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September 08, 2014
The New Dawn of Financial Capitalism
Complexity, greed and short-termism are undermining our financial
system, but a rerooting of finance in the real economy could lead to a
more sustainable version of capitalism.
By Ashby H.B. Monk
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PHOTO CREDIT: MANUEL GUTJAHR |
In 1882 a 28-year-old financier headed west to open a remote branch
for Bank of Ottawa. The local communities on the prairies needed the
bank’s services, he was told. So in June of that year, he left Ottawa
for Chicago and continued by train to St. Paul, Minnesota, through to
Winnipeg. His final destination was a small trading hub in Ontario
called Keewatin. Upon arriving he took off the three-piece suit he had
worn throughout the long journey, and with a letter opener he made a
slit in the lining of his vest. He removed nearly C$50,000 that the
bank had entrusted to him. The cash was to be used to establish a
local branch and finance the building of the Five Roses flour mill,
along with upgrades to the rails connecting to the mill.
For the next few years, he slept above the bank and worked to help
Keewatin get the funds it needed to develop and prosper. It was not
easy living; the winters could be brutally cold. His first wife fell
ill in the harsh environment and later died. But, duty-bound, the
young man stayed and delivered. His success led Bank of Ottawa, which
would one day become part of the central bank of Canada, to recruit
him in running its much larger branch in Winnipeg. Eventually, he left
the bank to help develop the local insurance industry. Of all the
positions he took over the years, however, he was most proud of his
work as a local banker on the prairie. When he died, the Ottawa
Journal praised him, first and foremost, as a banker: “John
Benning Monk, Manitoba pioneer banker, died at his home early Monday
afternoon. He was 92.”
J.B. Monk was my great-grandfather. I first heard his story when I was
18 and living in California. My father, whose job at Hewlett-Packard
Co. had taken him from Canada to Silicon Valley, was trying to explain
to his teenage son how easy he had it compared with his past
relatives, who’d had to walk through waist-deep snow just to get milk
and eggs. In trying to toughen me up, my father exposed me to J.B.
Monk’s deep and enduring focus on using the tools of finance for the
greater good. My father even pulled from an old trunk the vest J.B.
had worn on his long journey — with the long slit down the side — and
recounted the dangers and sacrifices he had incurred to put the bank’s
money to work in the Keewatin community. I’m sure I nodded my head
with as much sincerity as an 18-year-old could muster — and then went
to the beach.
But the story of J.B. stuck with me. And I came to realize over time
that although my great-grandfather may have been a pioneer, he was not
unique. Bankers and financiers of many stripes played integral roles
in the development of countries around the world. Finance once was a
highly personal industry founded on mutual understanding, woven into
the very fabric of society. No doubt there were exceptions, such as
the robber barons, but trust seemed to be at the heart of finance
during J.B.’s time. Local bankers put themselves at the center of
communities and sometimes even in harm’s way. J.B. sacrificed
considerably for Keewatin, and others in the community no doubt
recognized that. At a fundamental level they all shared the same
mission: security and prosperity.
Over the past century, however, trust has steadily eroded in the
business of finance. In fact, the innovations that were supposed to
render finance cheaper, easier, better and more efficient have become
some of the most costly in our society. In 1950 the financial services
industry enjoyed a 10 percent share of U.S. corporate profits. Today
that share is 40 percent. Of the 400 richest Americans ranked by
Forbes magazine, 26 got their fortunes from real estate, 28 from
media, 28 from energy and 29 from fashion and retail. The big winner
would be technology, with 48, if not for banking, finance and
investment. The last group takes the prize with a whopping 106 of the
richest Americans. Not bad for an industry that doesn’t actually make
anything.
Financiers and bankers have lost the public’s trust, in large part
because they have sought to use the increasing complexity,
sophistication and opacity of corporate and project finance to enrich
themselves at the expense of the capitalist system they were
originally meant to serve. The business of finance seems to have
devolved into a world of rent-seeking and zero-sum games. No doubt
some people are doing right by their clients, but the system as a
whole is so tilted in the wrong direction that doing right by clients
is now akin to not doing wrong by clients. Because finance was, and
is, crucial for capitalism to function effectively, its derailment
could derail capitalism. With this in mind, it’s important that
finance and investment be set on a more sustainable path. This path
should be rooted in service to the key players in the capitalist
system — savers and developers — and in a commitment to create value
within the real economy.
