Though the principles of the banking trade may appear somewhat abstruse, the practice is capable of being reduced to strict rules. To depart upon any occasion from these rules, in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous, and frequently fatal to the banking company which attempts it.
ADAM SMITH, The Wealth of Nations, 1776
The year is 1995, and I am sitting at a massive octagonal table on the top floor of the large modern building that dominates the town of Halifax, West Yorkshire. The location is the boardroom of the Halifax Building Society. The proposal before the board was that Group Treasury, which managed the cash held by the Society from day to day, should no longer simply serve the needs of the business—taking deposits from savers and making loans to home-buyers. Treasury should take active positions in money markets, and become another profit centre. The plan was to trade debt instruments: usually either government stock or the liabilities of other financial institutions. The Society would take full advantage of Lew Ranieri’s revolution in the promotion of markets in fixed-interest securities. Nick Carraway had given way to Sherman McCoy, and the Halifax was lusting after its share of the action.
In the years that followed, many financial institutions continued (and still continue) to report profits from their trading activities. The mainspring of investment banking profits in recent years has been trading in fixed-income, currency and commodities (FICC). But the aggregate value of debt securities and currencies is fixed, and although commodity prices fluctuate, the long-run trend has been downward. Individual businesses and traders can make profits at the expense of each other, but this cannot be true for the activity taken as a whole.
That raised a question in my mind. Where would Treasury profits come from? Who would lose the money we expected to make? The reaction to my question was not polite. I was sent for re-education so that the traders could resolve my confusion. I did not find this experience enlightening. We would make money, I was told, because our traders were smarter. But the people I met did not seem particularly smart. And not everyone could be smarter than everyone else.
Still, some people plainly are smarter, and in a variety of ways. There are people who are good at understanding the fundamental value of securities: traders who are adept at predicting the changing moods and mindsets of other traders; individuals who are skilled at analysing the massive volumes of data generated by securities markets. These three broad styles of financial intermediation may be respectively described as investment, trading and analytics, and the groups of people who engage in them as investors, traders and quants. Stock markets provide the clearest, and perhaps most important, illustration of these approaches and the changes in the nature of intermediation in the era of financialisation.
Warren Buffett is the most successful investor in history, having parlayed modest beginnings into a fortune that has made him one of the richest men in the world. Berkshire Hathaway is now one of the largest US companies. Berkshire Hathaway owns the world’s largest re-insurance company, GEICO, businesses as diverse as Netjets (which charters executive jets), Equitas (the insurance company created to handle the fall-out from the Lloyd’s débâcle) and See’s Candies. Berkshire also holds substantial stakes in major quoted companies, such as Coca-Cola and Procter & Gamble. Buffett is distinguished by the extreme simplicity of his methods, his disdain for the conventional wisdom of the finance industry and his refusal to invest in anything he finds difficult to understand. Buffett describes his investment philosophy in folksy, annual letters to Berkshire Hathaway shareholders, written in conjunction with Carol Loomis, a doyen of business journalism. He has said his favorite holding period is for ever.
There are some comparable European businesses. The Swedish company Investor AB, the investment vehicle of the Wallenberg family, owns a similarly wide range of businesses, including substantial stakes in most global companies with Swedish roots (such as AstraZeneca, Ericsson and ABB) and, somewhat improbably, the NASDAQ exchange. Buffett’s success has not provoked significant imitation, however, in Britain or the USA.
The most successful of those investors who stress fundamental value are those who, like Buffett, have a deep knowledge of and engagement with the companies they choose. Stock-pickers have more modest aspirations, but nevertheless base their decisions on thoughtful assessments of the prospects of companies. Bill Miller and Peter Lynch acquired stellar reputations with sustained out-performance of market indexes through successful stock-picking. But both have retired (and Buffett himself is now over eighty). The era of the superstar stock-picker seems to be at an end, although a few individuals—such as Dennis Lynch— maintain strong reputations.
But there are few instances of sustained long-term success in stock-picking, and the number of fund managers is so large that a few will seem to demonstrate sustained success through chance alone. The reputations even of Peter Lynch and Bill Miller had faded somewhat by the time they left the investment scene. Analysis of the performance of mutual funds—which offer small investors diversified stock portfolios— show not only that they on average under-perform the market but that the degree of persistence of out-performance is very low.
