Secondary Market
A company or an individual buys and sells financial products that already exist
What Is A Secondary Market?
The secondary market is where a company or an individual buys and sells financial products that already exist.
This market is a legendary place where Ray Dalio, Warren Buffet, and George Soros, among other billionaire investors, achieved their success and completed capital accumulation in it. What is the secondary market, then?
When people talk about the stock market, they most likely refer to it. The New York Stock Exchange (NYSE) and Nasdaq, among other stock exchanges, are all examples of the secondary market.
Even though stocks are the most commonly traded securities, other types like mutual funds, bonds, and mortgages are also traded in the secondary market.
The word “secondary” refers to the fact that the securities in question have completed the initial process of being created in the primary market, where new financial products are issued, or a company buys or sells to another company.
Unlike in the primary market, where financial products are created and sold for the first time, it allows investors to exchange securities with each other rather than with the issuing entity. This party issued the financial securities.
Below is an example of a secondary market transaction:
Assume Investor M wants to invest in a restaurant chain called Comfort Food T because, after conducting its research, Investor M thinks Comfort Food T has huge potential to grow.
However, the volume of securities that Investor M wants to purchase is substantial. Investor M can not open an account to do the deal himself as that will exponentially fluctuate the market price. So Investor M would reach out to Investment Bank J, who will facilitate the agreement for Investor M.
In this example:
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Sell-side: Investment Bank J
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Buy-side: Investor M
Key Takeaways
- The secondary market is where existing financial products, such as stocks, bonds, and mutual funds, are bought and sold, distinct from the primary market where new securities are initially issued.
- Buy-side firms, including Asset Management Companies (AMC), Hedge Funds, Pension Funds, Mutual Funds, and Insurance Companies, aim to generate profits by strategically investing in undervalued assets, emphasizing track record and asset under management (AUM).
- Major investment banks like Goldman Sachs, J.P. Morgan, Morgan Stanley, Barclays, and UBS operate on the sell-side, facilitating deals through brokerage, dealing, and research functions, contributing to the liquidity of the market.
- The secondary market involves various asset classes, including macro-related assets (e.g., fixed income, FX, commodities), equity-related assets (e.g., stocks, derivatives), credit-related assets (e.g., high-yield bonds, derivatives), and other assets (e.g., real estate, alternative investments).
Buy-Side Companies In The Secondary Market
In a nutshell, the buy-side firm in the secondary market generates money for its clients (or for itself) by searching and buying undervalued assets whose prices they think will increase in the future.
The top goal shared by all buy-side companies is utilizing the money to generate more money, as a portion of the profit generated is paid to them as bonuses.
Typically, a buy-side company in the secondary market would charge a management fee plus a performance cut for their services. For instance, a hedge fund would generally charge a 2% management fee and a 20% performance cut, which is the so-called “2 and 20 fee arrangement”.
The track record or return percentage is vital to a buy-side firm. The higher the track record, the more clients the firm will attract.
In addition, asset under management (AUM) is another measurement that tells the size of a fund and whether it is making money or not. The more extensive (and better) the firm, the higher its AUM.
Below are some buy-side firms in this market:
(The reason that some companies might be listed under different categories is that they have different arms of business that cover the varied investment needs of their clients.)
1. Asset Management Companies (AMC)
Asset management companies manage funds for high-net-worth individuals (HNWIs) and businesses by pooling capital from investors and investing the funds on behalf of their clients in a wide range of assets to generate profit.
Working with a group of investors enables AMC firms to diversify their investment portfolios, granting them access to higher value options with better growth prospects and diminished risks.
It is worth noting that even though big investment banks are generally considered sell-side, they sometimes have buy-side businesses. For instance, J.P Morgan Asset Management is J.P Morgan’s buy-side arm.
Examples of AMCs:
2. Hedge Funds
A hedge fund is an alternative investment company that pools funds from HNWIs and families and uses a wide range of proprietary strategies to invest or trade complex financial products.
Their goal is to exceed the average investment returns for their clients.
Unlike other investment funds, hedge funds are largely exempt from regulations set in place to protect investors. As a result, hedge funds can engage in more flexible investment strategies.
Examples of hedge funds:
3. Pension Funds
Pension funds are schemes that offer retirement income to insured individuals.
They pool money from pension plans set up by employers and financed by employees who make regular contributions from their annual income in exchange for payments after they retire.