I’d love to be able to say that my interest in rerooting finance in
the real economy grew out of an appreciation for my
great-grandfather’s legacy. It didn’t. The truth is, a few hazy years
spent in the bowels of the finance world at the height of exorbitance
and rent-seeking pushed me in this direction. After graduating from
Princeton University with a BA in economics in 2000, I shuffled off to
Wall Street to work as an analyst at an investment bank. Assigned to a
technology group at the height of the Internet bubble, I saw what the
excesses of Wall Street looked like up close. After that melted down
in epic fashion, I ended up in a venture capital firm focused on
financial services. Yet again this role provided me a rather unique
set of insights into the ways financial services companies actually
make money. There was a mix of offshore banking and insurance, with a
tiny dash of new financial technologies. Much to my parents’ chagrin,
I walked away from the high-paying venture capital world and instead
chose to do a decade of graduate studies and enjoy the relative
poverty that sadly went with it. I went to the Sorbonne in Paris for a
master’s in economics and then to the University of Oxford for a
doctorate, paying for a verre or a pint with consulting gigs
with
pension funds. (There will be more on all that later.)
Through these experiences, as a professional and as an academic, I
came to believe, perhaps naively, that putting finance and investment
on the right path would demand that we wake the industry’s sleeping
giants. In the same way that Bank of Ottawa sent one of its own
employees off to the frontiers of finance, today’s institutional
investors need to develop similar pioneering capabilities. As I saw
it, and continue to see it, ushering in a new dawn of capitalism
demands that the global community of long-term asset owners —
endowments, family offices, insurance companies,
pensions and
sovereign funds — take the $100 trillion or so that the
Organization for Economic Cooperation and Development estimates it
oversees and step up, professionalize and act like educated financial
consumers. The idea here is for the ultimate principals in the long
principal-agent chain of intermediaries — a chain that facilitates the
flow of resources between savers and developers in our capitalist
system — to take their role more seriously than they have previously.
Today the community of asset owners, which should be a potent
disciplinary force over intermediaries, doesn’t know how to play its
part. I accept that this won’t be easy, but it has to change if we
want to put capitalism on a more sustainable trajectory. And by
“sustainable,” I specifically mean a capitalist system that is more
attuned to the long-term fundamental challenges facing society.
Taking a step back, I see a few obvious reasons asset owners lost
touch with the real economy. Starting with the development of
Modern Portfolio Theory in the 1950s, a plethora of financial
concepts allowed for the mass production of finance. We as a society
were told that this mass production, which was based on the
deconstruction and repackaging of financial risks into products, was a
very good thing. It allowed for risk diversification and widespread
access to financial opportunities that had been available only to the
most-sophisticated investors. These products were engineered to
provide
investors with something that seemed to satisfy their risk and
return objectives in an easy manner. But although these products were
sold as simple, they were anything but. Converting numerous investment
risks into standardized return expectations is highly complex. And the
top-down models, heuristics and black boxes used for this left local
knowledge and trust — the cornerstones upon which investment decisions
were made — by the wayside. The ultimate financiers of our entire
capitalist system — the asset owners — were attracted by the ease of
buying something that purported to offer a predictable return. It was
simpler to assess standardized products than to actually study the
underlying real assets, which could be quite messy. But few asset
owners had the sophistication required to make smart decisions about
how to consume the rapidly expanding array of financial products and
services. Most didn’t understand the underlying fees, costs, risks and
incentives they were accepting, either explicitly or implicitly, in
the grand bargain to move toward mass-produced finance.
