By James Saft
(Reuters) - Eight years to the day after the fall of Lehman Brothers and one thing has not changed: finance remains a private tax levied on the rest of us.
Two stories from this week’s news illustrate this well:
First, almost 90 percent of U.S. actively managed stock mutual funds failed to beat the market over the past year, a study from S&P Global showed. (https://us.spindices.com/search/?ContentType=SPIVA) This from an asset management sector whose global profit margins were 37 percent in 2015, according to consultants BCG, about double that of the widely reviled pharmacy industry.
Second, Wells Fargo (NYSE:WFC) is now under federal and multiple local investigations for a mis-selling scandal under which more than two million bank and credit card accounts were opened without customer consent.
Both stories, in distinct but telling ways, show how finance has grown and grown, but without ever becoming more efficient, only more lucrative for practitioners, all the while distorting how capital is allocated and retarding economic growth.
Wells Fargo is not the Wall St debacle we’ve come to expect, with traders gambling with shareholders’, depositors’ and taxpayers’ money, but a garden variety fraud under which frontline low-level employees - all bad apples acting independently, the bank maintains - “created” accounts customers had not asked for. Though Wells Fargo fired 5,300 for the scheme, not only has no high-ranking executive been drummed out, but Carrie Tolstedt, the leader of the unit in question, will be allowed to retire and take with her $124.6 million of accrued stock and options. We do not know how many employees were let go for “underperformance” after failing to cross-sell enough to clients.
Wells Fargo looks likely to be a story of bad incentives and bad actions to meet them, but is also just one more instance of the way in which industry insiders work to part clients and shareholders from their money without providing fair value.
As for the active fund management industry, it is not even as if this is the first year in which a huge majority of funds fail to beat the market after fees. Over 10 years, 88 percent of U.S. equity funds have lagged the market, as have 96 percent of long-term U.S. Treasury funds and 97 percent of high-yield funds. Quite simply, profitable as it may be, the active fund management industry is not fulfilling its mandate. Its sole virtue may be that it is shrinking, as savers increasingly allocate to low-cost alternatives which track benchmarks.
TOO BIG AND TOO EXPENSIVE
Look at the high-level data and it is easy to see why my assertion that the industry is too big and too self-serving is fair. The unit cost of a dollar of financial intermediation has remained about two cents for 130 years, according to data from Thomas Philippon, Professor of Finance at New York University. If you can find another industry which has had no meaningful gains in efficiency over more than a century, drop me a line.
Despite being manifestly uncompetitive, finance has grown and grown, with its share of GDP now about 75 percent larger than it was in 1980. Much of that growth is down to growth in asset management fees and lending to consumers, according to a 2013 study by Robin Greenwood and David Scharfstein in the Journal of Economic Perspectives. (http://www.people.hbs.edu/dscharfstein/Growth_of_Finance_JEP.pdf)
And while it is undoubtedly true that a working financial sector is crucial to the health and growth of an economy, economists increasingly argue that we now have a sector which impairs growth.
Stephen Cecchetti and Enisse Kharroubi of the Bank of International Settlements argue that periods of rapid growth in finance bring with them slowing growth in productivity in other areas of the economy. (http://www.bis.org/publ/work490.pdf) In other words, above a certain level, finance acts as a levy rather than a spur.
The mechanism for how this works is not too hard to guess at. Talent flows to where it is best rewarded, and when bright young people see the kind of risk and reward tradeoff Tolstedt’s $124.6 million represents they come flocking, spending their careers working on cross-selling plans of dubious benefit rather than something more - what is the word? - more productive.
Or look at active asset management and consider the theory of Paul Woolley of the London School of Economics of how active benchmarking leads inevitably to bubbles and bad allocation of capital, as managers pile on to whatever goes up in price and shun that which falls in order to protect their own hides.
Eight years on from Lehman’s implosion, and the global recession which came along with it, one thing is clear: much remains to be done.
(The writer is a Reuters columnist. The opinions expressed are his own.)