“Nothing is
more terrible than ignorance in action.” – Abraham Lincoln.
By all accounts, this is not an
April Fool. Alistair “Northern Rock” Darling and Sir Win “Citigroup’s writedowns
and credit costs ? $54.6 billion” Bischoff are chairing a Treasury-sponsored
committee, the Financial Services Global Competitiveness Group (FSGCG), to
report on the weaknesses jeopardising the City’s reputation as a centre for
banking, broking and fund management. Which will no doubt come as news to those
who believed that the City still had any reputation for banking, broking and
fund management – or at least, one worth talking about other than in an
embarrassed whisper. Let’s not mention
the co-chairs themselves (“if you’re not part of the solution, you’re part of
the problem”). The first weakness, evidently, is that touching faith in
establishing valueless talking shops. The second is that name. The Financial
Services Global Competitiveness Group. A coinage utterly charmless and devoid
of character. It doesn’t even form a cute acronym, unlike US entities like
Fannie Mae and Freddie Mac, which may be (morally and literally) bankrupt, but
at least have some hint of human appeal.
Perhaps Messrs Darling and Bischoff would get a better steer on the City’s likely
longer term fate and prospects from the
Financial Users Consultative Committee for Education and Development.
The first sensible conclusion of the FSGCG ought to be that the gravest threat to the reputation of the Square Mile would be that the incumbent management of most of the UK’s banks remain employed*. Quite how the chief executives of the banking industry have been allowed, almost without exception, to squander billions in shareholder value by inappropriate investments and evidently uncontrolled risk-taking is scandalous.
It is doubly scandalous where those chief executives have denied any commercial
problems to the extent of hiking their banks’ dividends, only to come crawling
back to the market in a matter of weeks to tap shareholders for emergency
rights issues – some of which haven’t even come off. Buying depressed bank
shares is throwing good money after bad, particularly if the chief executives
who created the credit crunch are allowed to stay at the helm. It’s a bit like
paying the captain of the Titanic a success fee.
In a thought-provoking piece of
research that gets to the heart of this debate over the City’s sustainability
(“The Sociology of Markets”), Legg Mason’s Michael Mauboussin asks the
simple-sounding question whether financial institutions matter to asset
pricing. In traditional economics they don’t, which is just one reason why
traditional economics is a waste of time. Franklin Allen gave a presidential
address to the American Finance Association in 2001 in which he identified a
strange dichotomy. In corporate finance, agency theory – and the role of
economic agents – has been extensively explored over a period of 75 years. In
asset pricing theory, however, agents are almost completely absent. As in
traditional economics, the role of institutions within the financial markets
has been “assumed away” to make the equations easier. As Mauboussin points out,
“Several market observers,
including Jack Bogle [founder of the Vanguard Group], Charley Ellis [founder of
Greenwich Associates], and David Swensen [Chief Investment Officer of the Yale
University Endowment] have been vocal in pointing out that the agents –
professional money managers – have incentives to behaviour that is not in the
interest of investors.”
Mauboussin asks why financial
institutions and related agency costs have played so little role in asset
pricing theory. One answer, as he reveals, is that for a long time there was no
principal-agent problem.
“As recently as 1980, individuals
owned almost three-quarters of all stocks. Only recently have principals
delegated a majority of assets to agents – financial institutions such as
pension funds and mutual funds (sic) – but principals dominated agents as asset
pricing theory developed in the 1950s and 1960s. For instance, in 1950
individuals directly controlled over 90% of corporate equities. Agency theory
wasn’t in the models because agents weren’t in the picture.”
As Mauboussin makes clear, agency theory matters because agents control
the market. They control the market in absolute monetary terms, but also in
marketing, “research” and newsflow: they control the chatter about the
marketplace too, although it would be nice to believe that the rise of the
blogosphere is helping to restore the balance back toward some semblance of
independence. “And, not surprisingly, agents have very different incentives
than principals do. And this game is close to zero sum: the more the agents
extract, the lower the returns for the principals.”
The purist response to agency risk is to adopt exclusively passive
investment products, such as exchange traded funds (ETFs). But this still
leaves the problem of asset allocation, and also that of using so-called
alternative investments that by definition cannot be indexed. Unless one
slavishly follows a rigidly rebalanced approach across multiple asset classes
that permits no variation or subjective assessment of value, the informed
investor still needs to take active asset allocation decisions. Here, perhaps,
(contrarian) psychology comes into play. Touching on the difficulties of being
entirely “out” of the stock market during an admittedly treacherous period,
manager Crispin Odey makes a valuable point in his June month-end report for
the Opus Fund:
“Remember that in the whole of 1974 until December it paid to be out of
the market, but it was nearly impossible to get back in when the market turned
at the end of that year. Whilst I can still see a further fall in banks and
property companies of 30%, if that brings the market down we are starting to
talk about price earnings ratios for some of my [investee] companies of nearly
3x. To my mind investors should be starting to look further out and expecting
to make the real money some few years hence, but with the view that buying the
shares over the next nine months may feel painful but may turn out to have been
not only courageous but brilliantly timed.”
When markets turn from a bear market low, they can turn with
astonishing speed, like a suppressed cork finally popping with relief from a
champagne bottle.
There are, of course, two ways of mitigating the risk of being either
fully “in” or fully “out of” the stock market. If one’s risk appetite inclines
toward the former, the prudent course is to construct a portfolio consisting
largely or entirely of more defensive (or still growth) investments: in the
current environment, pharmaceuticals, utilities, industrial engineers and oil
equipment services all probably qualify. And if one’s risk appetite inclines
toward the latter, the pragmatic course is to construct a portfolio that limits
equity exposure in any event, with substantial complementary commitments to
cash, precious metals, infrastructure and low risk absolute return funds.
Download were_economic_agents_and_were_here_to_help.pdf
*Post script. Quote of the week:
"We have seen the top 11 executives leave UBS, the heads of CItigroup and Wachovia step down and the chief executive at Merrill Lynch go. But only one UK director has had to leave a UK bank and that was because he had angina. You have to say that is curious." - Mark Burgess, head of equities at Legal & General Investment Management.
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