I went to Oxford to work with Professor Gordon Clark on a thesis that
was meant to look at the regulation of offshore financial markets. I
can’t recall exactly what I was hoping to learn, but I no doubt had
visions of doing fieldwork on tropical islands. But a consulting
project for a large U.S. public pension fund right before I started at
Oxford set me off in a completely different direction. The goal of the
project was to help the pension fund assess permissible equity markets
in the world’s
emerging economies. I was tasked with traveling to Morocco and
Taiwan to run the audits of the countries’
macro and fiscal transparency. I remember, on my first day in
Taiwan, coming into a giant boardroom in the Ministry of Finance with
my translator and being invited to sit on one side of a long table. On
the other side sat 13 representatives of the ministry. For these
officials, receiving a thumbs-up from this 28-year-old kid, who barely
understood the difference between public and private accounting, could
mean hundreds of millions of dollars of additional capital from this
fund and billions more from its peers, while a thumbs-down could mean
getting nothing. There and then I realized that pensions matter. More
significantly, I also realized that
pensions should really be using far more experienced consultants
to audit countries’ macro and fiscal transparency, especially as it
pertained to Morocco and Taiwan. Anyway, much to my Oxford adviser’s
great relief, my Ph.D. topic quickly shifted to the design, governance
and management of public pensions and other long-term investors. And
I’ve never looked back.
As academics studying these funds, and indeed as consultants actively
working to help them improve their governance and management, Gordon
Clark and I have been given an unvarnished view of their operations.
What we’ve learned over the past decade has been profoundly
depressing: The big asset owners are often complicit in, and perhaps
even responsible for, the short-termism and rent-seeking in the
finance industry. Why? Because traditional institutional investors
have been outsourcing almost all of the assessment and selection of
their investments and rarely possess the expertise and competencies to
execute even the most basic financial transactions without the help of
some external, and often compromised, adviser. In this respect, the
sponsors of these investment organizations have been comfortable with
the idea that their funds’ success has been a function of the
effective oversight and management of a long chain of principal-agent
relationships. The ugly secret of our capitalist system is that the
ultimate providers of financial capital today are managing their
assets with business, risk and information technology systems that are
obsolete or lacking in critical functionality, redundancy and
security. That’s scary for anybody interested in preserving the
efficiency of capitalism.
To be fair to the sponsors of these funds, the outsourced model was
originally supposed to provide cost-effective, flexible and efficient
access to markets. Indeed, the academic literature on the subject
would tell you that intermediaries are important agents to help
minimize transaction costs. No, stop laughing; it’s true. Granted, in
finance the increasing use of intermediaries has simply led to an
explosion of even more intermediaries. Asset owners have lost trust in
their existing intermediaries, and the new ones are meant to hold the
old ones accountable. The idea of adding intermediaries to control
intermediaries may sound absurd, but it fits with Nobel laureate
George Akerlof’s research on information asymmetries. He showed that
new institutions inevitably emerge to try to help minimize information
asymmetries, especially around the issue of quality control. But
Akerlof also showed that as the number of intermediaries grows, people
tend to revert to heuristics such as “brand name” to try to ensure
quality in the intermediaries they pick. For example, the brand-name
coffee shop may not offer you the best cup of coffee in town — in
fact, it almost certainly doesn’t — but at least you know what you’re
getting. What this meant for finance was that the asset owners would
look to established brands to ensure they were buying quality, all the
while asking a growing number of these brand-name intermediaries to
help them try to hold the entire system together. It was the fox
guarding the henhouse. As new research by Kathryn Judge of Columbia
Law School shows, financial intermediaries were quite adept at
promoting self-serving arrangements that drove high fees and even
ensuring that high-fee options were retained despite lower-fee
options.
I admit I’m a slow learner, but even for me the problems in the
finance industry were starting to crystallize during my doctorate and
postdoc work at Oxford. And I was not alone in thinking that one of
the biggest problems that needed fixing was the role — or lack thereof
— of the asset owners in disciplining the investment chain. For
example, both my Ph.D. adviser and Roger Urwin of Towers Watson & Co.
have argued that asset owners should adopt governance budgets to help
them professionalize. Keith Ambachtsheer of the University of Toronto
has been a champion of trustee education and mentorship. Harvard
Business School professor Josh Lerner has led efforts, including at
the World Economic Forum, to foster long-termism among asset owners.
John Rogers, recently retired president and CEO of the CFA Institute,
has asserted that institutional investors should take their role in
shaping the markets and, indeed, the economy more seriously. Adam
Dixon of the University of Bristol has written extensively on the rise
of
sovereign wealth funds and how these new players can serve to
catalyze change in the finance industry more broadly. In an article
for Harvard Business Review, McKinsey & Co. global managing
partner Dominic Barton and Canada Pension Plan Investment Board CEO
Mark Wiseman recently underlined the importance of asset owners to any
plan to fix capitalism: “The single most realistic and effective way
to move forward is to change the investment strategies and approaches
of the players who form the cornerstone of our capitalist system: the
big asset owners... If they adopt investment strategies aimed at
maximizing long-term results, then other key players — asset managers,
corporate boards and company executives — will likely follow suit.” I
couldn’t agree more.
