Should Dimon Take a Cue from CTAs?

We’re out of the office today, celebrating Memorial Day in the U.S., but we couldn’t resist putting out one tiny post. An interesting op-ed came out last week, calling for the breakup of too-big-to-fail banks. A tired line? Maybe, but this time around, the author wasn’t arguing for regulators or Congress to take action. No, she wants the bank leaders themselves to drop the axe. From CNNMoney:

Yet instead of waiting for the government or shareholders to act, the leadership of these megabanks should take the lead in downsizing. The best way for Dimon to provide a better return to his investors is to recognize that his bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over. If, by downsizing, Dimon can achieve valuations comparable to the regional banks’, he will potentially release tens of billions of value to his shareholders. And rule the roost once again.

Do we really think Dimon and the rest of the crew are about to pull the plug on their trillion-dollar circus? No way. Should they? Maybe. We aren’t bank CEOs (and proud of it), but we’ve watched and worked with numerous CTAs who have done what seems so difficult for the Wall Street titans: admitted their limitations.

When a CTA develops a program, their goal is to provide the best return for a certain risk level to investors. Sometimes they succeed, and sometimes they don’t. However, when they do succeed, and they see their assets surging, they may find themselves facing so called “capacity issues” because of their size.  For example, risking a certain percent of each account they manage may result in the need to buy 10,000 contracts of some futures market, and the market only does 12,000 contracts a day, on average.  CTAs don’t want to become any meaningful percentage of a market’s daily volume, for fear of their orders creating adverse price movement. They want to be a fly on the back of the bull (or bear), not the cattle prod which makes the animal jump this way and that.

The best CTAs, well before facing such tensions, will make a determination regarding capacity. In other words, they sit back and ask, “How much can I handle in assets before performance is impacted?” Through testing and experience, they set a ceiling on the amount of assets the program can accumulate. After a certain amount of time watching the markets, the capacity number may change, but generally speaking, it’s about CTAs knowing themselves and their programs well enough to say enough is enough. When we read that JP Morgan is in a bet so big that they essentially ARE the market, we know that such delibertations aren’t going on at one of the biggest financial institutions in the world.

We know that managers shutting their doors can be frustrating, even if it is in the best interest of the investor. They see a program, they like it, and they want in. But look at the other side of the coin, where you are in a position so big that it will take weeks/months/years to get out, and your position is so big that everyone knows you want out and won’t let you out anywhere near a reasonable price. JP Morgan is far removed from the fly on the back of the bull – they are the bull rider, the clown, and the rodeo all rolled into one.

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