Two weeks ago we reflected on the dire state of the world's financial markets and speculated that some, if not most, of the blame for our present situation is due to the size, structure and nature of the banking and finance sectors.
This idea was originally proposed by Paul Woolley, financier, IMF economist, fund manager and academic, in a lecture in May to the London School of Economics. This week we will look specifically at what he sees as the chief problems of the finance industry and what measures he proposes to sort things out.
According to Woolley: "This is no storm in an academic teacup. The implications for growth, wealth and society could not be greater."
Woolley's view is that one of the fundamental theories determining market activity, that financial markets are efficient, is incorrect because it ignores one vital point. That point is that most investors don't invest directly - they delegate the responsibility to an agent; that is, a fund manager or a stockbroker.
This is where the problems start. First, investment managers and stockbrokers have more information than their clients, which allows them to derive extraordinary profits at their clients' expense. A good local example is Feltex, where it appears, with the benefit of hindsight, that the venture capital group which sold Feltex to institutional and retail investors had a better view of its value than the buyers.
Furthermore, the interests of the two groups, owners and agents, are usually not aligned. Woolley argues that the consequences are, first, that delegation to agents is the source of momentum investing and short-termism, which are the root cause of mispricing, bubbles and crashes, and, second, that agents are able to capture excess profits through constant innovation of complex products, lack of transparency and fee structures that encourage gambling.
Local investors in ING's CDOs will have some sympathy with this view. Delegation to agents, says Woolley, has created the conditions that foster short-termism and trending in prices.
"It is worse than that. Financial agents lie at the intersection of the savings and investment process for the entire economy. It follows that they have the potential to extract the bulk of the returns from the entire productive economy. They can bleed the economy dry. It has started to feel like that recently."
Woolley proposes 10 changes to the way major funds like our own NZ Super Fund engage with fund managers and invest their money:
Funds should adopt a long-term investment approach where they buy stocks on the basis of future dividend flows rather than on momentum.
The first approach is standard economics, which says that the value of any asset is equal to the total of all the dividends it will pay in its lifetime adjusted to present-day terms. That some investors adopt a different approach can lead to bubbles forming, usually defined as a price being well in excess of what future cash flow should imply.
The most common of these alternative approaches is known as momentum investing. It is an anomaly because it works when it shouldn't. Momentum is simply the strategy of buying whatever is going up and selling whatever is going down. It is apparently extremely popular with hedge funds but the major disadvantage is that it can cause massive overvaluation of sectors and stocks, and it requires high levels of costly buying and selling.
"Mispricing occurs when prices develop momentum, in other words trends, that take them away from fair value. Keynes knew all about the existence of fads and fashions in the stockmarket. Momentum is documented to be present in most markets much of the time. But momentum has remained the 'premier unexplained anomaly' in finance - unexplained by any rational model - until recently."
Woolley contends that asset prices are determined in what amounts to a battle between fair value and momentum.
Sovereign wealth funds and large investors, pension funds, etc, should tell their fund managers that they may not turn over more than 30 per cent of the portfolio a year. This strategy would severely limit momentum trading and save a lot in transaction costs.
Some funds turn over their portfolios twice a year and the FSA in Britain calculates that transaction costs total upwards of 1 per cent a year for the average pension fund. Woolley agrees that turnover is a major drain on savings. He reckons that most large super funds are guilty of overtrading.
"They suffer from short-termism and unnecessary trading - over 25 years, the shareholdings in your pension fund will be exchanged with other pension funds more than 25 times for no collective gain and a loss to you of 30 per cent of the value of your annual pension from unnecessary trading."
Investors need to understand that most of the tools used to manage risk and return are based on the now discredited theory of efficient markets. So they need to find new solutions.
Two strategies which have actually worked in recent years are that adding low-risk government bonds to a share portfolio can lower volatility as can diversification within a stockmarket.
Discredited strategies include the idea that property, commodities and venture capital can lower risk and improve returns by exploiting the fact that these assets are illiquid. The fact is that when there is a flight from risk, more risky assets fall and any higher returns accruing to the likes of private equity are simply due to their higher risk.
Adopt a stable benchmark for performance assessment such as the growth of GDP plus a risk premium. GDP is the ideal proxy for future liabilities.
Don't pay performance fees. Woolley argues that performance fees encourage short-termism and aggressive short-term trading behaviour as well as costing investors a lot more.
One local example of the potential problems with performance fees comes to mind. I won't name the fund but initial investors are, some six years after their investment, showing a loss of 13 per cent, excluding dividends. In the meantime, the fund manager has earned $7 million in performance fees from a fund of just $50 million, above and beyond the standard annual management fee.
Don't put money into alternative investments like hedge funds, private equity and commodities. Contrary to popular belief, there are no diversification benefits from alternative investments, higher returns come with higher risk and, even worse - because these sectors attract higher fees - investors are often left with the higher risk but most of the extra return goes in fees.
The managers of hedge funds invariably make more money than investors in hedge funds. Hedge funds have short investment horizons, thus they contribute to bubbles and crashes. Hedge funds have heavy unseen costs and private equity returns after fees are no greater than the returns on the stockmarket generally.
Insist on total transparency of agent strategies.
Ensure that everything in the portfolio is listed on a stock exchange. This prevents the possibility of fund managers massaging the data to achieve performance objectives as may have happened with some hedge funds.
Secure full transparency of banking service costs incurred by companies you invest in.
Provide full disclosure of compliance with these policies.
Initial responses to Woolley's manifesto have been positive and he is finding a great deal of interest in his ideas amongst major British pension funds, as well as policymakers. But Woolley has ambitious plans - he used to work at the IMF and hopes to persuade it to adopt his manifesto for the IMF's new US$12 billion ($16.56 billion) endowment fund and then reconvene the Sovereign Wealth Fund group members to rewrite the guidelines for sovereign wealth investment.
Woolley concludes that: "Once these strategies are implemented on a global basis, the gains will include more stable capital markets, faster economic growth and a less bloated and exploitative banking and finance sector."
I sent a copy of Woolley's "resolving the dysfunctionality of finance" address to the LSE to the chairman of the NZ Super Fund, David May, and asked for his comments. The NZ Super Fund has in recent years made quite a commitment to the alternative assets which Woolley says should not be invested in.
As shareholders, the Government and public of New Zealand need to know how much of our returns are being diverted to fund managers and others through performance fees, commission, management fees, investment banking costs, etc.
The NZ Super Fund's reaction to Woolley's recommendations will be the subject of next fortnight's column.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.