure you that you are not the first to ask that question and I daresay you will not be the last. The Financial Analysts Journal had an article a few years ago looking at the top-performing mutual funds. The authors of that article—one of them was from MIT—showed that Aggressive Growth’s outperformance was highly statistically significant.”

“But with so many funds doing business, wouldn’t you expect that one or two would do phenomenally well?”

“The authors took all that into account. Their study included several thousand mutual funds, but the type of performance that Aggressive Growth has had is a one-in-several-billion occurrence. No one is that lucky.”

Lloyd’s body language indicated that he was satisfied with his answer. Even if the study might be out of date, I was happy that someone else had confirmed Tara’s analysis, not that I had any doubts.

“I’ll believe you,” I said. “If it wasn’t luck, randomness, or whatever you want to call it that has historically accounted for the superior performance of Aggressive Growth, then what did?”

“The credit should go to Ken and his analysts. I’d be happy to have you meet with them. And with Ken, when he returns.”

“No need for that.” I saw Lloyd’s offer as a way for his side to eat up the clock. “What about your traders? How important are they?”

“They make their contribution. Everyone here contributes. Lowell is a team. Always has been and, I hope, always will be. Still, the traders can only buy and sell those stocks the portfolio managers specifically tell them to trade.”

“Are the traders ever given conflicting instructions?” I asked. “Let’s consider a hypothetical example. Suppose that Ken were buying stock in a company for Aggressive Growth and Harvey here were selling the identical stock for one of his sector funds. Could this happen?” I shifted my increasingly piercing gaze to Harvey as I said his name in the expectation that he would answer.

“Sure,” Harvey replied. “It happens all the time. My funds and Ken’s have different objectives. I’m restricted to stocks in a given sector, Ken can move from sector to sector as necessary to capture the highest return. A stock that might no longer be a good play for me within a sector may be just fine for Ken.”

“So how do your traders buy for Ken and sell for Harvey at the same time?”

Harvey paused, as if confused, so Lloyd jumped in: “We have a crossing system to handle that automatically so that the traders don’t need to send the orders to our brokers. It saves us a ton of money on commissions. It’s especially useful for our index funds, which have to buy and sell shares in proportion to their weight in the index regardless of what our research shows. For index funds, cost is king. Being able to cross trades with Lowell’s other funds gives our funds some of the lowest expense ratios in the industry.”

“And it doesn’t hurt your other funds either, now does it?” I said in the most provocative way I could.

Lloyd stayed cool. “No, it helps keeps expenses down across the board. That helps our performance and benefits our investors.”

Lloyd and Harvey had both answered my questions without leaving their comfort zone. If there was any funny business with how their funds traded with one another, they acted as if they were unaware of it. It was time to start moving in.

“Yesterday,” I said, “when the exchanges were closed, I’d imagine you were still able to trade among your own funds.”

“No,” Lloyd answered firmly. “Our crossing system runs only when the exchanges are open.”

“Why is that?” I asked.

“We can’t just make up our own prices,” Lloyd haughtily replied. “All our internal trades are done using the most up-to-date market quotes. Furthermore, every trade is subject to government regulations that require that the prices be as accurate as possible. In fact, the pension fund assets that we manage can only trade on the internal system at the closing price for the day. ERISA requires it.”

“Please excuse me,” I said. “But I’m still a little fuzzy on this.” I had long ago discovered that I could rarely get away with acting dumb, but it was worth a try. “If your trades don’t go to the exchange, how you know at what price to trade? Do you just take the last price at which the stock traded?”

“No,” Lloyd replied. “That price can be misleading, especially if there haven’t been any trades in the stock for several minutes.”

Then Harvey—who looked eager to get his say in—added, “We take the midpoint of the best bid price from a buyer and best offer price from a seller provided by the quotation system at the time the trade is crossed.”

“Could you give me an example?” I asked Harvey.

“Sure,” he replied. “Let’s consider GFF stock again. It’s now up around $24.65 a share. Suppose that its bid price, the best price that anyone is willing to buy at it, is $24.64 and that its offer price, the best price that anyone is willing to sell it for, is $24.68. Then, any trades would cross at $24.66, which is the midpoint of the two.”

“All of them? Regardless of whether it’s a hundred shares or a million?”

Harvey paused. I could tell that he knew where I was headed and was not happy about it. “Well, a million shares is unrealistic, but whether it’s hundreds or thousands of shares, the price would be the same.”

Lloyd interrupted, seemingly annoyed that Harvey had said anything. “You have to realize that both funds are better off than they would be without the crossing system. Based on the quotation system, Ken would have to pay at least $24.68 and Harvey would get at most $24.64. At the crossing price of $24.66, both Ken and Harvey are two cents ahead.”

