At first glance, the obviousness of this article’s title may discourage the reader from reading further. This would be wrong. The aim is to simply draw attention to the dramatic changes which have taken place over the last few decades in financial services industry and world capital markets as investors have attempted to put the odds of success in their favour.
As any trader or investor knows, the world’s capital markets are a merciless cauldron, severely punishing mistakes. The financial crisis of 2008 wiped many billions of US dollars off stock market values, resulting in many millions of investors losing most or all of their net worth. Succumbing to fear and panic, they sold into a declining market and turned an unrealised loss into a permanent loss. Sadly, many so severely mauled by the financial loss will never return to invest again.
The Technological Revolution
In order to understand the underlying cause of such devastation and financial loss, it is worth examining the foundational pillars of today’s capital markets and financial system. In doing so, we will see that the structure, modus operandi and motivation of the players in the marketplace are very different to that of three or even two decades ago. The mix of investors and participants has changed dramatically from 90% of total NYSE-listed trading being done by individuals fifty years ago, to 90% being done by institutions today. Any one old enough will know that the titans of today are far bigger, far more complex, have more access to data and work far more quickly than those of yesteryear. Consider these changes over the last 50 years:
- Trading volume has increased spectacularly. On the NYSE alone trading has grown from around 2 million shares a day to over 5 billion shares a day. Other global exchanges have seen similar increases.
- The derivatives market, beloved of product providers, has grown into a gargantuan animal from nothing to now being greater in value than the total cash market and most of it institutional trading.
- The profession of Chartered Financial Analyst, pratically non exsistent in 1934 when Benjamin Graham penned his classic Security Analysis, now includes over 100,000, with twice as many candidates currently awaiting qualification.
- Algorithmic trading computer models and numerous quant trading models are increasingly influencing market behaviour in a dramatic fashion.
- Globalization and light regulation has led to the rise of hedge funds and sovereign wealth funds who have become a huge influence in global markets creating almost a shadow banking system.
- With almost instant access to unlimted data, brokers and large securities firms produce a massive volume of analysis and information which is distributed instantaniously via the internet to tens of thousands of money managers around the world, who make decisions with almost equal rapidity.
The catalyst for this change is the ‘technological revolution’. It has changed the way we think, speak, dress and behave as well as giving unparalleled access to data and information.
Too Big to Fail
The world’s capital markets are now dominated by large, so-called institutional players: banks, mutual funds, life assurance and insurance companies, pension funds, hedge funds and sovereign wealth funds. Together with central banks, these players drive and influence the system. Price discovery is becoming difficult: a play on words that is almost an oxymoron. Data science, which is now in the academic mainstream, replete with its own PhDs, competes with complex mathematics to attract ‘hot money’. Central banks, injecting trillions of USDs into the global economy, distort supply and demand and economic cycles. Armed with huge war chests of cash as a result of huge profits, these juggernauts of the financial system are able to hire the brightest people with highest IQs and attract the crème de la crème. Investment banks like Goldman Sachs are an example of this. These groups of very bright, hardworking people with access to the very latest technology and unlimited data set a standard which is hard to compete against. They not only contribute to market pricing by buying and selling to each other but collectively become the market. But what is their motivation? Is it to their customer, the buyer of their products or user of their services, or is it to their shareholders? The question points to a conflict of interests.
The crash of 2008 graphically exposed the fact that most, but not all financial institutions are owned by large multinational conglomerates. The demise of the giant insurance company AIG is one example. It received taxpayer money to cover its debt, as a tourniquet to stem the collapse of the trading system that was indirectly caused by the inability of counterparties to deliver on contractual commitments. Although it was insolvent, it was not allowed to fail. As with the hedge fund, LTCM, which following its collapse in 1998 was bail out by 14 financial institutions to the tune of $ 3.6 Bn. Supervised by the Fedreal Reserve Bank of America this set the precedent. Others that followed, were also considered too big to be allowed to fail.
The main responsibility of directors of a business is to use their best endeavours to increase profits. But at any cost? These are two conflicting interests: to grow capital for shareholders or to grow investment returns for those buying their products or services. A look at academic research makes the case for the failure of much active investment management to beat an appropriate market index over 5, 10, 25 and 50 years or to make a return on capital for shareholders over the same period.