Almost alone among the legendary hedge-fund managers who emphasize economic fundamentals in their judgements, George Soros has been persistently successful. Julian Robertson and Victor Niederhoffer, who had made billions for their clients and themselves in the 1990s, were eventually burned by substantial losses. John Paulson, whose famous ‘big short’ earned billions by anticipating the collapse of sub-prime mortgages in the global financial crisis, subsequently made large losing wagers on the price of gold.
Buffett has said that he buys stocks on the basis that he would be happy if the stock market shut down for ten years. Buffett himself can get away with it because his track record is so lengthy and impressive, but his successors cannot. While the fundamental value of a security determines the returns available from it in the long run, over shorter periods the returns depend on the assessments of other traders.
As the value horizon—the time taken for an event to be accurately reflected in the value of a business—has lengthened, with business becoming more complex, the performance horizon—the period of time over which the performance of asset managers is measured—has shortened. Hence the rise of the trader chronicled earlier: the smartness that is rewarded is the smartness of the person who is adept at predicting the changing moods and mindsets of other traders. Simultaneously, the distinction between agent and trader, between broker and dealer, was eroded and effectively eliminated. The new ‘smartness’ was located, not in the service of investors through the medium of asset management firms such as Fidelity (which had employed Peter Lynch) or Legg Mason (Bill Miller), but for the benefit the investment banks which had come to dominate market-making.
The shift fed into the behavior of companies. The market impact of imminent announcements mattered to traders; the competitive strengths and weaknesses of the business mattered little. Companies became locked into the activity of quarterly earnings guidance and earnings management, in which business was directed towards ‘meeting the numbers’: achieving results slightly ahead of market expectations. This cycle of guidance and management became more and more divorced from the underlying realities of the business.
Investors look at economic fundamentals; traders look at each other; ‘quants’ look at the data. Dealing on the basis of historic price series was once described as technical analysis, or chartism (and there are chartists still). These savants identify visual patterns in charts of price data, often favoring them with arresting names such as ‘head and shoulders’ or ‘double bottoms’. This is pseudo-scientific bunk, the financial equivalent of astrology. But more sophisticated quantitative methods have since proved profitable for some since the 1970s’ creation of derivative markets and the related mathematics.
Profitable opportunities may be provided by arbitrage: observing regularities in the price movement of related securities. Rather obviously, for example, the price of a derivative based on a stock will follow the price of the stock itself. Arbitrage involves taking matched positions— buying one security, selling another, when the price differential moves outside its normal range. Such arbitrage strategies were widely used by Long-Term Capital Management, the hedge fund that collapsed spectacularly in 1998. LTCM, best known for its association with the two Nobel Prize-winning economists Robert Merton and Myron Scholes, was founded by John Meriwether, who had headed the trading operations of Salomon Bros in the 1980s (those described by Michael Lewis in his book Liar’s Poker) which pioneered the explosive growth of FICC trading. The fund was largely staffed by his former colleagues, and insiders often described it as ‘Salomon North’. In the end, the LTCM trades were settled profitably by the investment banks which had taken them over: a telling illustration of Keynes’ (possibly apocryphal) dictum that ‘markets can remain irrational for longer than you can stay solvent’.
More recently, the mathematical analysis of trading patterns has enabled some algorithmic traders to make returns from minute movements in the prices of securities. The most persistently successful of these quantitative-oriented funds are the Renaissance Technologies funds of Jim Simons, which have over more than two decades earned extraordinary returns for investors while charging equally extraordinary levels of fee. Simons was a distinguished mathematician before taking to finance.
The early and successful practitioners of this quantitative style could use sophisticated methods to identify recurrent patterns in data, and arbitrage anomalies in the manner of LTCM. High-frequency trading uses computers to make, or offer to make, small trades at very frequent intervals. It may be illegal to trade on the basis of actual knowledge of the buying or selling intentions of other investors, but it is legal if you do not know but guess, or if your computer can deduce their intentions from their responses to the trading offers it makes. All the dealings of these funds are undertaken by computers, and the skills of the traders, which are considerable—the typical employee will have a maths or physics PhD—lie in programming the algorithms that the computers employ.
Analysis of price data can, by itself, yield no information about the underlying properties of the securities—foreign currencies, commodities, companies—which are traded or on whose values the derivative products that are traded are based. Although speeding the flow of information from Chicago to New York by a millisecond may be privately profitable, so long as this access can be sold selectively to enable some traders to profit from their exclusive access, the world as a whole derives no benefit from this infinitesimal increase in the speed of dissemination of information. Since FICC trading, taken as a whole, cannot be a profitable activity, the profits of the traders who are recipients of the information are necessarily earned at the expense of other market users: in effect, these profits represent a tax that other users can best avoid by keeping trading to minimal levels. So what was to be the source of these Treasury profits?