This community of thought leaders — and there are many more who
deserve to be cited — has begun to realize the importance, for finance
and indeed capitalism, of empowering the asset owners of the world to
professionalize. And I’m here to tell you: This is starting to happen.
I believe we’re about to witness a new dawn of institutional
investment, which if it unfolds as planned could deliver a more
efficient and effective form of capitalism. And from our respective
academic perches at Oxford and Stanford, Professor Clark and I are
actively helping to drive some important developments among
institutional investors. The very fact that some of the largest
pensions, sovereign funds and family offices in the world are
supporting a financial research center that sits within Stanford’s
engineering school is evidence of the shifting priorities among these
asset owners.
The
Global Projects Center I run at Stanford, together with
engineering professor Raymond Levitt, has for its mandate the
rerooting of finance in the real economy. We work directly with some
of the largest asset owners on the planet, and we help them think
about how to provide the engineers walking our hallways with the
long-term financing they require to build real things in the real
world. We also work with the engineers to help them think creatively
about how to govern their own projects and where to look to find
aligned financial partners. In our estimation, if the financing
doesn’t come together in the right way, the projects being undertaken
may not be successful. For example, if an engineer wants to develop a
new type of green building that has a sophisticated energy
conservation component, this engineer will likely want long-term
investors involved right from the beginning. After all, it’s the
terminal investors that will reap much of the value from the energy
cost reductions associated with the investment in efficiency. Trying
to cobble together short-term financing with high leverage to fund
these long-term projects would be inefficient, risky and very
expensive in terms of the layering of fees and costs. Intuitively,
it’s wrong. Through our work at the center, we’re trying to fix this
for the people thinking big thoughts about infrastructure, real
estate, computer science, water, energy and so on.
Indeed, one of the many projects we are working on is focused on
resolving the infrastructure funding gap through innovative governance
vehicles for projects and investors. If the governance of green-field
infrastructure can be designed to accommodate the long-term interests
of institutional investors, and if the institutional investors can
develop the capacity to invest wisely and stay involved in managing
large-scale civil and social infrastructure projects, a flood of new
capital could be unleashed. This new capital could be deployed to
rebuild the infrastructure of mature economies or generate sorely
needed infrastructure for both developing and developed economies, and
to resolve the constrained financial circumstances that many local,
provincial, state and national governments are subject to.
Most people think we’re crazy to put a finance center in an
engineering school. But we’re not. We simply believe that bringing
engineers together with large asset owners offers powerful insights on
ways in which we can strengthen finance and put capitalism on a
sturdier footing. This is in large part because these are two of the
most important agents in capitalism — the investors and the developers
— so it’s incredibly valuable to provide them a space where they can
begin thinking about how to make long-term plans and how to follow
through on them. If I want to understand the real economy, I just open
the door to my office. I may not comprehend 99 percent of what comes
through that door, but the 1 percent I do understand makes it all
worth my while.
So, with all that we’ve been doing with large asset owners and
engineers at Stanford, what have we learned about the business of
institutional investment? What is the correct model that will drive
high returns and allow for a closer link with the real economy? In my
experience, it’s not the widely copied endowment model, which because
of its overarching focus on gaining access to external alpha
generators puts the asset managers in a position to discipline the
asset owners (see “
The Alternative Reality of the Endowment Model”). Instead, the
model of institutional investment that I’d like to see widely copied
is the one that recognizes the inherent competitive advantage that
comes with being a long-term investor. Consider this: There’s no
portfolio of assets that a short-term investor can hold that a
long-term investor cannot hold. Yet long-term investors can and do
hold portfolios that short-term investors can’t. That means that being
a long-term investor is, thanks to the power of diversification,
better than being a short-term investor. If you read the annual
reports of the
New Zealand Superannuation Fund or the CPP Investment Board — two
of the best institutional investors in the world today — you’ll see
this advantage articulated. These investors look for opportunities
where markets are inefficient. They believe that if an asset fits in a
neat box, it’s overbid and overvalued. They instead want to move into
markets with minimal competition (see also “
How to Be a Better Long-Term Investor”).
