Unhedged Commentary: Why Training the Sell Side is So Important

May 22, 2013  

   Macro Risk Advisors' Dean Curnutt
By Dean Curnutt

Last year, while presenting to MBA candidates at the University of Chicago's Booth School of Business, I asked students what industry and specialty they intended to pursue after graduation. Consulting, investment management and marketing were areas of interest. Private equity was hot and investment banking remained a sought after destination. But not a single student, by a show of hands, indicated an interest in sales and trading. I suspected there would be less interest than there was a few years ago, but this was truly surprising. So what exactly is going on here?

The answer begins with cutbacks made to Wall Street training programs. For the better part of the last 20 years, bulge bracket sell-side firms have run large, organized and successful programs aimed at finding and then harvesting young talent. Wall Street dealers have traditionally been a consistent presence in campus recruiting programs at top undergraduate and graduate institutions. At the MBA level, firms often hired individuals with no previous exposure to financial markets or products. Underpinning these "athlete" hires was a view that given the proper training, a talented individual could learn to excel in a Wall Street role.

The 2008 crisis has had lasting change on the industry. Revenue for the investment banking industry is down more than 30 percent since 2009, even though things are better than at the depths of the crisis. The financial industry's return on equity, historically in the 20-25 percent range, is roughly half of that, according to Boston Consulting Group. When profits are down, cost containment becomes important, leaving expensive initiatives like training programs vulnerable. Recruiting team staffing, visits to campus, team events, and the opportunity cost of time to teach classes all add up from a cost perspective. The funding has not been available to run them at close to the scale they had been and even the largest firms are scaling back on the resources they devote to training programs.

The pressures on Wall Street profitability are secular in nature and show little sign of abating. Trading volumes are low and increasingly going electronic. Proprietary risk taking by dealers is being regulated away, and historically bumper products like credit derivatives are being pushed to more transparent and less profitable exchange traded venues. Despite less favorable business dynamics, investment in the process of training young professionals is still extremely, and possibly systemically, important for Wall Street. As the pace of industry change and the level of competition are only set to intensify, investment in young talent will prove to be money well spent over the long run.

While the past five years have been quite challenging for the sell-side, they provide an extremely rich narrative through which to educate young professionals. The chaos that ensued in 2008 led to extreme pricing dislocations and a wholesale breakdown of many hedging techniques. Traders who managed risk through this period are in a great position to pass along lessons of the crisis to younger colleagues. What hedges should have worked but did not? What outside-the-box thinking proved effective? Wall Street professionals, having endured a dramatic environment for market risk over the past several years, can equip their younger colleagues with tools that better prepare them and clients for the next crisis.

Even though finance is complex and fast moving, its fundamentals are very teachable. The real world market pricing of options, for example, is closely tied to the textbook theory of derivatives valuation. Relative prices observed in the option markets are largely governed by the same arbitrage relationships that are taught in business school classrooms. In fixed income, a host of cash flow based securities - swaps, bonds, FRAs, and futures - all carry a similar risk profile, but subtle differences must be accounted for to ensure the relative prices are fair. This bond math and other fundamentals can and should be taught to the young professionals that join Wall Street dealers.

Other aspects of the sell-side client service model also need to be taught, though the education process here is more highly nuanced. For example, on a fast-paced execution desk, there are countless (and potentially costly) mistakes ready to be made by the junior sales associate who has not received proper guidance. "Trial by fire" may be the model that trading desks fall back on, but it is both lazy and potentially perilous. This is especially the case since nearly every aspect of the client-salesperson-trader interaction can be anticipated and, as a result, taught.

This much-needed training can be accomplished by simply taking the time to map out various scenarios and creating mock trading interactions around them. These exercises can pass along the perspective and judgment that are critical in fast moving, high-risk situations. With these practice sessions, the junior salesperson is left in a considerably better position to respond to a live situation having seen and experienced the playbook.

While it may be self-evident, all of this matters because Wall Street has always been a client-driven business focused on delivering solutions. The challenges that clients, especially hedge funds, face are indeed formidable. They must deliver favorable risk adjusted returns in a low rate environment fueled by an unprecedented degree of central bank policy accommodation. They are also asked to anticipate and insulate portfolios from the next potential financial market shock.

As markets will surely bring many surprises in the years to come, clients will need the expertise and problem solving that Wall Street can offer more than ever. The turmoil of 2008 continues to create industry wide headwinds, but as the saying goes, "never let a good crisis go to waste." Investment in the growth of young professionals is critical to enabling the sell-side to meet the needs of its client base, especially as the world of risk becomes more complex. Wall Street firms that take the long view and commit to training and harvesting young talent will be the ones that come out ahead.

Dean Curnutt is CEO of Macro Risk Advisors LLC, an equity derivatives strategy and execution firm that specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York-­based firm is a registered broker/dealer with the FINRA.

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