Steve Waldman has a longish and very useful post “I sing the praises of financial innovation” in which he seeks to identify some good and bad financial innovation (I very much support Martin Meyer’s observation that, for the most part, what is called financail innovation is finding new technology that makes legal what was illegal under the old technology).
You must read his entire post, but I wanted to focus on the key bits. Here is the list of innovations he likes:
The growth of venture capital and angel investing
The democratization of access to financial information (e.g. Yahoo! finance)
The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).
I can add one to his list:
Electronic order placement
Frankly, it is a luxury to be able to place a limit order at 3:00 AM anywhere in the world.
However, I have to differ with him on the growth of VC and angel investing being an innovation. It is instead a reflection of increased concentration of wealth at the top of the food chain. And as for the growth of professional VC, there is less there than meets the eye (I am certain to get some enraged comments).
A friend who ran a successful VC firm (as in founded it and went successfully through two funds, seven years apart) is leaving the industry because he has concluded it adds no value. He argued that not only are the superior results concentrated in a few funds (the famous usual suspects) even their returns were the result of a very very few deals. Thus the profile of the industry is that the total industry returns are dependent on a few deals that return 50 to 100 to one. And he further argued that with the industry about to slip past the dot-com era in counting ten-year returns, that the returns were about to start to look awful and funding allocations by pension fund consultants would skew away from the industry.
And his section on bad innovations:
Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I’d place them directly in the “good” column.) But there are many, many more bad innovations that we have yet to come to terms with:
401-K plans with limited investment menus
The conventional wisdom that long-term savings ought by default be placed in passive stock funds
The conflation of ordinary saving and financial return seeking
The tolerance, advocacy, and subsidy of financial leverage throughout the economy
The move towards large-scale, delegated, and professionalized of money management
The growth of investment vehicles accessible primarily or solely to professional and institutional investors
Waldman discusses these issues at greater length in the post. His discussion about how badly we treat savers is particularly useful
With 401 (k)s, it isn’t just the lousy menus, but also the limited ability and long lead times for changing allocations. And some funds also take a heinous amount of time to credit annual contributions. I don’t have a full overview, but I have heard enough bad stories to be convinced that this product is heavily slanted towards the administrator, with too many having “gotcha” features, compared to very user friendly IRAs.
With supposed professional management has come a lot of faux science. For instance, the academic literature has repeatedly found that investors benefit from being diversified by asset class (stocks, bonds, foreign stocks, foreign bonds, cash, real estate, perhaps commodities, although some research has found that CTAs fail all tests of being an asset class; the term of art is that it puts you on the efficient investment frontier). The notion of asset class is broad categories. Yet the industry has gotten investors to confuse styles with asset classes and produces all sorts of cute analyses over pretty short (by historical standards) periods of time which show low covariance of X fund versus, say, the S&P 500. Since I used to work for firms that were adept at cutting the numbers in ways to prove their points, I have little confidence in anything not produced by someone who has no skin in the game (and the pension fund consultants have every reason to promulgate this methodology, since it is how they justify their fees).
Warren Buffett put it more colloquially:
To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.
The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new “beat my- brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.
Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
So Yves, I am in complete agreement with your source regarding the negligible performance of venture capital, not that it’s my area of expertise. The whole idea was that investors with experience in sectors would have a better success rate spotting effective innovations or niche-advantageous start-ups. There is nothing, nothing at all, to support that contention. VC was no better than anyone else at picking who would succeed. They threw enough darts that they hit a few big payoffs. A very few firms were a tad better, presumably because they had better industry contacts and understood the products a little better. But even so. . . . And this should surprise NO ONE. The venture capital game, and it is a ‘game,’ is all about getting bunches of equity for pennies, it is _not_ about growing industries or promoting advantageous products. If the idea is the latter, one hires talent, gives them labs, time, and enough money to tinker, and keeeps throwing their ideas over the wall until one goes big. If the idea is the former, one finds impoverished innovators who will sell you a big chunk of their sweat for a song. Notice the difference . . . .
My reaction when I first read that Buffet quote before was, that summary is worth _a year_ of business school because knowing the numbers won’t help you if you don’t know what the game is, and he just told you what the game is.
I would use the same analogy and substitute “CEO” and “CFO” for all the classifications of “helpers.” Really, how well did Jack Welch do compared to other CEO’s and how much is attributable to a booming economy? But everybody thinks zillions have to be paid to attract talent… but for what? Did Hank Paulson know what was going on at Goldman Sachs???
