Institutional Investor | Avenue of Giants, December 5, 2015 commentary of Ashby H. B. Monk: "It’s Time for Finance to Go Organic" [Academic attention to source and distribution channels for financial products]

Source: Institutional Investor | Avenue of Giants, December 5, 2015 commentary

Ashby Monk, Ph.D., executive director of the Global Projects Center at Stanford University and a senior research associate at the University of Oxford, has been blogging about sovereign and pension funds since 2008.

It’s Time for Finance to Go Organic

December 05, 2015 at 7:00 AM EST

Before the second half of the 20th century, organic food was just called “food.” People cultivated, harvested, cooked and ate locally; they had a clear sense of a food’s “place,” where it came from and how it arrived on their plate. They did not require an advanced degree to understand the ingredients.

Over time, however, the food industry transitioned away from whole, local products and replaced them with processed foods. Scientists augmented and reconstituted foods to make them cheap, durable and palatable. Most people thought this was a good thing, as these methods helped feed the masses.

What few realized, however, was that the process of delocalizing and mass-producing food created a new set of problems — namely, extremely high long-term costs, especially for human health. The obesity epidemic in the U.S., and indeed the world, has been driven by this cheap food. The delocalization, homogenization and productization of food fostered a market with considerable opacity and complexity. There was a general lack of transparency about the ingredients that were being introduced and consumed, let alone how they affected health over the long run. People started to eat things they did not understand. But the companies that made this food weren’t shouldering the cost, so they still found it profitable to sell. And consumers continued to buy it.

In response to a growing realization of the repercussions of consuming such highly processed food — such as the obesity epidemic — the organic movement began to take hold, reinforced by the Food and Drug Administration’s requirement that companies list on their products all ingredients and nutritional content. Once individuals understood what they were eating, they began to consume differently. Organic foods became more popular despite being more costly in the short run, as the long-term costs in terms of health were finally being considered.

At this point, you must be wondering what all this has to do with finance. A lot, I think. In a forthcoming paper with Rajiv Sharma, I argue that the ever-greater complexity and delocalization of finance has allowed for a similar obfuscation of ingredients — namely, fees, costs and expenses — which has led to a distortion in the underlying incentives that are being created in our capitalist system. I contend that it is this distortion that is driving an increasingly short-term-focused and disconnected financial world. And we need to fix it.

Traditionally, finance was a personal industry, founded on mutual and local knowledge. Bankers often put themselves at the center of their communities, providing a service that was well understood and important. While effective, this model of finance, as with the original model of food production, was difficult to scale to the masses. In an era of capital-starved industries and big developmental needs, researchers set about to transform the financial services industry into something that could be more easily accessed by all.

Starting with the formulation of Modern Portfolio Theory in the 1950s, a plethora of theories allowed for the mass-production of finance. Financial theory told us that the delocalization, deconstruction, disambiguation and repackaging of risk into products facilitated investment diversification, which in turn allowed for the widespread distribution of capital. The ultimate financiers of our capitalist system, the asset owners, were attracted by the convenience of buying products that purported to offer a “predictable return.” It is easier to assess standardized offerings with return targets than to actually study the underlying real assets and their risks; the latter could be quite messy. And, as with food products, financial products are often abstractions of real assets, typically tranched and stripped of local or idiosyncratic characteristics, and sold on exchanges with the help of rating agencies and a legion of intermediaries. They even share the terminology of the food industry, as they are “packaged” and given “wrappers.”

But while these new tools and techniques posited themselves as simple, they were anything but. Converting numerous investment risks into standardized return expectations was highly complex. As with consumers of processed foods, few long-term investors have the sophistication required to make smart decisions about where and what to consume among the rapidly expanding array of financial products and services. Most do not truly understand the fees, costs, risks and incentives being accepted, either explicitly or implicitly, in the grand bargain to move toward mass-produced finance.

Truth be told, the LTIs are oftentimes complicit, using the expected returns of complex products as a means of increasing the expected returns of their overall funds, which then serve to reduce the actuarial obligation of the sponsor. This has particularly been true of public pension funds, where overly optimistic return targets are often paired with underresourced internal investment teams thrust into a world of aggressive financial products they barely understand: a recipe for disaster.

Not all is lost. In the same way that the food industry has been pressured to deliver organic foods to increasingly knowledgeable consumers, a growing community of sophisticated LTIs is moving away from overly processed and engineered products and mandates. Instead, they are working to get access to real assets in the real economy in creative and more aligned ways. To be clear, these investors are not going back to the era of “pioneer bankers,” living in local communities and funding rural projects. Rather, these organic investors are using innovative tools that empower them to take a long-term view in their investments and integrate the long-term and short-term costs of investing. Some are investing directly in assets; others are forging mutually dependent relationships with intermediaries.

Similar to food, then, organic finance may initially seem more expensive. Indeed, paying a pension fund’s internal staff millions of dollars probably feels to boards much like how shopping at Whole Foods feels to consumers. But the short-term costs are more than made up for through long-term gains. In fact, many Giants now see organic finance as far cheaper and more competitive over the long run, and the academic research appears to confirm this bias.

The organic finance movement (if you’ll allow me to call it that) is thus simply about taking all investment ingredients seriously, especially the fees and costs. In the same way that food now comes standard with details on calories and ingredients, so too should investment products come with easy-to-understand labels that transparently describe the costs of financial intermediation. Once people realize the true cost — and consequences — of the opaque products, they will consume in a more sustainable manner. And that’ll be good for capitalism.