’We must have a bit of a fight, but I don’t care about going on long’, said Tweedledum.
LEWIS CARROLL, Through the Looking Glass, 1871
There are traders who are smart, though not many: Buffett, Soros, and Simons are people of outstanding intelligence who have used that intelligence to earn billions in securities markets. Many others have simply been lucky. The extraordinary sums that the most successful investors have earned have encouraged many others of more modest talents to enter the field. This gives rise to a paradox. The profits of the smart are the losses of the less smart. But the existence of some smart people in the financial sector may increase profits for everyone—whether they are smart or not.
Here’s why. When you buy some products, you want the best. As the surgeon picks up his scalpel, you may regret having searched for someone who will do the job more cheaply. If you plan to sell your house, it is worth paying extra for a negotiator who will get you a better price. If you risk a long term of imprisonment, you want the best attorney.
You can’t be sure you will survive the operation, get the best price for your house or stay out of prison by paying more, but you suspect that you have a better chance. For many such products, haggling over price appears not only unseemly but unwise, implying that the purchaser does not really want a top-quality job. In activities like these, a business strategy that emphasizes cheapness is not likely to be successful. If some people have skills that are worth paying for, but it is difficult to determine who they are, everyone will be able to charge more. This mechanism is part of the explanation of high profits—and high remuneration—in the finance sector.
Price competition is also often ineffectual when the item in question represents only a small part of the overall cost of the transaction. People will drive to another store to save a few pounds on their grocery bill, but not to save the same amount on their furniture. When you think it through, this makes little sense: but it is certainly the way many of us feel. Yet small percentages of very large amounts can be large amounts. You might not think a 1 per cent annual fund management charge is very high—and by current standards it is not—but 1 per cent of $100,000 is $1,000. On a $50 billion takeover bid, a fee equivalent to one quarter of 1 per cent seems insignificant but amounts to $125 million. Fees of this level would not be unusual: chief executives want the best, and generally what they are spending is other people’s money.
Yet perhaps the most surprising source of high fees for corporate advisory work is in the new issue market, since the percentages are not small and the money often comes from the pockets of founders and early shareholders. In the USA, 7 per cent is a standard fee for an IPO (initial public offering), and rarely discounted (European fees are typically lower and more variable). But no evidence of a cartel has been produced, and probably none exists—there is simply a strong perception of collective interest in maintaining the status quo.
Regulation is often the enemy of competition. Where regulation prescribes the conduct of business in considerable detail, it is inevitable that all firms will behave similarly: a particular conception of ‘best practice’ will be shared between regulators and regulatees. Incumbent firms with close links to agencies may use regulation to resist innovation and raise barriers to new entrants. Moreover, there are economies of scale in managing regulation. Established firms employ professional regulatory staff: a large bank may have tens of thousands (J.P. Morgan reported hiring an additional 11,000 compliance and regulation staff in 2013 alone), and smaller firms can access this expertise only to a limited extent by hiring consultants. Similar economies of scale apply to lobbying regulators and legislators.
But simple consumer reluctance to switch providers is a major obstacle to competition in retail financial services. It is a well-known joke in the industry that customers change their spouses more often than their banks. They all seem the same: why transfer your loyalty from Tweedledee to Tweedledum? This inertia on the part of retail buyers is common across all financial products. Credit cards have consistently been one of the most profitable retail banking products. Bank of America, ‘first mover’ in this industry, continues to hold a strong position, despite aggressive attempts by entrants to solicit new business. Many people just do not like buying financial services, and minimise the time and effort they devote to their purchase as a result.
The days when retail customers of financial services were rewarded for their loyalty are long gone. The replacement of a relationship-based culture by a transaction-based one means that the best deal is almost always obtained by shopping around aggressively rather than by building trust. Customer perceptions have lagged behind this harsh reality.
But the profits of customer inertia and price insensitivity were not enough—and certainly not enough to seem to justify high levels of remuneration for senior employees. The aim of most financial companies has been to increase profits by establishing ‘the Edge’ in wholesale financial markets. This was the aim of the discussion around that Halifax board table.
Excerpted from "Other People's Money: The Real Business of Finance" by John Kay. Published by PublicAffairs. Copyright 2015 by John Kay. Reprinted with permission of the publisher. All rights reserved.