I think the system is even worse than what Buffet describes. The asymmetry of returns can mean that one fund manager gets 20% of profit (when his fund takes the right position) but the other fund manager (who took the wrong position) can potentially bear almost no cost at all (if there is no skin in the game). Obviously, some of this evens out with year to year variations within any one hedge fund and clawback policies. But it certainly does not *all* even out. Clearly, more than 20% accrues to hedge fund managers as a class because some hedge funds never make any money but the hedge fund manager class does not suffer a commensurate loss in this situation. It really is a crazy way for pension funds and university endowments to allocate money, especially when the overall returns do not seem to have justified the outsized compensation. I represent many real estate funds, and *literally*, institutions like Harvard could not give some of them money fast enough. Money was being made hand over fist and everyone looked like a genius. I heard the word “genius” so many times I could have spent hours a day just documenting the instances. Well, some of the managers were very intelligent. But as the tide went out, it was pretty apparent some were swimming naked, too. I cannot believe how unskilled some of the managers are, with their lack of skill having been completely masked by the rising market. They are totally untethered now. They simply do not know how to unwind or work out their existing positions, or even think through the situation logically. There was a huge selection bias the last decade for those who craved risk at all costs, even though some had no idea how to manage assets, how to contain costs, or how to evaluate assets. I hope people remember this in the future, but I doubt they will.
Can you please translate what you mean by CTAs in the phrase “CTAs fail all tests of being an asset class”? The only commodity-linked meaning I can find is “commodity training advisor” (a person, so clearly not a candidate for an “asset class”…) buried among clinical trial agreement, cognitive task analysis, call to action, common travel area, content targeted advertising, computerized tomography angiography… TIA for clarifying — acronyms are often very opaque!
I strongly agree about 401K investing. My wife was local HR for an office of a couple hundred people. Even with good contacts at corporate she could not find out what fees her 401K choices were charged. I called the large insurance company that ran the 401K for her company and was told flat out that my wife was not the customer, her company was, and only the company could ask for such information. I got the required filing they made to Dept of Labor, and it had no usefull info on fees (some top level fees aggregated for the entire plan). Finally I ran into the owner and he had someone call me. The fees were obscene. Managed funds (run by the company providing the plan) charging 1.5% to 2%, it was wrapped in an annuity that charged for “return of premium insurance” another 75 bps, they hired an “investment advisor” to hold seminars and “educate” the employees (although they claimed absolute ignorance on the fees charged!), … In the end 3% to 3.5% depending on the investment. Can you really expect the average employee to call the owner to find out essential information for making an investment allocation. What bothered me more, when I’d mention this to my wifes colleages (people with college degrees) their reaction was thats just a few percent no big deal. I don’t think i ever successfully explained that the difference between a return of 3% and 6% is 100% not 3%. The other thing I learned from this excercise is the fraction of people that borrow from their 401Ks is scary (scary if it is going to be relied on for retirement). Also, given the unfunded liabilities of Social security and Medicaid, should we be betting that we will pay the same or lower tax rates in the future (this is a key assumption behind a tax deferred investment like a 401K)? 401Ks sound great, but if you kick the tires, in general they are going to accomplish eff all of nothing IMHO
I didn’t have time to go over this story, but from the first few sentences, it looks like hogwash:
Why the CDS Market Didn’t Fail
Jane Baird has the latest on what Alea calls “the non-event of the year”: the Lehman Brothers CDS settlement on Tuesday
Comments appreciated; see yah later…
SUNDAY, OCTOBER 12, 2008
Good and Bad News on Lehman Credit Default Swap Settlement
Eraj Shirvani, chairman of International Swaps and Derivatives Association (ISDA), the industry body that manages the auctions, said these concerns were misplaced. “Sellers of protection mark their positions to market every single day. So those firms have already marked down and provided collateral against their positions. As a result, there should be little or no unanticipated additional cost involved in the settlement of Lehman CDS,” said Mr Shirvani, who is co-head of European credit at Credit Suisse.Net exposures were usually around two per cent of the gross amount, which vastly reduced the potential cashflows. Assuming $360bn of gross exposure, this would translate into $7.2bn if these estimates are correct.
A classic manipulative delivery squeeze in a bond futures contract takes place when a manipulator acquires a substantial long position in the futures contract and a sizeable fraction of its cheapest deliverable bond issue. The squeezer attempts toprofit by restricting the supply of the cheapest deliverable issue. This action increases the price of the original cheapest-to-deliver issue and simultaneously forces holders of short futures contract positions to either deliver more highly valued bond issues or else buy back their futures contract positions at inflated prices.
The first is the purchase of the cheapest deliverableissue. The second is the purchase of bond futures contracts. The third is throughforward repurchase agreements. These agreements involve a simultaneous forwardpurchase of the cheapest deliverable issue for settlement prior to, and a companion forward sale for settlement after, the futures delivery date. These forward repurchase trades are extremely important from the perspective of the squeeze as they provide control of the cheapest deliverable issue across the futures contract delivery date.
