The Value of Everything (UK)

by Mariana Mazzucato

  Credit default swaps (CDSs) are another example. Originally an insurance against a borrower defaulting on their loan, CDSs have largely become a way to bet on someone else being unable to repay their debts. CDSs may have their uses for people whose own solvency might depend on the debtor’s ability to repay. But their speculative use was literally stripped bare in the case of ‘naked’ CDSs, which played a major role in promoting sovereign and corporate debt defaults on both sides of the Atlantic. Naked CDSs are so called when the buyer of a swap has no vested interest in the credit-taking party being able to repay; in fact, the buyer, in order to collect his or her winnings, actively wants the debtor to default. It’s like taking out fire insurance on a neighbour’s house and hoping it will burn down. Far from seeking to keep the borrower’s (and the whole system’s) risks down, the swap buyer has every incentive to help the fire break out.

  But even if creditors only ever bought CDSs as an insurance policy, they are still inherently dangerous because of systemic risk – where default risk is no longer confined to a few borrowers and spreads to all. At times of crisis, defaults become highly correlated. One failure to repay triggers others. Banks or insurers who write CDSs end up underwriting this systemic risk, as they found to their own – and countless others’ – enormous cost in 2007–8. By 2010, due to the cost of bailing out banks and the economic recessions that followed their cessation of business lending, a number of European countries were experiencing sovereign debt crises. They were struggling to service their public debts, and in order to do so severely cut provision of public goods and services. The same banks that had benefited from the bailout now profited from governments’ plight, earning some 20 per cent of their entire derivative revenues from such naked CDSs.

  Financial intermediation – the cost of financial services – is a form of value extraction, the scale of which lies in the relationship between what finance charges and what risks it actually runs. Charges are called the cost of financial intermediation. But as we have seen, while finance has grown and risks have not appreciably changed, the cost of financial intermediation has barely fallen, apart from some web-based services that remain peripheral to global financial flows. In other words, the financial sector has not become more productive. Another way to grasp this simple fact is to measure the amount of fees charged by institutional investors and compare them with the performance of the funds they manage. The ratio between the two can be interpreted as a sort of degree of value extraction: the higher the fee, the lower is the gain for the investor and the greater the profit for the manager. So the ways in which manufacturers and non-financial service firms have used their size to hold down costs and prices do not seem to apply to finance. An excellent study on this topic concludes: ‘The finance industry of 1900 was just as able as the finance industry of 2000 to produce bonds and stocks, and it was certainly doing it more cheaply.’37

  Let’s now take some of the main parts of the fund management business, a huge financial intermediation machine, and look in more detail at fees and risks.

  Millions of savers invest in funds – usually mutual funds or unit trusts – either directly themselves or more often indirectly, for example through pensions. The objective of any fund manager is to produce a rate of return for the funds he or she oversees. The benchmark for that return will be the relevant markets in which that fund manager is investing, be it the US stock market, the European bond market, Australian mining companies and so on. Managing your fund to outperform the average market return (or the benchmark) is called ‘active management’, or, more pointedly, ‘picking winners’. Succeeding in doing better than the benchmark is said to be achieving ‘alpha’ (alpha of 1 per cent means that the return on the investment over a selected period is 1 per cent better than the market during that same period). The alternative basic investment management strategy is called ‘passive’. A passive fund is usually an ‘index’ or ‘tracker’ fund, where the manager simply buys shares in proportion to a stock market index and tracks that benchmark.

  But performance must be balanced with fees. Consider investing long-term, say over the forty-year working life of a given employee. One of the leading figures in the US fund management industry is John Bogle. He founded Vanguard, a very large index investment group (not an active investor) which charges low fees. Bogle has estimated an all-in cost for actively managed funds of 2.27 per cent of the funds’ value. The amounts may not seem excessive. But Bogle never tires of saying to fund investors: ‘Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns.’38 In fact, if you assume Bogle’s estimate of fund management costs and also assume an annual return of 7 per cent, the total return to a saver over forty years will be 65 per cent higher without the charges. In hard cash, the difference could mean retiring with $100,000 or $165,000.39 It’s a good deal for the fund manager; rather less so for the investor.

  Let’s, however, concede for a moment that there is a role for active management and the associated fees. Let’s also allow for the increase in the volume of assets under management and the application of IT to assess investments, manage them and communicate with clients, which ought to give fund management benefits of scale and efficiency. What should we expect the size of those fees to be? In a presentation to the Asset Management Unit of the Securities and Exchange Commission, the US regulator, Bogle presented the following statistics:

  Figure 19. US mutual fund assets and charges 1951 and 2015

  The striking and perhaps surprising conclusion is that over more than sixty years, expense ratios, even among the same firms, have not gone down but have gone up – and significantly. Why has this happened?

