Functions of an Investment Bank

Investment Banks – A Beginner’s Guide

After the 2008 financial crisis, we all wanted to know more about investment banks. This term was not a part of our everyday vocabulary before the first signs of the credit crisis.

An Introduction

Investment banks have nothing to do with regular commercial banks. We don’t go to an investment bank if we want to get a credit card or to raise a mortgage.

On the other hand, you go to an investment bank if you would like to earn some extra money. For example, you would like to explore some new markets, but you do not have the necessary funds.

Consequently, you can sell some bonds with the help of an investment bank. As a result, you could gather the needed financial assets.

Also, investment banks can sometimes resolve complicated situations. Warren Buffett, the chairman of Berkshire Hathaway, refused to split the stocks. Thus, smaller investors could not buy them. However, this problem was solved by bankers and the shares were available to everyone.

In order to exclude any intermediaries, he came up with a dual-class capital structure. Moreover, he did it with the help of his investment bank. This allowed the executives to control the majority of votes, while having a small percentage of entire equity.

It is important to point that none of this would have happened if it were not for the investment bankers.

Different types of investment banks

We can say that investment banks deal either with the buy or the sell side of the business. However, there are institutions that deal with both.

  • sell side: aids the buying side with acquiring assets
  • buy side: clients of investment banks looking to buy stock or shares

Division of labour

Usually, the work in investment banks is divided between the front office, middle office and the back office.

The front office generally helps businesses with the acquisition of new assets. In addition, they can help companies with potential mergers. They also work on in-depth research for a selected group of clients. Furthermore, they deal with potential risks regarding future investments. Also, they quite often work with clients on corporate financing and merchant banking.

The front office

The middle office represents a very important part of every investment bank. They make sure that none of the transactions are violating the restrictions.

Moreover, they keep an eye on the liquidity. It is one of the most important things to be done since the 2008 crisis. In addition, the middle office can impose limitations on the activities of other employees. Therefore, we can think of the middle office as risk managers.

The middle office

It is quite safe to say that any of this would be impossible without the back office. Their work may appear as dull and unappealing, but it is essential for every investment bank. Moreover, they handle all the technological problems. In addition, they work on better algorithms and make sure that trades are confirmed.

The back office

What do investment banks deal with?

For a long time, investment banks located in the United States were not a part of commercial banks. The regulators thought that this would be too big of a risk. They worried about the liquidity of regular banks. Although investments banks can generate a lot of profit, they also deal with much riskier processes than commercial banks.

However, these types of rules were not present in countries such as Switzerland. Interestingly, they thought that merging of investment and regular commercial banks was a great idea.

Functions of an Investment Bank

Also, it is important to note that the Union Bank of Switzerland had losses of about 21 billion Swiss Francs. Furthermore, this occurred  due to the investment bank.

In order to cover their losses, they had to trade with shares and securities. As a result, they managed to replace more than 60% of shareholder equity.

Most experts say that the last financial crisis happened because of the investment banks. That was due to their trade with collateralized debt obligations (CDOs). It was the regular stockholders that had the most problems due to these trade speculations.

Investment banks can also offer preferred stocks to more important investors. These types of investors are usually banks or insurance companies. Moreover, they can issue bonds. This can help companies during an expansion.

Furthermore, investment banks can insure bonds or create new stock (credit default swap).  Also, they can speculate on the possible worth of gold in the foreseeable future.

Hedge Fund 13F Season is Coming!

Despite the boring sounding title, this time of the quarter is actually really fun! If you are at all interested in following hedge funds (for the reason of finding out new investment ideas), then these filings are great places to start. As the Investopedia definition says, 13F”s are required by any fund that has over $100m in assets. Basically, this includes all the major funds. Funds are required to list their positions as of the end of the quarter within 45 days after the quarter ends. However, much like a balance sheet, a Form 13F only shows the holdings at a specific moment in time (i.e., a single day).Hedge Funds

That said, there are definitely some caveats to watch for when consulting a fund’s holdings at the end of a quarter. For funds with high turnover, such as a high-frequency trading firm or short term swing trading fund, the 13F’s are probably not valuable, since the fund’s positions have most likely changed significantly since the filing. Some funds included in this bucket are Renaissance Technologies and D.E. Shaw. However, 13F’s are great for value investing funds, because most value investors hold positions for a very long period of time. Some of these funds that I follow personally (and their managers) are:

  • Berkshire Hathaway (Warren Buffett)
  • Baupost Group (Seth Klarman)
  • Soros Fund Management (George Soros)
  • Greenlight Capital (David Einhorn)
  • Pershing Square (Bill Ackman)
  • Appaloosa Management (David Tepper)
  • Icahn Capital (Carl Icahn)
  • Paulson & Co (John Paulson)

These are some of the most well known value funds or activist funds. The links above are to the SEC’s EDGAR search results page for them. If you click on “Documents” next to the 13F-HR filing, then click on the .txt file, you can view the fund’s holdings for this quarter.