I waited, trying to draw Lloyd or Harvey out, but they must have known better than to say anything. Then, I waited some more. Then, I looked all around the room, out the window, and then at Lloyd. Finally, I said, “I’m confused.” I waited and listened to the ventilation system hum and the fluorescent lights buzz. “Yesterday, you told me that if I wanted to buy a lot of stock, I would probably push the price up unless I got lucky and found a big seller, in which case I might get a lower price. By crossing trades internally, you seem to preclude all of this.”

Lloyd grudgingly clarified matters. “The bids and offers that the quotation system posts can be for as few as a hundred shares. And, of course, many buyers and sellers never post their orders at all, they are just lurking out there, waiting for a good price to come along.”

“So you are telling me that the bid might come from a buyer willing to buy a hundred shares for $24.64, while the offer might come from a seller willing to sell a million shares for $24.68. In which case, I could easily buy a million shares at just $24.68, but if I were selling a million shares, I might have to accept a drastically lower price given that the buyer is only willing to take a hundred shares at his bid price.”

“Basically, yes,” Lloyd said. “Though as I noted yesterday, for a transaction that large it would not be wise to send it through the exchange all at once and you might want to avoid it altogether by letting a broker locate a buyer for such a large block.”

“Fine,” I said. “But for smaller transactions, the same basic principle holds. Which means that the price that Ken would have to pay for a few thousand shares of stock is likely to be lower if he purchases it through your internal system than if he has to deal with your brokers.”

“Well,” Lloyd said, “it will certainly be lower because he doesn’t have to pay commissions.”

“But if we ignore commissions altogether,” I said (trying to act annoyed), “Ken can expect to get a lower price from Harvey than from a broker. Right?”

“Yes, on average,” Lloyd replied. “But I wouldn’t call it buying from Harvey, his shares are being crossed.”

“Call it what you will,” I said. “So what you’re saying is that Ken can also sell at a higher price on average by crossing the shares with another of your funds than he can by selling them to outsiders through a broker. Correct?”

“Yes, I think it’s safe to say that.” Lloyd tensed his facial muscles. “You’re simply pointing out that we come out ahead on both sides of the deal, which is what I said earlier.” Lloyd relaxed and placed his palms down on the table as if to gesture that closure had been reached.

I pushed on, refocusing elsewhere. “So, Harvey. Suppose that Ken owns a stock whose price is falling and he wants to get out of it. Let’s say he own ten thousand shares and the bid is $9.95 and the offer is $10.05. If you were to buy those shares from Ken, it would cost you $10.00 a share. Correct?” Although it had been a long time, I had not forgotten how to be obnoxious.

“Yes, that looks right to me. But I’d have no way of knowing whose shares I was purchasing.” Harvey hesitated as he answered.

“Why is that?”

“I just let the traders know what I want to buy and sell; they figure out the best way to do it. I thought that we covered that yesterday.”

“So we did. And, from what I recall, you make the decisions and the traders do the shopping.”

“Yes.”

“How much discretion do your shoppers—I mean, traders—have?”

“Discretion?”

“For example, if I were to ask you go out and buy me a diet cola that would leave you with considerable discretion as to the brand, size, packaging, etc. Do your traders get to exercise similar discretion?”

“No,” Harvey said in a tone that told me my probe had struck a nerve. “There is a buy list and there is a sell list. That’s all. The only discretion they have is when and what price to buy and sell stocks from the two lists. And even then there are limits.”

“It seems like the answer to my question is actually ‘yes.’ As long as I had the foresight to write up a buy list that included all the varieties of diet cola on it.”

“It’s not the same thing.”

It was time to give Harvey a little line before reeling him in. “Getting back to Ken, if he wants to sell a stock that is on your buy list, then you’ll end up buying it. Right?”

“If I’ve specified that number of shares and have the cash to do it, yes, then I’d buy the shares from him.”

“Let’s suppose that after buying from Ken, you were to change your mind suddenly and decide to sell them. It’s not likely that Ken would want to buy them back right away, so you’d have to go through a broker. Do you think that you could get $10.00 a share for them?”

“Possibly. It depends on the market.”

“But if the stock’s price is falling and the best bid out there is $9.95—and it’s only for a few hundred shares—then the price might have to drop substantially before you could get out.”

“Sure,” Harvey said, “if I tried to sell right away. But I could always wait it out.”

“I think I understand,” I said. “But then there’s no guarantee that things wouldn’t get worse, now is there?”

Harvey looked toward Lloyd for reassurance before answering me. “Look. In this business, there are never any guarantees.” Harvey threw another glance at Lloyd. “If I knew what point you were trying to make, maybe I could help you.”

Lloyd jumped back in. “I can assure that whatever odd scenario you have in mind our crossing system is completely innocuous. We would have never have proceeded with the system without the SEC and ERISA being on board every step of the way. What we’re doing is legal. And other fund managers have their own crossing systems with identical rules.”