  Fund managers deserve much of the blame. First, fund management’s strategy of divide and conquer is part of the explanation. In the interest of diversification and providing investors with plenty of choice in investment strategies, fund managers have multiplied the number of funds they manage. They have also handed control of funds to individual portfolio managers who take a more short-term view of returns than investment committees of, say, a whole fund management group, which on the whole takes a broader view. The result has been much more aggressive investing and a significant increase in asset turnover as managers buy and sell stocks to try to boost returns. According to Bogle, portfolio turnover rose from 30 per cent in the 1950s and 1960s to 140 per cent in the last decades.40 Another measure of asset management quality is volatility: the degree of uncertainty or risk about the size of fluctuations in a share’s value. Just as turnover has risen, so the volatility of funds has increased significantly from 0.84 to 1.11 over the same period.

  Second, there are transaction costs. Greater turnover – buying and selling more shares – keeps fees higher than they might have been, adding to transaction costs without adding to investors’ capital gains given the zero-sum nature of the market. Crucially for the investor, additional fees reduce returns by increasing the cost of managing money. While transaction costs for each trade have fallen over the last thirty years, the frequency of trading has increased exponentially in recent years. Thus, the total amount of fees has risen as well. As Bogle notes:

  When I entered this business in 1951, right out of college, annual turnover of U.S. stocks was about 15 per cent. Over the next 15 years, turnover averaged about 35 per cent. By the late 1990s, it had gradually increased to the 100 per cent range, and hit 150 per cent in 2005. In 2008, stock turnover soared to the remarkable level of 280 per cent, declining modestly to 250 per cent in 2011. Think for a moment about the numbers that create these rates. When I came into this field 60 years ago, stock-trading volumes averaged about 2 million shares per day. In recent years, we have traded about 8.5 billion shares of stock daily – 4,250 times as many. Annualized, the total comes to more than 2 trillion shares – in dollar terms, I estimate the trading to be worth some $33 trillion. That figure, in turn, is 220 per cent of the $15 trillion market capitalisation of U.S. stocks.41

  Moreover, this mas
sive trading is often between fund managers, which makes it truly a zero-sum game within the industry. The idea of a financial transaction tax (related to the Tobin Tax, named after the Nobel Prize-winning economist James Tobin, an early advocate) is to reduce this ‘churn’ and make investors hold their stocks for longer, by raising the cost of each sale. It satisfies the conditions for an efficient tax in deterring a practice which imposes deadweight costs – the main obstacle to its introduction being that all large exchanges would have to impose it, to stop trade migrating to those that choose not to.

  Hedge funds are in many ways a response to demands from the increasing number of HNWIs for superior returns on their portfolios. As more active share traders, hedge fund managers tend to pride themselves on their ability to pick stocks on the basis of proprietary information. This information may be obtained legally, for example by detailed research by an in-house team, although it might also be obtained in some unlawful way. Superior information should lead to superior returns, but it is also costly. To the extent that superior returns are obtained, the cost may be justified. But we should remember that in the end it is a game that balances winners and losers and has little social value: the gains or above-average returns that some investors enjoy will be offset by losses or below-average returns others suffer.

  While some hedge funds have certainly been very successful, moreover, average returns have been less impressive. About 20 per cent of hedge funds fail each year. Even when returns have been high they often owe as much to idiosyncratic gambles as to investment genius. A spectacular example is the American John Paulson, who made $2 billion from betting in the run-up to the financial crisis that US house prices would crash. Since then, however, his firm Paulson and Co. has done less well and some investors have withdrawn their funds.

  The middling investment performance of hedge funds stands in sharp contrast to their glamorous image and – more importantly for investors – their high fees. For many years typical hedge fund fees have been called ‘2 and 20’ – a 2 per cent fee on the volume of assets managed and a hefty 20 per cent of realized and unrealized profits. Some hedge funds specialize in high-frequency trading – buying and selling assets very fast and in large volume, sometimes within fractions of a second, by the use of special computers – which raises costs for investors. All this adds up to a total yearly cost of 3 per cent.42

  This same ‘2 and 20’ model is also used in venture capital. Like hedge funds, VC claims special skill in picking profitable opportunities in young businesses and technologies. In practice, VC usually enters the fray after others, notably taxpayer-funded basic research, have taken the biggest risks and the technology is already proven.

  Private equity firms provide a case study of how fund managers increase their likelihood of making a profit. PE firms also charge annual management fees of the order of 2 per cent. Over the, say, ten-year lifetime of a fund, this fee represents a commitment of 20 per cent, leaving only 80 per cent which is actually free to earn a return. So limited partners, rather like investors in mutual funds or hedge funds, start out with an embedded cost to catch up on – which is hard to do. What’s more, as the New York Times revealed in 2015, some companies in which PE firms invest end up paying fees to the PE firms for years after they have been taken public again.43

  In addition to the management fees, PE funds have found many other ways to get paid in order to avoid relying on their portfolios’ actual performance. These include paying themselves fees (on top of fees paid to consultants, investment bankers, lawyers, accountants and the like) for any transactions undertaken (the acquisition itself, acquisitions of other companies, the sale of divisions and so on), paying themselves monitoring fees as part of their role on the boards of these companies, and other service fees. All in all, this results in a fixed component for them of about two-thirds of the general partners’ compensation.44

  The final element of the PE firm’s compensation is carried interest – the investment manager’s share of the profits of an investment above the amount the manager committed to the partnership. For many years now, market practice has been that carried interest is 20 per cent of the profits generated over and above an agreed hurdle rate – i.e. a return on an investment below which a company will not pursue an investment opportunity or project. This element of the compensation is specifically meant to motivate general partners to perform, and PE capital gains are taxed at a favourable rate. But in practice, fees are so high that carried interest amounts to only about a third of general partners’ compensation.