Due to their nature, pension funds require careful management to ensure that retirees receive promised benefits. This means that pension funds typically invest in less risky assets.
Although, in recent years, they have increasingly ventured into various asset classes beyond their traditional investments.
Examples of pension funds:
4. Mutual Funds
Mutual funds are professionally managed investment funds that pool capital from many investors to purchase a collection of financial securities. Unlike individual stocks and bonds, mutual funds provide diversification and professional management.
The value of a mutual fund is directly tied to the performance of its investment portfolio, which means if you buy a share of a mutual fund, you are essentially purchasing a part of the portfolio’s value.
In this sense, owning a share of a mutual fund is different from investing in a share of stock, as the mutual fund share does not grant its investors any voting rights.
Examples of mutual funds:
5. Insurance Companies
Insurance companies offer financial compensation for possible future hazards. They function by pooling risk from individual clients and spreading it across a more extensive portfolio.
Typically, insurance companies make money from the premiums they charge payers for insurance coverage. Then, they would invest the premiums into profit-bearing assets.
Examples of insurance companies:
Sell-Side Companies In The Secondary Market
The sell-side in the secondary market is mostly big investment banks, specifically those banks' sales & trading divisions (also known as “global markets”).
The primary function of these investment banks in the secondary market is to provide prices to the buy-side companies and facilitate as many deals as possible.
The sales & trading division brings money to the bank through three primary business functions: broker, dealer, and research.
1. Broker
The brokerage business in investment banks connects institutional investors to the financial instruments the investors are interested in buying or selling. Brokers make money through commission fees.
For instance, Hedge Fund X wants to purchase a huge volume of Company A’s stocks. Hedge Fund X would likely approach one of the investment banks to get the deal done.
In the brokerage business, investment banks provide access to financial products and offer margin accounts by lending funds to clients to increase their purchasing power when buying securities.
In the brokerage role, the investment banks do not take any positions (buying or selling securities on behalf of clients) but act as a middleman who earns a commission by charging a percentage service fee from clients.
2. Dealer
Unlike brokers, who connect interested parties, dealers deal with buyers and sellers.
If Hedge Fund D wants to sell some of Company K’s stocks, a dealer will buy the supplies from Hedge Fund D directly rather than connecting it to an institutional buyer. The dealer would then find ways to sell Company K’s stocks on its hand.
Dealers make money from price differences. In the above example, the dealer would buy Company K’s stocks at a lower price from Hedge Fund D and then sell them at a higher price.
3. Research
The research function mainly provides opinions to the buy side by conducting different kinds of research according to other asset classes that give timely market analysis, forecast global economics, and offer investment solutions.
The goal of the research division is to attract clients to do deals with its firm so the investment bank can earn more money.
The list below shows some of the so-called bulge bracket investment banks. It is worth noting that many investment banks nowadays have businesses in both the primary and secondary markets to attract more clients.
1. Goldman Sachs
Founded in 1896, Goldman Sachs is an American multinational investment bank headquartered in New York City that provides a wide range of services for corporations, financial institutions, governments, and HNWIs.
The company has five divisions: investment banking, consumer & wealth management, asset management, global markets, and global investment research. Goldman Sachs’ market capitalization is 97.724 billion US dollars as of June 2022.
2. J.P. Morgan
J.P. Morgan is an American multinational investment bank headquartered in New York City. Even though its current body was formed in 2000, its history can be traced back to 1799, making it one of the oldest financial institutions in the world.
It is the largest bank in the U.S. as of March 2022 and is considered the fifth largest bank in the world in terms of total assets. J.P. Morgan’s market capitalization is 338.289 billion U.S. dollars as of June 2022.
3. Morgan Stanley
Founded in 1935 by Henry Sturgis Morgan (J.P. Morgan’s grandson) and Harold Stanley, Morgan Stanley is an American multinational investment bank headquartered in Midtown Manhattan.
Even though J.P Morgan’s grandson established Morgan Stanley, it and the investment bank J.P. Morgan are two separate, individual entities that don’t have any ties with each other.
As of June 2022, Morgan Stanley’s market capitalization is 130.146 billion U.S. dollars.
4. Barclays
Headquartered in London, Barclays is a British multinational universal bank that offers the banking activities of both a commercial bank and an investment bank. As of June 2022, Barclays’ market capitalization is 33.384 billion U.S. dollars.