As an example, I recently worked with three sovereign funds on a $1.2
billion collaborative vehicle designed to scoop up promising
clean-energy companies that the venture capital industry had failed to
carry through to commercialization. Rather than viewing the companies
as abiding in the valley of death, these funds saw clean energy as a
valley of opportunity. Thus far, they’ve deployed about $700 million
on a no-fee and fully aligned basis. Although we don’t yet have
visibility on the returns (it’s still very early), this vehicle was a
useful step in transitioning the way investors do things. We continue
to collaborate on this and other opportunities where the competitive
advantages of sovereign funds allow them to invest in underserved
markets.
Based on experiences like this, I’ve come to realize the importance of
long-termism. If the engineers at Stanford have shared any complaints
over the past few years, it’s that most capital is too short-term to
maximize the real value of what they are doing. Message received. With
this in mind, we’ve come up with four key research and engagement
themes to extend the time horizon of institutional investment: the
professionalization of asset owners, the reintermediation of finance,
the adoption of technology by asset owners and the development of new
conceptual models.
Professionalization of Asset Owners
The first thrust of our research is to help empower institutional
investors to take greater responsibility for the end-to-end management
of their assets. They cannot simply be pass-throughs from the plan
sponsor to professional money managers. They have to professionalize
themselves. This seems self-evident, but many funds have resisted.
At the most fundamental level, the sponsors and boards of directors
have not invested in professionalization because they have not yet
seen the true cost of the outsourced investment model. It’s plain to
see why: As demonstrated by the recent leaking of private equity
limited partnership agreements from the Pennsylvania treasury’s
e-contracts library, a key characteristic of a successful finance
company is the ability to obfuscate fees and costs. Institutional
investors and their boards simply do not know how much they are paying
for money management. And this means they are not assessing their
organizations’ effectiveness with full information.
Worse still, some asset owners prefer to put their heads in the sand
rather than get real transparency on fees and costs. I can think of
one executive of a large asset owner who told a senior investment
officer to “stand down” on the fee and cost issue for fear of alerting
the board and the sponsor. Another told me that he didn’t want to know
what he was paying in fees — that it would be too depressing to see
how much he was giving away. I can also think of organizations that
present incomplete fee pictures in their annual reports. Some focus
only on base fees and bury performance fees in net return numbers,
whereas others make no attempt to quantify the implicit fees
associated with holding, moving or trading assets (despite the fact
that the implicit numbers, such as spreads and transaction costs, are
often as high as the explicit fees). In addition, many large asset
owners suffer from an overconfidence bias, nurtured by insufficient
information and lack of appreciation for how costs migrate within
mandates and across the entire portfolio. Most institutional investors
fail to link payments made to internal staff with payments made to
external service providers. This seems bizarre to me, as both payments
are costs of running the same business.
For institutional investors to move toward professionalization, they
have to start by getting fee and cost transparency. They have to
really know the price they’re paying for external service provision.
My assumption here is that boards, at least those with sane people on
them, would prefer to pay internal staff millions than pay external
staff billions for the same service. But if you look at the industry
today, that doesn’t happen. And the high fees paid to the finance
industry have allowed it to consolidate power and then wield that
power to extract a disproportionate share of value from the global
economic system. Think of it this way: Paying overly generous fees
today is a recipe for paying even higher fees tomorrow.
I recognize that many of the people working in these funds are very
happy with the status quo. They prefer to avoid career risk by
shifting investment risk to others. They also realize that their
domain expertise may not be needed in the next generation of
institutional investing, where direct-investment skills may be
required. It is thus understandable that they may not want change.
After all, if you need new staff, it’s only natural that existing
staff would try to thwart the change.
But the reputational risk associated with the current path is growing.
Institutional investors do not want to explain to their sponsors, let
alone to the general public, that their lack of attention allowed the
private industry to accumulate wealth beyond anything remotely
reasonable and that their oversight has been complicit and even
instrumental in allowing most, if not all, of the scale economies in
finance to accrue to the private managers. If that’s not enough to get
somebody moving, then how about the carrot of risk-free returns? It’s
far easier to save money through smart implementation — call this
implementation alpha — than it is to
generate alpha returns in the market.
