Finance used to be simple. Banks were low-risk institutions that linked savers and borrowers, channelling deposits as loans to industry and homebuyers. Stock exchanges were forums to raise money for new businesses, and enable price discovery so that stockholders could determine what those businesses were worth. That, at least, is the economic textbook story.
But the financial services sector has grown like a weed over the last two decades using heroic quantities of leverage. It claimed a larger and larger slice of aggregate corporate profits in the Anglo-Saxon economies. Regulators became spellbound by the banking lobby, complexity flourished, and ethical standards collapsed. All of a sudden, every banker had become Gordon Gekko – it was every man for himself and the devil take the hindmost. And as the ‘Flash Crash’ of 6 May revealed (when $1trn briefly evaporated from US stockmarkets), the stockmarket became a playground for traders and leveraged speculators.
But now that the state is one of the biggest shareholders in our banks and the economy looks set for an extended period of sub-par growth, can finance be tamed, or even reformed? Paul Woolley, a former academic, economist and fund manager – and founder of the eponymous centre for the study of ‘Capital Market Dysfunctionality’ – believes it can. In a new report, The Future of Finance (which you can download from www.futureoffinance.org.uk), Woolley asks why financial markets became so inefficient and exploitative – so manifestly unfit for purpose. And he suggests the following ten point framework for institutional fund groups.
1. Adopt a long-term approach to investing based on dividend flows. Avoid momentum-based strategies reliant on short-term price action. Short-termism is now the bane of both fund management and corporate culture more generally. You see it every time Wall Street obsesses about quarterly earnings – and every time chief executives try and beat them.
2. Cap portfolio turnover at 30% per annum. Consider Warren Buffett’s recommended ‘punch-card’ approach to investment. Imagine that you have a punch-card with just 20 tabs. Every time you make an investment, you use up a tab. Once you’ve used up all 20, you can no longer trade. Adopting that kind of discipline might concentrate fund managers’ minds on what is essential trading and what is unnecessary churn.
3. Realise that all of the tools currently used by institutional fund managers are based on the discredited theory of efficient markets. Not only can prices diverge massively from any semblance of fair value, but the prices of all sorts of different financial instruments will tend to correlate and move in lock-step when the market collapses.
4. Adopt stable benchmarks for fund performance. Woolley suggests a benchmark of GDP growth plus some form of risk premium. In my opinion, some form of absolute return or simple cash-plus benchmark is more practical for individual investors. Most cannot afford to lose huge amounts of their wealth on the inevitable swings of the market.
5. Do not pay performance fees. “Trying to assess whether a manager’s performance is due to skill, market moves or luck is near impossible. Also performance fees encourage gambling and therefore moral hazard.”
6. Do not engage in any form of “alternative investing”. Woolley explicitly identifies hedge funds, private equity and commodities. This strikes me as a little draconian – given the potential diversification benefits of commodities and particularly precious metals.
7. Insist on total transparency from managers regarding their strategies, costs, leverage and trading.
8. Do not sanction the purchase of “structured”, untraded, or synthetic products. This rule would have prevented some of the grotesque losses incurred by banks and others in the CDO and CDS markets.
9. Work with other shareholders and policy-makers to secure full transparency of the banking and financial-service costs borne by companies in which you invest.
10. Provide full disclosure to all stakeholders and allow public scrutiny of each fund’s compliance with these policies.
One phrase captures Woolley’s indictment of current fund management: agency risk. “Agents have better information and different objectives than their customers (principals) and this asymmetry is revealed by mispricing, bubbles and crashes.” So, will the finance industry adopt Woolley’s ten commandments? Sadly, it seems unlikely. But in identifying some of the pitfalls facing the unwary as well as proposing some remedies, he has done a huge service to individual investors.
• Tim Price is director of investment at PFP Wealth Management. He also writes The Price Report newsletter.
Category: Market updates