Crap from space>>
Credit Derivatives: Macro-Risk Issues Credit Derivatives, Macro Risks, and Systemic Risks by Tim Weithers University of Chicago April 20, 2007
There remains a great deal of unfamiliarity on the part of many market professionals with respect to the specifics of these contracts: “However, for a CDS (credit default swap) contract to be valid, it needs to be backed up by some tangible bonds in the marketplace (even if far smaller in size). Usually that is not a problem, since few companies are debt free. But if corporate events occur which prompt a company to withdraw its bonds – such as a merger – this can suddenly make CDS contracts worthless. … For the CDS market is now so monstrously large that the behaviour of the derivatives is exerting an increasingly large impact on the cash market. The tail, as they say, is wagging the dog” There are actually well defined protocols for such corporate activities as mergers, acquisitions, spin-offs, and other corporate actions called succession events (which we will not get into here). Perhaps one last thought on underlying mismatches before leaving this topic (as it is one of the main sources of concern regarding credit derivatives). There are a number of (very successful and important) derivative contracts which “cover” underlyings which themselves are relatively small, illiquid, not traded, or even nonexistent as a stand-alone asset. Dozens of instances cometo mind. The Treasury Bond futures contracts are on a notional 6.00% (semi-annual) coupon 20-year U.S. Treasury bond; there is no such thing (and even if, by chance, there were today,
there wouldn’t be tomorrow). What’s made this contract particularly interesting is the fact that it has been, and continues to be, physically settled (giving rise to lists of “eligible-for- delivery” securities, conversion factors, cheapest-to-deliver instruments, embedded options,…) and the fact that the U. S. Treasury stopped issuing bonds for a time.
While the futures contracts never stopped trading (though there always did remain deliverables) and while a large portion of the volume of trade has shifted to the 10-year Treasury Note futures contract, there is no reason why bond futures, in principle and in practice, couldn’t trade even if there were no deliverables.
Synthetics – Cheapest to Deliver: In some synthetic CDOs, the calculation agent has the option todeliver the cheapest deliverable after a credit event. This is detrimental to the CDO. In response, arating agency can apply a haircut to recoveries if there is a cheapest to deliver option
regulators and exchanges should take notice of the fact that the marked asymmetry in penalties for settlement failures between cash and futures markets creates conditions that favor squeezes. Finally, futures exchanges should remove the reasons whyincentives for squeezes are generated in the first place. Towards this end, they should mark-to-market the specifications of their bond contracts much more frequently than they do at present, so that the prevailing market conditions do not differ dramatically from those assumed in the calculation of conversion factors. And, futures exchanges should also explore the possibility of redefining their bond futures contract to be cash-settled on a basket of traded bonds, instead of requiring physical delivery against a contract specified on a bond with a notional coupon and maturity.
Is this OT?
This CDS/derivative thing is all about the maturity and underlying future cash flow of defaulted collateral…. but then again, it could be connected to The Large Hadron Collider, so any help appreciated!
See: The LIFFE, like the CBOT, calculates the conversion factor for each bond by discounting the individual bond’s remaining cash flows using the assumption that the spot yield curve is flat at the level of the notional coupon defined in the futures contract. Clearly, if the level of the spot yield is significantly different from the defined notional coupon, or if the slope of the yield curve differs significantly from zero, the conversion factors defined by the exchange will not equate the net delivery costs of all eligible deliverable issues.
See Kilcollin (1982) for biases that conversion factor systems of this type introduce into the delivery mathematics and Garbade and Silber (1983) for a more general discussion of penalty versus equivalence systems for quality adjustments on contracts with multiple varieties
Although my comments here may jump back and forth between abstract info and attempts at humor, the previous post on CDS valuation is somewhat related to a few of my current posts that hint at yield curve manipulation and the mechanics of valuation and the concept of rates near or below zero. I know, weird stuff..
Re: “Clearly, if the level of the spot yield is significantly different from the defined notional coupon, or if the slope of the yield curve differs significantly from zero, the conversion factors defined by the exchange will not equate the net delivery costs of all eligible deliverable issues.”
Yves, this was a great post. A lot of financial innovations, says the cynic in me, are artifices to redistribute wealth under the guise of free markets principles that help the economy. In reality, very few people have any faith in capitalism or free markets.
On the lighted side, here is a list.
You cannot say you believe in free markets if:
1. You think that the economic cycle has been repealed.
2. You think that the Federal Reserve will rescue the economy.
3. You think inflation is a blessing and deflation is a curse.
4. You mistake a lobbying department with a profit center.
5. Your business’ best friend is a senator.
6. You think that a war will save the economy and your business.
7. You dislike government spending unless you benefit from it.
8. You tolerate that a public company be run for the benefit of the apparatchiks, I mean management, and not the patsies, I mean owners, of the company.