Reintermediation of Finance
The second thrust of our research focuses on reintermediation, which
we define as the fostering of a new generation of aligned
intermediaries. Rerooting a public pension fund in the real economy
will inevitably create strains on already resource-starved
organizations. As such, a new generation of intermediaries to support
the professionalization movement is required. In my view, this begins
with institutional investors deepening their collaboration with one
another but extends into a whole host of new managers, service
providers and consultants. If you’re going to move away from the
existing set of intermediaries and all the economies of scale they
enjoy, then you have to replace them with something else.
One of the new intermediaries of finance that we’re focused on is the
collaborative organization. I’ve been lucky to help launch and grow a
variety of these peer-to-peer groups. For example, I worked to launch
the Innovation Alliance, which helped a handful of sovereign funds
share deals in growth-stage, capital-intensive venture-backed
companies, largely in energy innovation. In addition, I helped to grow
the
Institutional Investors Roundtable, a Quebec-based not-for-profit
group focused on seeding new collaborative platforms that was founded
by some of the largest direct investors in the world. I’ve aided in
building
Institutional Investor’s Sovereign Investor Institute, a
membership group that meets six times a year in six different global
locations and brings more than 100 asset owners together for knowledge
exchange. Last but not least, there’s the affiliate program of the
Global Projects Center, which gathers 12 or so asset owners together a
few times a year to think deep thoughts about the future of investing.
None of these collaborative platforms has been anywhere near as easy
to put together as I thought on the way in, but all have delivered
significant value to the asset owners participating, helping to
connect like-minded investors.
Moving beyond the asset owners and their collaboration, there will
still have to be outside intermediaries to serve the long-term
interests of these funds. One of the big research projects we’re
working on right now at Stanford is focused on best practices and
policies for seeding new managers. As David Swensen, CIO of Yale
University, has said: “Attractive investment management organizations
encourage decisions directed toward creating investment returns, not
toward generating fee income for the manager. Such principal-oriented
advisers tend to be small, entrepreneurial and independent.” And to
find such managers, you may have to seed them.
You can think of seeding as the venture capital of asset management.
The objective is to maximize the alignment of interests between the
asset owners and the asset managers and to minimize fees, which means
the institutional investor can get the same or higher net returns on a
lower base of gross returns. Importantly, there is plenty of research
that demonstrates the outperformance of new and emerging managers. I
can think of more than 15 large asset owners that are seeding in the
domains of hedge funds, private equity, real estate, infrastructure
and venture capital.
Technological Adoption
The third thrust of our research agenda is centered on the adoption of
innovative technologies among asset owners. To date, a widespread lack
of technological sophistication has served to disempower institutional
investors. With the computing revolution the private financial
services industry has accumulated and consolidated its economic power.
However, a new generation of technology entrepreneurs are focusing
their sights on helping institutional investors better do their jobs.
For the sake of transparency, I should add that I believe in this
trend so much that, much to my wife’s chagrin, I have invested
considerably in, and advise a handful of, these “invest tech”
start-ups. In all cases I view my role as pushing rather aggressively
for the asset owners. What I want is for technology entrepreneurs to
understand the importance of institutional investors and build
products to help them. Anyway, there’s a lot happening, much of it
within what I call the three D’s of investment technology:
disintermediation, dissemination and democratization.
-
Disintermediation:
What
AngelList did for high-net-worth individuals, new platforms soon
will be doing for institutional investors. Powerful matchmaking and
correlation engines will help institutional investors connect with
unique and thoughtfully identified investment opportunities (for
example, companies that match up with the comparative advantages,
networks and geographies of institutional investors). Those
companies that made their money in financial services because they
sat at the intersection of networks (brokerages, bankers and even
some asset managers) should be nervous. Think of it this way: When
was the last time you went to a travel agent? Now apply that same
idea to an entire segment of the financial services industry.
-
Dissemination:
Installing a robust IT system means faster dissemination of data,
which you’d think would mean better investment decisions and
performance. If only it were so simple. Building the sorts of IT
backbones required to move reliable data quickly is time-consuming,
expensive and painful. Moreover, getting data from one risk or
analytics engine or service provider to talk to other engines and
providers is extremely difficult. Can you build these types of
systems using spreadsheets? No chance. The processing power required
to chug through the complex equations and big data would crush your
laptop. But isn’t this just what you get with a Bloomberg terminal?