It is worth noting that a universal bank is more relevant in the U.K. than in the U.S., as there was a historical divide between commercial banks and investment banks in the U.K. In contrast, in the U.S., the distinction was drawn only after the Glass–Steagall Act.
However, the regulatory divide has mostly been removed in the U.S.
5. UBS
UBS is a Swiss multinational investment bank based in Zurich, Switzerland. It was formed in 1998 by merging two of Switzerland’s largest banks – Union Bank of Switzerland and Swiss Bank Corporation (SBC).
Known for its strict confidentiality and culture of banking secrecy, UBS is not only the largest Swiss banking institution but also the biggest private bank in the world. As of June 2022, UBS’ market capitalization is 53.251 billion U.S. dollars.
Asset Classes In Secondary Market
An asset class is a group of investment securities with different degrees of risk that share a similar financial structure and are subject to the same legal regulations. Below are the most common asset classes:
1. Macro-Related Assets
Macro-related assets are financial securities hinged on macroeconomic events and geopolitical factors on a national and global scale, i.e., interest rates, currency exchange rates, levels of international trade, political events, and international relations.
a. Fixed Income (Rates or Bond)
Fixed income refers to financial securities that pay investors a set amount of dividend until the maturity date of the asset.
In the macro asset class, the fixed income products are usually sovereign bonds with low default risk and reflect a country’s macroeconomic condition.
b. FX (Foreign Exchange) & Derivatives
FX instruments and their derivatives are products designed to mitigate currency risk. This asset is purchased to hedge the risk of equity and bond returns being depleted by FX moves.
Moreover, investors can profit from FX products if they can accurately predict where an FX rate is headed.
c. Commodities
Commodities are natural resources or agricultural products, like gold, pork, and oil, that are traded in bulk. They are purchased mainly for inflation protection aside from the Investor’s diversification needs and the asset’s return potential.
Because commodities are sold and bought in bulk, they are not a good investment for retail investors but businesses and institutional investors.
d. Derivatives (Swaps, Swaptions, etc.)
These derivatives are more complex financial securities derived from fixed income, FX, and commodities products.
The macro-derivatives enable investors to utilize alternative investment strategies instead of the long-only method.
2. Equity-Related Assets
Equity-related assets are financial securities whose overall return is linked to the performance of an underlying share price of a stock.
a. Stock
A stock, also known as a capital stock, represents fractional ownership of a corporation in proportion to the full ownership. The store owner is entitled to a portion of the corporation's assets.
Shares measure stocks. The stock investor’s ownership of a company depends on how many shares they own.
Usually, people invest in stocks for capital appreciation, dividend payments, and voting rights to influence a company.
b. Derivatives (Options, Structured Products, etc.)
These derivatives are more complex financial products derived from stocks, and their return is linked to the performance of the share price of the stocks they are linked to.
3. Credit-Related Assets
Credit-related securities are mostly debts issued by corporations and municipal governments. These debts are generally riskier than government bonds.
A. High-Yield Bonds
a. Corporate bonds
Corporate bonds are debts corporations issue to fund their financial needs like expansion.
Investors who purchase corporate bonds get paid an interest fee during the debt term and the principal when the bond matures.
b. Municipal bonds
Municipal bonds are debts issued by municipal governments to fund daily obligations and capital projects like building public infrastructures.
B. Derivatives (AMS, MBS, CDS, etc.)
These are more complex products that are derived from high-yield bonds.
4. Other Assets
a. Real Estate
Real estate assets can be split into two main property types – commercial and residential. Residential real estate is usually utilized for living, while commercial real estate generates income.
Real estate assets are considered tangible assets as the properties are actual, physical things with an intrinsic value.
b. Alternatives
Alternative assets fall outside the more traditional asset categories like stocks and bonds. They can vary significantly in accessibility and structure but generally share a few key features listed below.
What differentiates alternative assets from traditional assets is that they are relatively illiquid, which means it is hard to sell or convert them into cash,
Moreover, alternative assets are unregulated by the Securities and Exchange Commission (SEC), and they do not necessarily move in the same direction as traditional assets when the market fluctuates.
Real estate listed above is one of the five main categories of alternative investments. The other four are hedge funds, private capital, natural resources, real estate, and infrastructure.
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