The Resplendent Response to Crisis
I’ve never met someone who thought fixing the financial system was a bad idea.
It’s a nice consensus, but there’s cacophony underneath it. Think about how a dozen people would complete this sentence: the financial system is broken because ________. I’d expect to hear everything from “my stocks are down” to “it lacks a suitable macroprudential oversight framework which leaves it exposed to systemic risk.”
What’s the constructive response?
I’m not smart enough to offer a definitive, complete solution. But Ashby and I have been exploring what’s underway to build something better on each episode of Free Money. Since markets are selling off and you’re probably reading all sorts of scary stuff, I figured I’d take you through five great academic papers we’ve been discussing on the podcast so that you can see a light at the end of the tunnel.
This first paper may shock you, so please make sure you’re sitting down.
The FinTech Opportunity - Thomas Philippon:
Financial intermediaries (banking, asset management, etc) cost roughly 2% of The United States’ total assets every year.
Despite advances in technology, costs have not fallen much since 1886.
Financial technology may increase the industry’s efficiency, but the current regulatory approach is unlikely to.
You read that right. Losing 2% of assets each year sounds bad on its own. As I write, ten year treasurys in the United States are yielding less than that.
But really think about this. None of the innovations of the past century — including the telegram, telephone, and internet — have reduced the cost of finance.
So this is bad when you think annually, but much worse when you think cumulatively. If that money was left invested instead of extracted by financial intermediaries, its value would have compounded. And our society would be much, much richer if not for certain organizations which exist to entrench and extract.
Corporate Purpose and Financial Performance - Gartenberg, Prat, & Serafeim:
Firms where employees report significant feelings of purpose and management clarity show superior accounting and stock market performance.
Senior executives tend to perceive greater purpose for the overall organization, but mid-level employees drive its link to financial performance.
A portfolio of these firms earns significant risk-adjusted returns (as high as 7.6%) on a forward looking basis.
Some organizations have higher purposes. It makes sense that the people who work there are more motivated, and that this motivation translates into superior financial performance.
But do purpose-driven organizations exist in financial services? They sure do. Pension funds, foundations, endowments, sovereign wealth funds, and their fellow asset owners collectively oversee about $100 Trillion for varied but specific purposes. Their employees invest a pool of capital to fund something specific over the long term.
Often, that thing is somebody’s retirement. Or a university. Or healthcare. Whatever it is, it’s something specific. And it’s a safe bet that the people who work to support these activities — often at below-market salaries — could use an extra 2% a year.
In the abstract, that’s just a cute observation. But the $100 trillion these organizations control is around a third of all the money on earth. If they found a way to work together, they might be able to plug the leakage that’s created by intermediaries.
Designing an Institutional Investor’s Collaborative Network: A Case Study of Value Network Analysis - Feng, Sharma, & Monk:
Institutional investors traditionally rely on brokers — who are powerful because they control information — to access private investment opportunities.
These institutions could also access information and private investment opportunities by building mutually beneficial collaborative relationships with similar organizations.
The work involved in building and using such a network naturally increases an organization’s ability to create and share knowledge and grows its awareness of regional or global best practices.
They’re working on it.
Private market investments tend to have higher expected returns than other financial markets. They also have some of the most significant capacity constraints, which has allowed gate-keeping intermediaries to promote competition for access instead of creative collaboration among asset owners.
It doesn’t need to be that way. And increasingly, it isn’t. As these organizations recognize their shared interest in working together, the locus of power in investing is shifting towards entities which invest for social purpose.
The Ties that Bind: Work Connections and Mutual Fund Investment Ideas - Genc, Shirley, Stark, & Tran:
On average, two equity mutual funds will have an 8.7% overlap in their holdings.
When one of the fund managers has a work connection with another, overlap is 30% greater than average (11.2%).
Risk-weighted performance improves by .9% for every 1% of abnormal overlap, (e.g., 2.3% in the above example).
And as these investors build deeper connections with each other, they’re able to make better and better investments.
The Geography of Investment: Informed Trading and Asset Prices - Coval & Moskowitz
The average fund manager overweights local stocks by .8% relative to the market portfolio.
Those holdings outperform the rest of their portfolios by 1.18% on a risk-adjusted basis.
This outperformance increases above 3% when companies are smaller (in terms of the total value of their stock) or widely held by other professional investors.
This includes investing in their communities. There is evidence that investing local means investing better, but the real magic will come when these asset owners are able to truly assert control over the markets they operate within for our collective benefit.
It’s hard to picture what that will look like, exactly. Our mental image of investing has been colonized by Wolf of Wall Street type. You know what I mean: American Psychos who use their power to extract instead of create.
The hope here is that someday we’ll all picture people with society’s best interest at heart. They will be connected enough to finish each other’s sentences, collaborative enough to support the big ideas in their community with capital, and capable enough to compete in a global market.
A girl can dream.
Free Money aims to deliver that world faster than expected and better than imagined by any ethical and legal means necessary.
In this episode, we talk about the absurdity of some Wall Street villains and why Australia is so innovative. We also answer important questions, like “what’s a pension?”
In our last episode, we talked about the power of big tech companies and proposed legislation that promises to stop Wall Street looting. We also answered questions on the effects of low interest rates, hiring practices that promote diversity, and whether the boom in Environmental, Social, and Governance investing is creating a bubble.
Don’t miss either of them. And — this is crucial — don’t miss the next one. If you’re at risk of that, be sure to click the button below.