Celebrating the End of a Rigged Game

Tom (Stock research analyst): “Hi Fred. Can I get a little confirmation that we’re still on track for the quarter?

Fred (Public company chief financial officer): We’ll be fine. In fact, a couple of deals came in last week and we’ll be two cents to the upside and we’ll probably raise Q4 guidance. The sales guys are on fire.

Tom: Congratulations. The stock sure needs the lift! Thanks for the update. Talk to you on the conference call.

Fred: No problem Tom. By the way, can you get me tickets to the Super Bowl again?

Tom: Absolutely. We’d love to host you and your wife again in our box.

Believe it or not, up until 10 years ago, the above conversation was both common and legal. It is why mutual funds and institutional investors could often “beat the market” and the rest of us didn’t have a chance. But this month, we celebrate the 10-year anniversary of SEC’s ratification of Regulation Fair Disclosure, or Reg FD. It leveled the playing field for all investors and took away the most important value-add offered by a mutual fund manager or broker. When historians write about the death of the mutual fund industry, they will point to Reg FD as “the day the music died.”

Until October 2000, investing was rigged in favor of Wall Street pros. It worked like this: An analyst for a large bank like Morgan Stanley or Goldman Sachs would contact the chief financial officer of a public company he covered to get material-non-public information like how a quarter had ended, or a preview of an upcoming important announcement. It was called “selective disclosure” because company management would tell a select group of stock analysts and large institutional shareholders information that was unavailable to the public.

The analyst used this information to make more money for his firm. He would call mutual fund clients based upon how profitable they were to his firm. The mutual fund customer that traded the most and generated the most commissions got the first call. As the first mutual funds got the information and traded on it, the stock of the firm in question would start moving, he would tell the next set of clients, and the stock would move some more until all the big clients had established their positions. Finally, the analyst’s report was published, the best clients were making money, and as the rest of his clients continued buying the stock, the analyst was making commissions for his firm. Days later, you and I were buying a stock that had been bid up by institutions in advance of the information.

In addition, until Reg FD, only analysts and public company executives were allowed to participate in quarterly conference calls in which management would disclose and discuss quarterly results and answer analyst questions about the quarterly performance and receive management’s estimates for the future.

Reg FD made a very simple, but radical, change that “unrigged” the game: Officers of public companies became responsible for making important information available to everyone at the same time. Today, if a CEO is presenting his company to investors at an invitation-only conference and he accidentally makes a statement that would imply a future forecast, his CFO will scramble to issue that information to the public. Company officers have been sanctioned for communicating non-public information in “code” by a wink or a nod to an analyst. Anyone can now listen to the quarterly conference call.

Most investors have never heard of Reg FD, and for good reason. Mutual funds and professional investors don’t want us to know that their biggest tool for justifying their fees is gone forever. They are like everyone else now and must do a Herculean job at research to even have a chance at doing better than market returns. Like the athlete who relied on steroids to outperform his peers, the mutual fund manager must perform without the steroids of selective disclosure.

If you are still paying mutual fund fees, understand why the world’s smartest investors are not. They understand that Reg FD has outlawed the steroids. They have converted their portfolios to index fund and ETFs.