  PE firms also protect themselves by loading down the companies they acquire with debt, typically 60–80 per cent of the cost of an acquisition. Consider this: if an asset worth 100 is bought with 30 put in as equity by the investment manager and 70 from debt, the investment manager can make a 100 per cent return if the debt is paid off and the equity value goes up to 60. And yet PE firms hold on average only 2 per cent of the value of the funds they manage.

  What do PE investors get for their money? When PE firms present their results to investors, they usually highlight their internal rates of return – the rate of return on capital invested (technically, the discount rate which makes the net present value of all cash flows [positive and negative] from an investment equal to zero). One may well argue that all the charges and compensation could be justified if they resulted in outsized returns. And in fact, there are many studies that claim superior returns for PE firms compared to other investment vehicles. Figure 20, from one highly cited work, appears to show that in recent years PE has outperformed by 27 per cent (average and median for the 2000s). But that performance should be viewed over the ten-year lifetime of a fund, so it actually represents an outperformance of just 2.4 per cent per year.

  To be fair, this is still outperformance in absolute terms. But several factors effectively negate it. The performance has been achieved through highly indebted investments that are relatively illiquid (hard to sell). In fact, limited partners often require extra outperformance to take account of this additional risk – a premium of the order of 3 per cent – in recognition that PE’s superior performance is otherwise offset by its increased risk-taking. Furthermore, the basis for comparison in the table below, the Standard & Poor’s (S&P) 500 index, is less relevant than an index of small- and medium-sized companies in the US such as the Russell 2000 or 3000. Relative to these indices, the outperformance is significantly lower, about 1–1.5 per cent. In short, once the returns reported by private equity are adjusted for risk and compared to appropriate benchmarks, it becomes much harder to justify their high charges.

  Figure 20. Buyout funds performance vs S&P 50045

  The fund management industry naturally argues that the returns it can make – seeking ‘alpha’ – for clients justify the fees it charges. In an influential article,46 Joanne Hill, a Goldman Sachs partner, identifies conditions in which trying to achieve alpha need not be a zero-sum game – conveniently showing that investment banks’ proprietary trading might have some social and economic value. But these conditions include an assumption that the market is divided into traders with short- or long-term horizons, who are pursuing alpha over different time periods and measuring it against different benchmarks. Without this artificial separation, alpha is indeed zero-sum – and turns into a negative-sum game once active managers deduct the extra fees they must charge for selecting stocks rather than just buying them in proportion to the relevant index.

  CONCLUSION

  Asset management has grown into one of modern capitalism’s defining characteristics. If nothing else, its sheer scale and central importance to the financial security of many millions of men and women have given financial management its influence. But at least as significant is that many of its activities extract value rather than create it. Financial markets merely distribute income generated by activity elsewhere and do not add to that income. Chasing alpha – selecting and over- or under-weighting stocks so as to outperform an index – is essentially a
game that will produce as many losers as winners. This is why actively managed funds frequently fail to beat the performance of passive funds. Much of fund management is a massive exercise in rent-seeking of a sort that would have caused raised eyebrows among the classical economists.

  Reform is not impossible. Financial regulation can be used to reward long-termism and also help to direct finance towards the real economy, as opposed to feeding on itself. Indeed, the point of the financial transaction tax – which has yet to be implemented – is precisely to reward long-term investments over quick millisecond trades.

  Furthermore, the fees being earned by asset managers should reflect real value creation, not the ‘buy, strip and flip’ strategy common in PE, or the ‘2 and 20’ fee model common to PE, VC and hedge funds. Were the fees more accurately to reflect risks run (or not run – such as the large taxpayer-funded investments that often precede the entrance of VCs), the percentage of realized and unrealized profits retained would be lower than the customary 20 per cent. It is not that financial actors should not make money, or that they do not create value; but that the collective effort involved in the value-creation mechanism should be reflected in a more equitable share of the rewards. This is tied to Keynes’s notion of ‘socialization of investment’. He argued that the economy could grow and be better stabilized, and hence guarantee full employment, if the quantity and quality of public investment was increased. By this he meant that funding investment in infrastructure and innovation (capital development) ought to be done by public utilities, public banks or co-operatives which direct public funds towards medium- and long-term growth rather than short-term returns.