Reply #15: Steve Waldman on Good and Bad Financial Innovation

[Demeter]

http://www.nakedcapitalism.com/2008/10/steve-waldman-on-good-and-bad-financial.html


Steve Waldman has a longish and very useful post "I sing the praises of financial innovation" in which he seeks to identify some good and bad financial innovation
http://interfluidity.powerblogs.com/posts/1224388192.shtml

(I very much support Martin Meyer's observation that, for the most part, what is called financial innovation is finding new technology that makes legal what was illegal under the old technology).

You must read his entire post, but I wanted to focus on the key bits. Here is the list of innovations he likes:

Exchange-traded funds
The growth of venture capital and angel investing
The democratization of access to financial information (e.g. Yahoo! finance)
The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).


I can add one to his list:

Electronic order placement

Frankly, it is a luxury to be able to place a limit order at 3:00 AM anywhere in the world.


And his section on bad innovations:

Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I'd place them directly in the "good" column.) But there are many, many more bad innovations that we have yet to come to terms with:

401-K plans with limited investment menus
The conventional wisdom that long-term savings ought by default be placed in passive stock funds
The conflation of ordinary saving and financial return seeking
The tolerance, advocacy, and subsidy of financial leverage throughout the economy
The move towards large-scale, delegated, and professionalized of money management
The growth of investment vehicles accessible primarily or solely to professional and institutional investors

Waldman discusses these issues at greater length in the post. His discussion about how badly we treat savers is particularly useful

With 401 (k)s, it isn't just the lousy menus, but also the limited ability and long lead times for changing allocations. And some funds also take a heinous amount of time to credit annual contributions. I don't have a full overview, but I have heard enough bad stories to be convinced that this product is heavily slanted towards the administrator, with too many having "gotcha" features, compared to very user friendly IRAs.

With supposed professional management has come a lot of faux science. For instance, the academic literature has repeatedly found that investors benefit from being diversified by asset class (stocks, bonds, foreign stocks, foreign bonds, cash, real estate, perhaps commodities, although some research has found that CTAs fail all tests of being an asset class; the term of art is that it puts you on the efficient investment frontier). The notion of asset class is broad categories. Yet the industry has gotten investors to confuse styles with asset classes and produces all sorts of cute analyses over pretty short (by historical standards) periods of time which show low covariance of X fund versus, say, the S&P 500. Since I used to work for firms that were adept at cutting the numbers in ways to prove their points, I have little confidence in anything not produced by someone who has no skin in the game (and the pension fund consultants have every reason to promulgate this methodology, since it is how they justify their fees).

Warren Buffett put it more colloquially:

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.

The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new “beat my- brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.

Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.