9. You think that a company can increase profits well above inflation in perpetuity and all hedge fund managers are geniuses.
10. You think that the government is not the solution. The government is your sugar daddy.
Yves, I have to disagree with at least some of the comments about VC. I’m a PhD student in Molecular and Cellular Biology, and VC is absolutely critical in turning a great idea into something that can produce a viable consumer product. Making that leap requires a lot of time, effort, and most importantly money.
And even with millions of dollars, if you are, say, inventing a drug, you’ll still probably need a collaboration with a major drug company to get through FDA drug testing. If your friend was disappointed about running VC firms, maybe he wasn’t running the right kinds with the right motivations. They have some great biotech VCs in the Northeast that help bridge the gap between academic research to useful ideas.
Just one PhD student’s view.
“The conventional wisdom that long-term savings ought by default be placed in passive stock funds”
Please, please please tell me why this is bad. I am a layman and a loyal reader who has divvied up his life savings among various Vanguard index funds, a la Wllm. Bernstein. You know, the basic 70%-30% stock/bond allocation with 30% of the stocks in a variety of international funds. I’ve stuck with this for 10 years. Am I a fool? If so, why? I have enormous respect for you and the work you do on this blog, but I entreat you to explain your reasoning on this.
Tangentially…Reg FD is a good example of innovative regulation…it promoted the democritization of information…aka paying exorbitant soft dollars to a prime broker no longer gets you a meeting w/xyz co’s mgmt to have them tell you “the quarter is in the bag.”
In the same vein, something that needs to go are soft dollars. Their just another hidden charge “helpers” levy on unsuspecting clients…unbelievable that the sec still allows that sort of unabashed conflict of interest to continue…it completely defeats the whole purpose of wrap/fixed mgmt fees.
Ok, here is my hate mail wrt to venture capital.
I have founded a venture backed company, as well as participating in an LBO (but never did an IPO). None of these innovations are particularly beautiful up close, but venture capitalists behave the most predictibly, and have by far the longest time horizon.
Your 3 con arguments strike me as false logic:
1. A few deals amount to all the industry profit. Yeah? A few days a year mark all the stock profits in a year.
2. A few usual suspects make the good profits amongst VCs. Well, same with hedge funds. Talent matters, and there have been too many wanna-be’s hanging out their shingle.
3. Since the dot-com bubble burst, there has not been much profit. VC relies entirely on IPOs to repay investors. Its been a bad decade for the stock market. No surprise that VC’s are in the same boat.
VC is highly cyclical, and we are at the bottom of the cycle. Easy to throw stones right now.
Your arguments are not very fact based and not very convincing. Saying that VCs are patient does not prove that they are good investors or a good deal for people who put money in them.
I recall seeing a study cited in the Economist, and now years later cannot track it down, that found that venture capital produced equity like returns with far more standard deviation. In other words, it was an inferior deal on a risk/return basis to straight stock investment.
Your “few days” is no response to the charge that the entire industry’s performance rests on a very few deals. The promise of VCs is that they can find and nurture superior opportunities. If there are very very few that pan out, that says that the VCs are considerably overselling their ability to find good situations. You’d expect a much less steep gradient of outcomes if the VCs were making a difference in selection and management.
My attorney does a tremendous amount of work with entrepreneurs with promising technology. Engineer, both research and big corporate experience in developing technologies, then worked for a major PE player. He steers clients away from VC, towards debt, angels, anything but VC. There are networks of investors affiliated with Stamford and MIT, for instance, who fund deals and the VCs never get their hands on them. His belief is that you have to overpromise to get VCs interested and when you come short, they are much more aggressive in reducing the ownership interest of the founding group than other capital sources.
Now that is probably an isolated opinion, but if even a few lawyers and accountants feel that way, it also suggests some very good deals are being steered away from VC to other money sources.
One cannot prove a negative, and I was not trying to. VC’s are easy targets, (but I don’t think private equity and hedge funds are terribly popular right now).
I personally worked with VC’s. I was treated with respect, and everyone made a little money. Similar with private equity (although I didn’t make money there).
The argument about a few days was a simple statistical argument. The shape of the distribution curve has a high number of failures and a relatively low number of successes. That is not the fault of the culture of VC, that is the nature of early investing. The highest correlating factor to success is the track record of the entrepeneur. And guess what? They all go to the top shops.
Angels are a lot like property flippers – it doesn’t take a lot of skill in a favorable market. Angels are history. We are back to friends and family and sweat equity.
small tech tends to flourish in the turndowns, as entrepeneurs are less likely to be be fully employed and over compensated.
I don’t know if this item quite fits into the category of “bad innovations,” but I offer it as an obvious addition to the list of things that ought to change:
Financial institutions that are “too big to fail”