“I appreciate that,” I said, “and I hope that you’ll appreciate that GFF’s standards are higher than those of either the government or your competition.” It was difficult to say those words without choking considering the numerous defense contract “bidding irregularities” that occurred early in the Mighty Quinn’s reign. “I also appreciate your desire that I get to the point, so here’s my point: Suppose I wanted to find an easy way to improve the performance of your Aggressive Growth Fund—enough to take it from being one of the better growth funds all the way to the best. Ken’s big problem now that his fund has grown is that whenever he buys stock in a company he drives up the price and, even more importantly, whenever he sells stock he drives down the price, affecting not only the price he gets for the shares he sells but of those he continues to hold. In theory, he could avoid this problem by using Lowell’s other funds as a kind of buffer between his fund and the financial markets.”

“That’s a very interesting theory,” Harvey responded, “but it’s full of holes. Why should I, or any of the other fund managers at Lowell, go along with this? Sure, it would help Ken’s fund, but it would hurt everyone else.”

“Because you’re all team players,” I replied. “Ken’s fund was the ideal vehicle for putting The Lowell Group on the map and ultimately for attracting GFF. Lloyd already pointed out that performance like Ken’s cannot be a random occurrence. Of course, with Ken at the top of heap, one star, more or less, for your other funds really doesn’t matter. Or it didn’t until GFF entered the picture. But now the partnership is dissolved and it’s every man for himself. And, as you say, it’s not like you are doing anything illegal.”

Harvey was now completely at loose ends. “C’mon. You’ve got to be kidding,” he said, trying to dismiss me with a laugh. “Why are you wasting everyone’s time with this absurd theory? There’s no evidence that anything like this ever occurred.”

I stopped and focused completely on the situation before me. Everything had been building toward this moment. I took a long, deep breath before saying, “Oh, there’s evidence alright. Plenty of evidence.”

I could see the vein in Harvey’s neck begin to throb. “How can you come in here only yesterday and today tell me you have evidence of a preposterous theory? This is outrageous.”

I stayed calm. “All the evidence is right here,” I said as I removed the backup drive from my bag. I slid it across to Karen and said, “You can have it back, we’ve made two copies, built our own database, and performed an analysis of it.”

I could have also told them that we had completed the Big Dig on our way over this morning—they would have found that to be just as believable. Particularly since Zero and I had made them think we needed a password to get to the data on the drive.

“Well,” Harvey said, “you should take your analysis and look over it again.”

“I am happy to do that right now.” I pulled a laptop computer from my bag, opened it with a flourish and said, “We have four thousand six hundred and seventy-nine instances where Ken sold shares to one of your funds and then you sold them less than a week later. Now, the interesting thing is that these trades are always for relatively small blocks of shares, as if someone were trying to make them inconspicuous. Let’s start with this trade on the sixth of January—”

Before I could finish the sentence, Harvey stood up, popping the top button of his shirt. Then, nearly vaulting over the table at me, Harvey yelled, “I don’t give a flying fuck what you’ve got there!”

Harvey then appeared to get a grip on himself, but his voice still echoed through the room, “How dare you waltz in here and accuse us of anything! You don’t understand the first thing about us or our business! I’ve worked here nearly twenty years and collectively the Lowell people in this room have over a hundred years of experience! You guys from GFF have absolutely none!”

“Our experience or lack thereof has absolutely no bearing on what your own trading data shows,” I said as calmly as I could.

Harvey’s face had turned a most Cantabrigian crimson and Lloyd’s was a shade short of a luscious rosé. “Everything that we did was legal!” Harvey shouted. “We told you that. We can run our business any way we want to!”

I felt that physical harm would come to me if I reminded Harvey that it was not their business anymore. As it was, the rest of the Lowellies looked on in disbelief at the very real possibility that at any moment Harvey might begin to strangle me.

Violence was averted not by cooler heads but rather by Lloyd’s very British assistant who entered the conference room oblivious to the scene that was being played out in front of her and could undoubtedly be heard through the closed door and down the hall. She said that there was a call for me on line three and was on her way.

I stood on somewhat rubbery legs and walked over to pick up a phone at the back of the room. It was Alice. She told me that a car was waiting in front of the building and that I should take it to meet Roland as soon as an “opportune moment” arose. I kept my side of the conversation with Alice to a minimum—”Hello,” “Thank you,” and “Goodbye.”

When I returned to the table, Lloyd was trying to act as if nothing had happened. Harvey was still steaming, but at least he was back in his seat.

With an uncharacteristic calmness, Lloyd said, “This looks like a good time for a break. We’ve still got work to do this morning, so why don’t we meet again after lunch.”

Lloyd and Harvey bolted from the room. The others quickly followed them, leaving the Alaska Four to our own devices.

Randy was somewhere between amused and amazed, Tara was aghast, and Zero was apathetic. I stopped for a long breath and said, “Let’s get out of here.”