A man cannot serve two masters
Over the last decades, the successful professional family firm has given rise to public conglomerates, and the professional family firm is now a dying breed nearing extinction. Unlike their present day successors, their first allegiance is a duty of fiduciary care to their customers. Their secondary duty is to make money. They have first a professional duty of care, and second the running of a business. With this practice, customers knew that their interests were placed above the financial self-interest of the firm. It built trust. It became a fiduciary requirement. Today this has been replaced with a culture in institutions and in the financial marketplace first to serve the interests of the shareholders of the often huge multinational corporations, and secondly to serve the customer. In effect, the order of the day is earnings, growth of the business, and increasing the bottom line profit. A duty of care has been replaced in boardrooms by a cynical attitude of profitability at the expense of the customer. These huge and complex businesses are managed, not by successful experienced investors, but by corporate managers with skills to improve bottom line growth. The emphasis is not to improve the investment returns for those buying their products and services but to improve the earnings of the business interests which they serve. The two are mutually exclusive.
Post the London Libor scandal, the ‘London whale’ and now the investigation of the London ‘Gold fix’ (in an unfortunate or prophetic use of the word ‘fix’), it is ironic that the motto of the London Stock exchange is ‘My word is my bond’. I am old enough to remember when this was as much a truism in buying and selling in the high street, as it was receiving credit. Sadly, it is not so today. The notion of keeping to a verbal commitment and putting the interests of someone else first is foreign in today’s financial marketplace. As in any walk of life, there are many fine individuals who are exceptions to this, but these are employees without authority, rowing against a relentless tide.
As a result of technological advances, the inexorable drive to increase market share and increase profits spawns a plethora of new financial products, each more fantastic and complicated than the last. Perhaps they are interesting for some, but do we need them? With the exception of some bespoke products, they are not produced because the customer needs them, but as a vehicle to attract more money for the producer. It is asset gathering by another name. The customers need to be convinced that they need the product. To do this an army of salesmen and women is required, in order that the business model can not only survive but be extremely profitable. Again academic research shows that more often than not over time, investment committees that are responsible for very large capital sums fail to deliver on their investment target. They are proved to be poor judges of their investment management to tailor a product or strategy for them. Although most of the managers hired fail to beat a relevant market index over time, their fees and costs have already been paid and collected.
Sales course titles such as ‘Needs-Based Solutions’ are euphemisms for ‘How to convince someone that they have a need’, ‘Allowing the customer to buy’, ‘Techniques to achieve a sale’ or simply ‘Overcoming objections’. ‘How to secure a sale’ needs no further comment. Maintaining this sales army comes at a huge cost. This cost is borne, not by the shareholders or employees, but by the customers who purchase the goods and services. The cost, of course, is reflected in the headline performance of the investment product. Most mutual funds and investment products quote their investment returns without fees and costs.
When investing in the stock markets, the maths for what we may receive is really quite simple. We will receive what the market gives us, less the cost of participating, less tax. It is a zero sum game. All the players collectively are the market. For every one that wins, another must lose. To win, one must exploit the mistakes of the other. Today’s winner will be tomorrow’s loser. Because the cost to participate is considerable, it is an important component of the eventual performance. Putting a customer’s needs before our own and looking to build a relationship of trust often means seeking to keep costs as low as possible whilst receiving a reasonable and realistic remuneration. This is contrary to a business sales model that maximises profits through charging as much as possible. Justified by the cost of production of products, the cost of bringing the products to market and maintaining the vast sales army to convince the customer to buy. The counter argument that costs do not matter provided you have results is misguided, as it does not stand the test of academic scrutiny over the long term of 15 years and more. It seems counterintuitive, but looking at a simple table of compounding costs over time, this becomes clear.
We have witnessed a total disregard for a duty of good stewardship towards customers in a race to the bottom, putting the overall interests of the shareholder and business first. Coupled with a culture of rewarding failure and obtaining profit at any cost, we have witnessed an epidemic of fraud, scandal, questionable practices and dishonesty. Hardly a quarter goes by without another story of impropriety in the financial system, but seldom does the story merit the front page. ‘Man bites dog’ is no longer sensational, but commonplace.
When exercising a duty of fiduciary care, or trust, the customers’ requirements will always be put first. This will often mean not only going the extra mile, but being prepared to put the financial wellbeing of the customer before financial self-interest. Trust is built through deeds, not words; transparency in all dealings as an adverb, not an adjective; to treat others as we would wish to be treated ourselves; to be content with serving just one master. As with many things in life, it sounds so obvious and simple but in practice it is harder to do.
Taking the sales model out of the investment process puts the odds for a successful outcome in favour of the investor. Wisdom and prudence would ask of an investment advisor, producer or service provider: Which master are you serving? If you are a buyer of investment products or services as an individual or organization, whose interest is your provider serving? Have you bothered to investigate, and are you sure?
Jeremy Blatch TEP
Greenwich Associates Research
Don’t Count on It! by John C. Bogle
Winning the Loser’s Game by Charles D. Ellis
Security Analysis by Benjamin Graham