No. This is about intelligently overlaying a fund’s proprietary
portfolio data on market and third-party data to develop unique
investment insights that are truly real-time and bespoke. These
companies will offer the equivalent of a financial iPhone; you’ll
run all your apps on their standards and data.
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Democratization:
When the computational revolution really kicked off, three decades
ago,
hedge funds and savvy asset managers accumulated power because
they had technology nobody else had. Today that authoritarian
control of computation is being democratized. The processing power
that cost $100 million in 1980 now costs a few thousand dollars.
Although in the past only the most-sophisticated asset managers
possessed the tools required to manage complex global portfolios,
soon the most-sophisticated systems on earth will be available to
all. As a result, new companies are emerging to provide black boxes
to the masses.
As institutional investors adopt these
innovative technologies, they will have the power to dispense with
antiquated rules in the investment industry. The rule that seems most
prone for dispensation is the one that says managers should get paid a
percentage of assets under management. Managers would like
institutional investors to believe that moving money is similar to
moving dirt in trucks from point A to point B — that it requires a
constant fee that escalates in parallel with the rise in total assets
under management. But as it turns out, moving a nine-digit number from
computer A to computer B is as costly as moving an 11-digit number.
Yes, big trades are harder to place and certain investment strategies
have capacity constraints, which may warrant higher fees. But in these
exceptions the service provider should be forced to justify the
management fee; it should not be the standard upon which all
investment contracts are based.
Ultimately,
technology will help institutional investors streamline and
strengthen operations, manage and distribute knowledge, access unique
(and currently expensive) markets and level the playing field with the
private financial services industry.
Development of New Conceptual Tools
The fourth thrust of our research has to do with the adoption of new
theories and concepts by institutional investors. My interest in
studying conceptual tools and their adoption was sparked by
sociologist Donald MacKenzie. His research shows that financial
theories do not just describe financial markets, they also shape them
by influencing the behavior of the actors. They are endogenous. “Man
has become the tool of his tools,” as Henry David Thoreau said. If we
can change the finance and investment tools, we can change the
investment man and his world.
Because of the recent crises, there’s a real opportunity to change or
at least supplement the existing tools. To quote another philosopher,
Marshall McLuhan, “Most of our assumptions have outlived their
uselessness.” Indeed, the recipes of institutional investment
inherited from the past — Modern Portfolio Theory, the Capital Asset
Pricing Model, the Efficient Market Hypothesis, Mean-Variance
Optimization and Value at Risk, among others — no longer seem to match
up with the ingredients in today’s financial markets. Some investors
are already operating in a post-MPT world, supplementing the existing
models with new conceptual tools so as not to be shaped by models with
unrealistic assumptions.
For those investors looking to move beyond traditional theories and
dogmas, “investment beliefs” have become quite popular. Beliefs refer
to accepted truths about the world and financial markets that an
institutional investor’s management team and board have agreed should
guide their behavior. These can include such beliefs as “alpha is
rare” or “environmental sustainability will add value in the long
run.” These beliefs are not necessarily theoretically proven (yet),
but investors collectively choose that these beliefs should guide
their thinking. In so doing, the beliefs provide long-term investors
with rigor while allowing for more flexibility than traditional, often
short-term, theories. I was lucky to be invited to give a presentation
on investment beliefs to the California Public Employees’ Retirement
System board a few years ago and was quite surprised to see that these
beliefs were being taken as key signposts for long-term decisions.
Other conceptual models are growing in importance, such as real
options approaches for dealing with long-term uncertainty, which
borrow the tools of financial options for real-world contracts.
There’s also the Universal Owner Hypothesis framework, which helps
guide investors’ engagement with the broader economy. Last, investors
are increasingly interested in using an impact lens as a means of
guiding long-term capital to its most productive uses, which in turn
can (in the right contexts) drive high returns. For example,
Malaysia’s Khazanah Nasional generated 14 percent dollar returns for
more than a decade using a developmental objective overlay.
