In part II of the City Grump’s series of extracts from the excellent “Of Markets and Men“, its author, James Featherby, draws out the disconnect between money managers and those who give them the money: you and me.
Asset managers are losing themselves in a sea of speculation and hypothetical returns. In turn, many large companies are taking ever greater operational risks in pursuit of high performance. Featherby suggests an intriguing new way we can re-engage with those who run our money and with the companies they invest in; read on!
?Speculative trading is problematic partly because there is no sense of responsibility for any underlying business or the economy as a whole, and if you are not responsible you are unlikely to care. Similarly, claims based trading, hedging arrangements that in return for a price allow us to make financial claims on others that do not vary depending on their future profitability, has produced a financial climate in which too many are uninterested in the welfare of society or the business that produces those profits. Together, speculative and claims-based trading have begun to be destructive to the process of efficient capital allocation. The market was not designed to be used for these purposes on this scale.
The decision making process of many asset managers, including pension funds and insurance companies, is heavily influenced by statisticians and actuaries with little expertise in the business of business. (?) They have the prime seats at the table, and they steer the conversation towards sectoral asset allocation and hypothetical returns, not individual investments and specific implications. We should not quickly forget that the economic theories of rational expectations and efficient markets failed to predict or prevent the financial crisis or the massive loss of share values that followed. And it is now clear that there are no risk free assets. Models that pretend otherwise are just as likely to misallocate capital as good old fashioned business judgement.
Companies are also increasingly operating at the edge of their competencies as a result of competitive pressures and investor expectations. This seems to have been the case with BP’s Deepwater Horizon, but it is also the case amongst banks, insurance companies and financial investors trading in securities they may not fully understand.
The investment in research and development of new technology for products and services including financial ones is increasingly out of balance with the investment devoted to risk identification, prevention and remediation. There was, for example, significant underinvestment by the banks in in the infrastructure necessary to understand and manage the sub-prime products they held on their balance sheets. And when a large player in a market makes a competency mistake the risk to society is increased because the consequences of that mistake tend to reverberate louder and further.
In the name of efficiency, there has also been a significant change in recent years in the trade-off between business stability and financial efficiency. Many businesses now carry minimal stock, outsource vital functions to third parties they cannot control, rely on suppliers without giving them support, and leverage their operations with significant debt. In other words, businesses are taking greater risks with less inbuilt operational resilience; and others are frequently feeling the consequences when the business stumbles or falls. The consequences are amplified when the business is big.
Scale also reduces the resilience of society in another respect. Companies tend to have command and control mentalities. This means that, even after a period of reflection, they tend to take one-way bets with their strategic decisions. Their inclination is to develop a single house view, and then follow it closely. And given the human tendency to believe and follow conventional wisdom this makes them, and therefore the rest of the economy, less resilient to life’s uncertainties.
Diversification by mega-businesses, including full service banks, does not avoid systemic risk if all those businesses are diversifying in the same way. Diversity of business model, a different concept entirely, is more beneficial to society. Complex and diverse is more resilient than complex and similar.