Although the document isn’t pretty, it gets the point across. Name of Issuer is obviously the the company itself. Title of class is what type of position the fund holds (“Com” stands for common shares). Market Value and Principal Amount can be used to find out how many shares the fund owns, although most 13F’s disclose that as well. CUSIP Number is not really important. There are some other columns as well, but these are the main ones we’re interested in.

So, there you have it! Instant stock ideas! Obviously, it goes without saying that you must still further research any investment opportunities before you buy it. Refer to my list of the Top Ten Rules of Value Investing for more on that.


Was this post helpful? Have any further questions regarding hedge funds or investing in general? Let me know in the comments, and be sure to subscribe to the Investing Part Time RSS feed to ensure you get all the upcoming posts!

If you liked this post, check out:

  1. How to Create a Personal Hedge Fund Tracker using Google Reader

How to Create a Personal Hedge Fund Tracker using Google Reader


There are many companies out there, such as AlphaClone, that let you pay a monthly fee in order to get access to their database of hedge fund holdings and “clones,” or model portfolios that track the stocks several prominent funds hold. However, there is no reason why any individual investor with a little bit of free time should have to pay for this service. In this post, you’ll see why: One of the most helpful things about the Securities & Exchange Commission’s EDGAR database is the fact that they let you set up an RSS reader to check for updates (filings) for a specific company whenever they are updated. This is great for non-professional investors with no subscription to Bloomberg Professional, since it is free and easy to set up. You can use whatever RSS reader you’d like, but Google Reader is our preference. Once you have a reader ready to go, following your favorite company or fund is quite easy. In this post, we’ll assume you want to follow some hedge funds.

1. Go to the SEC EDGAR Search page, using this link. Getting to this page via the main site is a bit confusing. The screen you’re looking at should look something like this:

2. From the EDGAR search page, enter the name of the fund or fund manager (in some cases, the two are one in the same). The next step is sometimes challenging. If you’re lucky, there will only be two or three search results, so you can click on each to see which one is most regularly updated. Due to the structure of some of the larger hedge funds (i.e. some of them are registered offshore, or they have a separate management company and the funds are all treated as individual companies), there may be multiple entries. One example of this is Pershing Square Capital Management:

The manager, Bill Ackman, is one of the most widely followed managers. He recently took an activist stake in JCPenney and Fortune Brands (which distributes brands like Titleist, Jim Beam, and Moen), a move which has been widely analyzed since. In fact, following the announcement of moves like this of big hedge fund managers, the stocks involved will usually trade up quite a bit. Any investment by Warren Buffett in the past decade has exhibited this.

3. If you find yourself in a case where there are multiple companies to check, you may have to click into each one. Always look for the “company” with the most recent filings. In the above case, most of the shell companies called Pershing Square often only have one or two documents filed in their name. The reasons why this is the case are beyond the scope of this post. Regardless, even if the fund is not very big, it will still file quarterly reports known as 13F-NTs, which show the long and short equity positions that the fund held at the end of that quarter. These are especially useful when tracking value funds, since the managers like to hold positions for a long time. Even if you buy a stock right after the 13F-NTs are released, you still might gain a decent upside with some of their positions.

4. The final (and easiest) step is to start following them. Hit the RSS icon above the search results on the left side of the page:

5. Repeat steps 1-4 for all the hedge funds and/or companies you would like to follow. We do this for companies that we own, since it is a much easier way to catch press releases and earnings statements than waiting for it to come in the mail or read about it on the Wall Street Journal. If you get in the habit of checking Google Reader every day, then you can always see when something new is filed. The sidebar in Google Reader will then look something like this:

Feel free to find some of those names yourself! No other names come to mind? Check out this list from MarketFolly. A side note: avoid some of the well-known high frequency trading firms, such as Renaissance Technologies, SAC Capital, or D.E. Shaw. They might move in and out of positions too rapidly for any tracking mechanism to be useful. Look for some long-term value investors. Activist investors (such as Ackman) are also good since they try to create catalysts at the company to boost value to shareholders.

If you are interested in learning more about hedge funds, be sure to bookmark or subscribe to Market Folly. We have no affiliation to them, but it is one of our favorite blogs. They post an incredibly useful “What We’re Reading” column each week (see example) that aggregates some of the best articles and stories that week. All of the articles are generally pretty good, and it will also give you a much bigger list of investing blogs to follow.


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