In addition to conceptual tools for guiding investments, many
investors are developing new tools for managing organizational and
investment risk. These include the development of risk budgets, the
hiring of risk officers and the use of innovative models for assessing
and dealing with risk. The work that Richard Bookstaber is doing at
the U.S. Treasury’s Office of Financial Research is quite important in
advancing the mainstream appeal of new risk models. There’s also a
growing trend among investors to think in terms of governance budgets,
similar to risk budgets. For Oxford’s Clark and Towers Watson’s Urwin,
governance is a finite and measurable resource, and a fund’s
investment style and strategy should match its governance budget.
Within our community at Stanford, we’re hoping that our work to
develop new professional capabilities, new aligned intermediaries, new
technological tools and new conceptual reference points will help
asset owners extend their time horizons and reroot themselves in the
real economy. It should be noted that it’s in their interest to do so.
Recent research by Toronto-based CEM Benchmarking shows that the
institutional investors that take this approach — in-sourcing some of
their assets — outperform those that don’t. This is new research that
merits additional study to verify its accuracy, but even if it is an
anomaly, it’s at least anomalous in the right direction.
The new generation of long-term investors that I’m working with — as
an academic, investor, consultant and often therapist — should have
the ability to take end-to-end management of their assets. They may
not choose to invest directly, but they will at least be able to weigh
an internal option against the services being offered in the
marketplace. And when those services are too expensive (that is,
almost all of the time), they will have a credible alternative.
Moreover, having the capacity to do direct deals will build a culture
of risk and responsibility, and trigger a whole series of insights
that all institutional investors should have. The more you know, the
more you know what you don’t know.
By innovating and having direct capabilities, institutional investors
will be able to use local competitive advantages to develop structural
alpha opportunities. Many institutional investors have advantages they
aren’t leveraging today. These investors will also be able to take
countercyclical positions. When markets are crashing as a result of
illiquidity, they can step in and catch the falling knife — not
because they think it’s right for society (though it is) but because
they’re going to get compensated for doing so when markets rebound
(which they usually do). In a similar vein, these investors can
allocate into markets that might otherwise be deemed inefficient or
illiquid. They can get paid for lockups. They can sell insurance. They
can play in markets that short-term investors cannot. You get the
idea. What I’m trying to say here is that the long-term investing that
I want to foster is not (necessarily) about buying and holding. It’s
being smart about the intrinsic long-term competitive advantages that
institutional investors have and using them to the maximum effect.
The mass production of finance undoubtedly served to bring finance to
more people. But it came with underappreciated costs for capitalism
and society. And in the same way that society has begun to revolt
against the mass production of food, in part represented by the wild
success of Whole Foods Market and the organic food industry, a small
group of asset owners are starting to move away from overly processed
and engineered products and mandates, and instead are working to get
access to real assets in the real economy — let’s call this whole
finance. These investors are reducing the layers of complexity and
abstraction that have served to enrich the financial services
providers and are finding ways to access the real economy in
more-aligned and cost-effective structures and vehicles. This, we can
only hope, will help to put our economy on the right track.
What I find most interesting about this new dawn of financial
capitalism is how we are coming back full circle to some of the themes
and concepts that marked my great-grandfather’s experiences. The
technological advances — such as the one that allowed wire transfers
to replace young bankers stuffing their vests with cash and traveling
across the country — were viewed as universally positive. For a long
time there wasn’t recognition that we were losing something in the
process of gaining so much. We lost the personal interactions that led
to the development of trust. They were replaced with diversification,
productization and homogenization. But now technology is becoming
powerful enough that we might get back to some of those roots: local
knowledge (
big data), communities (crowd sourcing) and trust-based
relationships (networks). This is encouraging because the next
generation may live with a form of finance and capitalism that is far
more aligned with and interested in what the local community wants and
needs than it has been for decades.
When I look at J.B. Monk’s vest with the slit down the side today, I’m
reminded that changing finance, and indeed capitalism, won’t happen
through words alone. At some point, like J.B did, you have to be
willing to head out to the frontier and be a pioneer in this business.
It’s for this reason that I’ve been on partial leave from Stanford for
the past few years. For every three days I spend at the university as
an academic studying large asset owners, I spend another three days as
a consultant working with and for large asset owners on innovative
models of investment. For me, today’s pioneering investors, willing to
entertain many innovative models to get greater alignment with the
real economy, are just as much of an inspiration as J.B. Monk. • •
Get more from Ashby Monk on his blog,
Avenue of Giants.
Follow him on Twitter at
@sovereignfund.
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