I attended an interesting lecture at Civitas, on Wednesday night (23rd of June), given by Dr Paul Woolley on the title above.
Dr Woolley’s main contention was that the financial services system is clearly broken, particularly by the principal-agent problem where the agents (traders, fund managers, financial advisers) are milking the investment gains of the principals (that’s you, me, and everyone else with a retail pension), mainly through technological financial innovation, moral hazard, leverage, and the general opacity of the financial system.
The other main problem, he relayed, is the reliance of most people within the financial services system upon the Efficient Market Hypothesis (EMH), first proposed by Professor Eugene Fama in the 1960s and based upon the mathematical theories of the lognormal random walk, in which a single stock price perfectly reflects all the knowledge the market has about that stock at any given moment; without further information, the chance of today’s stock price going up or down tomorrow — or staying the same — can be predicted by a random variable drawn from a mathematical model; there is no historical pathway which can successfully predict tomorrow’s price movement!
To generate this randomness you can use a Martingale Brownian motion process using a Mersenne Twister algorithm, or a Black Swan Monte Carlo engine using a Latin Hypercube, or even a fairy cake using a really nice hot cup of tea, but however you predict tomorrow’s price movement, you cannot use historical chartism or technical analysis.
Obviously, virtually everybody in the City of London is using, or is at least aware of, the success of chartism, the Elliot Wave, and the other major tools of technical analysis, with constant talk about breakouts, support levels, and ceilings. At the same time, even chartists use the EMH model to price all of their structured products, to derive stock volatilities, and to generate their Values at Risk (VaR), whether they are using the weak, the semi-strong, or the strong forms of Fama’s EMH model (which use market information, all public information, or all public and private information, respectively, to define how accurate EMH pricing should be).
There is something within this dichotomy, observes the good doctor, which is dysfunctional. Everyone is acting rationally and yet we still had the Nasdaq bubble, the Housing bubble, and we have the ongoing financial crisis whose second part is ready to step back in from the wings, once the quantitative easing stimulus has worn off. If Adam Smith was right, then everyone acting in their own self-interest should produce the best of all possible worlds, and yet everyone in the financial services system acting in their own self-interest has led to a bloated monster which has sucked the productive sector dry, consuming both human talent and all other resources along the way. What has gone wrong?
As a former value-fund manager of some repute and one of the first to use quantitative methods, with some time also spent working alongside the IMF, Dr Woolley clearly possesses an impressive CV and knew of what he spoke.
His approach to a remedy consists of several elements. First, he is funding several centres, including one within the London School of Economics (LSE), to research what is going on under the hood of the financial system as it stands. Second, he outlined an initial plan where pension fund managers should be precluded from investing on a short-term momentum basis; they currently turn over each stock within their portfolios at about an average of eight months each.
Dr Woolley contends that this average period of stock turnover should be much longer, if real value is to be extracted from a stock (Charles Lee, the originator of fusion investing, thinks that it takes at least three years for a ‘fundamental’ value to materialise within a stock price). To prevent this high stock turnover of alpha-seeking fund managers, the plan is to cap stock turnover to 30% per annum; to preclude pension funds from investing in hedge funds, derivatives, and commodities; and to use GDP as a basic benchmark to compare pension funds against.
If his plan is implemented, Dr Woolley thinks that an extra 1.5% per annum of growth would be raised by pension funds, but only over the longer-term rather than the shorter-term.
I asked Dr Woolley whether or not his plan was just another set of regulations that the agents in the City would be able to skip around, taking us back to square one; others also asked whether or not this was an intrusion upon property rights.
Faced with a plethora of such questions, Dr Woolley’s multiple answers kept coming back to the overriding idea that however we do it, we need to introduce (or re-introduce) a culture of long-termist thinking into the minds of pension fund managers and that we need to get them away from their focus on the annual Christmas bonus round. A specific answer to one questioner included tax exemptions for those pension funds which stayed within the turnover cap plan (or tax penalties for those that didn’t).
As any regular readers of the Cobden Centre will know, we have many objections to the further imposition of yet more government regulations, taxes, and other central plans onto free people, and my own general solution to the principal-agent problem would not be to impose more rules of good behaviour, administered by a hopefully benevolent central planner, but simply to let Schumpeter’s unfettered creative destruction process execute itself properly by letting the market work; bad agents should be allowed to go bankrupt and taken to court to have their assets re-allocated by their contractual creditors, rather than these bad agents being bailed out with other people’s money, by the state, to cause yet more waste of yet more resources.
That will focus the agent’s mind, as it does in the rest of the free market; this engagement of Schumpeter’s weapon of creative destructionism will either make the agent think beyond next year’s bonus or it will put them back on the street alongside all the other working Joes.
At the moment, however, if the risk-return levels go south, the taxpayer principals are forced by government to pick up the socialised losses of the finance agents; if the risk-return levels go north, the finance agents get to keep the privatised gains extracted from the pension investments of the taxpayer principals.
As to the human capital that is being expended on this, if you have ever witnessed the mass-exams of the finance profession, where thousands of bright young energetic people subject themselves to gruelling financial tests of all kinds, then you will have witnessed the same examination fervour which aspirant mandarins put themselves through to achieve the higher echelons of economic success in imperial China.
If you have the mathematical ability, the motivation to do the hours required, and no particular bent as to what you should do with your life, then given a choice between working in a car factory in Sunderland generating useful consumer products or working in a Docklands bank generating collateralised structured financial products for pension fund managers, for ten times the money, it becomes what the Americans call a no-brainer.
I should imagine there are now even people who acquire doctorates in physics, not so much to help humanity reach the stars or to fuse the hydrogen atom safely to provide us with inexhaustible energy, but merely to get their first role within the quantitative finance function of a major money-centre bank, before moving on a few years later to a sexy hedge fund in St James.
To heck with colonising Mars; what’s my bonus going to be this year?
In my eyes, the moral hazard of the state backing risky behaviour, with virtually-guaranteed bailouts and bank account protections, along with legal tender laws and other fractional-reserve finaglings, all administered by a central bank which generates currency out of thin air as a ‘lender of last resort’, have created all of the problems that we currently face. It is central planning which is the problem, not the solution.
However, I did find it highly refreshing that even among what you might call the mainstream of financiers and economists, many of whom were in the room at Civitas, there is the genuine beginnings of a general recognition that something is broken and that something needs to be fixed; this is without even examining the reasons as to why the state has so gamed the system towards the financial sector, though we can come back to that enormous subject another day.
We have a different solution from Dr Woolley, here at the Cobden Centre, as to how we can fix this ragged something, based upon the Austrian Business Cycle Theory. But let us hope that we can all come together one day, before it is too late, and fix our monetary and financial system before the whole thing disappears into the liquid quicksand of Keynesian economics.
As a lowly IFA it has been my business at the very basic level to get clients to invest for the long term. And my experience leads me to endorse all you say. The appalling theft of capital over time from individuals by the fund industry (and the advice industry) is unforgiveable. We realised this years ago, and tried to do something about it. Of course the FS establishment screamed.
I have a view that blokes like me, up against the public day by day – on the street as it were – have an imaginary little indicator screwed to the back of their necks form which it is possible to read off the mood of the public. Mine curretly reads fear and ignorance. They know they need to save and invest but they don’t know how to do it or whom to trust for advice. The whole thing is an appalling mess.
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