Financial Innovation Is Depressing
DealBook has a special section today on ideas and innovation on Wall Street and let's just say it will not inspire too many idealistic Stanford undergrads to stop work on their iPhone apps and take that financial-engineering job at Wells Fargo. It's all pretty sad stuff.
My favorite article in the section is of course the one on innovation in fraud, which it turns out is genuinely fertile ground for creativity, though tell that to the Stanford kids. To be fair, though, there is also innovation in catching fraud, specifically a Commodity Futures Trading Commission Rule, adopted in 2011, that outlaws market manipulation. So! Nice work there CFTC.
But then there is this subtle article about index funds. Index funds: brilliant, world-changing financial innovation, totally, no doubt, top financial innovation of 1976.1 What have they been up to lately?
But several companies say they already have created a better mousetrap -- broad index funds that can beat the overall market, rather than merely matching it, even including fees.
“We don’t think you need to settle for average returns,” said Chris Brightman, the head of investment management for Research Affiliates, which says it has constructed so-called fundamental indexes that will deliver superior returns.
Sure, maybe, but the improved-index fund is really a marketing coup more than anything else. Like, here:
I think the improved index fund gets all the advantages of each category, with none of the disadvantages.2 Active management means running screens to pick stocks, researching the ones selected by the screens, picking the best ones, investing in them, and charging a healthy fee for all that work. Passive management means buying all the stocks and charging a couple of basis points to cover your electric bill.
The improved index means running screens to pick stocks, picking whatever the screens say, and then charging I'll guess an intermediate fee while saying both "see we're an index fund, everybody loves index funds," and "We don't think you need to settle for average returns."3 Magic!
Or there is the one on innovation in getting people to invest in private equity funds under the new, more liberal JOBS Act rules.4 This one focuses on online databases matching private equity funds and accredited investors and actually sounds likable enough. There is some appeal to eliciting investments based on track records and data rather than random personal connections or dodgy consultants or, um, one of the database guys says, "We can’t replicate the 70 people working the phones for you," which seems like a self-evidently bad way of selling private equity investments to individuals. I mean, this has to be an improvement over that.
But note that here too the innovation is essentially one of marketing, not of better allocating capital. Coincidentally, today there's a new NBER paper finding that "Conventional interpretations of PE performance measures appear optimistic" and that private equity investors "may just break even, net of management fees, carry, risk, and costs of illiquidity."5 Smaller investors can find private equity funds more efficiently just as bigger investors start to question the model.
Finally, there is the one about how new leverage rules are reducing banks' return on equity and thus forcing them to innovate by firing everyone and shutting down branches, about which the less said the better.
This is all sort of a bummer. There are basically three categories of financial innovation here:6
- Cut costs by providing less and worse service.
- Better marketing of old, possibly unpleasant things.
- Clever new fraud.
That is the stereotype is it not? That the financial services industry is about finding legal ways to deceive people into paying too much for stuff they don't need, or failing that finding illegal ways to do that, or failing that just firing everyone and giving up.
There are good kinds of financial innovation, of course; they go something like:7
- Find new ways to lower the cost of capital for individuals and businesses.
- Shift risks from those who don't want it to those who do.
Etc. Are there any such innovations these days? Sure, maybe, if you look hard enough. Blackstone is using rental securitizations to lower the costs of renting houses to people.8 Peer-to-peer lending might lower businesses' cost of capital. Fantex is using tracking stock to shift a portion of NFL players' large and undiversified career risk to gamblers who want exactly that risk.
But people hate all those things. Rent securitization is 2007 all over again. Peer-to-peer financing is ripe for fraud. Fantex is exploitative and badly structured. One result of the financial crisis and its aftermath is that people deeply, deeply distrust financial innovation. The wounds of mortgage-backed securities -- which were supposed to lower the cost of credit and shift risk from lenders who wanted to hedge onto investors who wanted the risk -- are too fresh for those goals to sound compelling. If you say you've found a new way to lower financing costs or to shift risks in optimal ways, no one will believe you. So you might as well make pretty modest claims for pretty modest innovations -- in cost-cutting, in marketing or, of course, in simple fraud.
1 Unless that was also the year the ATM was invented? Which seems unlikely. Wikipedia puts it in around the late 1960s, though it was preceded by the 1961 "Bankograph," which is probably a better name than "ATM" and certainly a better name than "ATM machine." Anyway that's like the one financial innovation that everyone agrees was good so it would probably win any head-to-head contests.
3 Provably false in the aggregate, but always possible for you. You don't need to settle for average returns, you are a special snowflake, buy our snowflake index fund, etc.
Incidentally, I am sort of fond of the notion of enhanced indexing and I'm being overly mean here. But I'm with the Vanguard folks cited by DealBook who are like, "well this is not really indexing is it?"
"In a move to take advantage of the SEC’s ratification of the JOBS Act, $100 million hedge fund investor Topturn Capital has aligned itself with professional Australian surfer Joe Curren. The company believes this will set a new precedent in hedge fund marketing. 'We feel that how we represent our company will change the industry norm,' Greg Stewart, Co-Founder and Chief Investment Officer of Top Turn Capital, said. 'People look at numbers all day everyday. We just brought in The Trojan Horse for our investment strategy by introducing a surfer into the equation.'”
Um, Greg, you know how the Trojan horse worked, right? It's like, you get a thing that looks all nice and friendly, and you hide your guys in it, and then you pop out and kill everyone? Or, wait, is that in fact why you introduced a surfer into the equation? Okay, carry on, good luck killing everyone.
5 Ehhh it's a largely model-based paper, not a real measurement of actual private equity performance.
6 Also in the innovations issue there's the Twitter mining thing we talked about this morning, which is a genuine-ish innovation-ish, ish, though if it was like "we're going to monitor farmers' fertilizer orders to help predict soybean prices" or some other "use computer to measure signal" thing we wouldn't be reading about it. Journalists are into Twitter is what I'm saying here.
7 AND THERE IS MY FAVORITE OF THEM ALL: "Accomplish thing that is economically equivalent to another thing that has been banned or rendered inefficient by regulation." We could talk about that all day, but some other day.
8 Or "to increase Blackstone's profits," those things are hard to distinguish from each other, though efficient markets etc. etc. etc.