invited editorial comment

The Journal of Portfolio Management 2016.42.3:1-7. Downloaded from www.iijournals.com by Robert Jones on 04/29/16. It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

INVITED EDITORIAL COMMENT

Defending the Wall ROBERT C. JONES

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o, this is not the long-awaited sixth book in the Game of Thrones series, but rather a vigorous defense of our embattled industry. Wall Street got its name from the wall that was built there in the 17th century to protect the early settlers from local inhabitants. Nearly 400 years later, “Wall Street” has become vernacular for the entire market-based global financial system—and it too is now under attack from local inhabitants. Main Street does not trust Wall Street: Bankers now rank the same as or below politicians and lawyers in the public’s esteem. For those of us who work on Wall Street in this broader sense, it’s time to correct public misconceptions about our industry. In this article, I provide some responses to adversaries, “friends,” associates, and others who may accost us with the following assertions. You people just push money around all day and don’t really produce anything of value for society. The primary function of capital markets is to allocate capital to promising opportunities and businesses, and to withdraw capital from less promising ones; markets can either nurture or starve a business. By picking winners and losers, capital markets fundamentally shape how our economy grows and develops—from loans to small family businesses to mega IPOs for Facebook and Alibaba. Without smoothly functioning capital markets, there would be no electricity, no cars, no iPhone, no Google, no Internet—and, indeed, no modern developed world. Open capital markets are also largely responsible for the “Chinese miracle,” which isn’t really a miracle at all because all developed economies have open capital markets. There are no exceptions. Give me a break. Is Wall Street taking credit for the Internet? Government researchers at DARPA (Defense Advanced Research Projects Agency) invented the Internet, not Wall Street.

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Wall Street doesn’t generate business ideas; it finances them. Ideas come from companies, universities, hospitals, government research labs, dinner conversations, LSD trips, and who knows where else. But a great idea without capital is just an idea; a great idea with capital is a business. Human capital (the talent and energy of entrepreneurs) definitely drives the bus, but financial capital provides the fuel to build factories, hire employees, and grow. And without fuel, the bus goes nowhere—no matter who’s driving. So yes, DARPA birthed the Internet, but entrepreneurs and free capital markets made it f ly. OK, I agree that picking winners and losers is a critical economic function. In fact, it’s too important to be left to a bunch of screaming traders, heartless billionaires, and short-term speculators. Markets allocate capital based on the combined views and information of investors worldwide, not on the priorities or preferences of any individual or group. As such, they are inherently democratic. You may think that the market should direct more resources to “good” businesses such as solar energy, and less to “evil” ones such as fossil fuels—but that’s your opinion. Some investors may believe that solar energy has too little capacity to be a significant long-term energy solution. They might prefer to pursue nuclear, geo-thermal, tidal, wind, or other options. Other investors may believe that low-cost fossil fuels will remain a critical energy source in the developing world. No one knows which views or technologies will prevail. But markets do a remarkable job of accumulating the odds and adjusting them for new data. So feel free to invest in solar energy. If you’re right and the consensus is wrong, markets will reward you handsomely; if you’re wrong, you’ll lose. If you accept the market consensus and invest passively in all these energy

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technologies, you’ll usually earn a fair return relative to risk. Finally, whatever you think of specific industries or businesses, free capital markets gave us the modern world and all its wonders. Conversely, when government elites allocate capital, we get Versailles, the Yugo, Solyndra, HealthCare.gov, and the ghost cities of China (and occasionally, real assets such as NASA and the interstate highway system). By “investors worldwide,” don’t you mean a bunch of rich people? Why should rich people be the ones to pick winners and losers? That’s pretty elitist if you ask me. Actually, the world’s largest capital pools belong to institutions such as pension funds, sovereign wealth funds, foundations, endowments, insurance companies, mutual funds, and banks. The primary beneficiaries of these pools are workers, retirees, students, the disadvantaged, taxpayers, depositors, and the general public—hardly an elite bunch. But regardless of who ultimately benefits from these capital pools, they are usually managed by professional investors (e.g., fund managers, bank trust departments, and registered investment advisors). The investment management industry is diverse and extremely competitive— sometimes with thousands of providers, any of which can be hired or fired at any time. Yes, investors who have been successful in the past will control more capital, but shouldn’t our best allocators have the most inf luence? In any case, professional investors aren’t going to allocate capital to businesses with little chance of consumer acceptance or commercial success. Consumers determine the ultimate success of any business. Markets just adjust the odds to ref lect new information so that all bets—bullish, bearish, or passive—are fair. Moreover, free capital markets are open to all investors; anyone with an opinion is free to trade. Normally, however, only informed investors will trade actively, which means market prices generally ref lect an “informed consensus.” This doesn’t mean they’re always right, but it does mean they’re awfully hard to beat. An informed consensus ref lects the “wisdom of (select) crowds,”1 which means it will usually be more correct, on average over time, than any individual forecast. This is basic information theory: The average of numerous informed estimates will usually contain more information and less noise than any of the underlying estimates. Numerous studies show that prediction markets usually outperform experts, and even actuarial models, when forecasting everything from sports scores to election results 2

INVITED EDITORIAL COMMENTS

and corporate earnings. Why? Because markets ref lect the combined wisdom of all these experts and models. So markets aren’t always right, but they are (usually) fair and efficient. How can you say that markets are fair and efficient? Have your forgotten about the Internet and housing bubbles? “Fair and efficient” means that markets quickly and accurately ref lect new information—not that they are always correct. But studies (and theory) have shown that the market consensus is more correct, on average over time, than any individual or group. Accordingly, market prices are the best available estimates of value. The fact that the vast majority of professional investors underperform the market is testimony to this form of market efficiency. Today’s global capital markets are the most fair, efficient, deep, and liquid in the history of the world. Investors anywhere can invest in just about anything at much lower costs than ever before. Good ideas seldom lack investors, and bad ideas (and firms) usually die young. Information is widely available and distributed. Trading is generally continuous and cheap. In everything from start-up capital to corporate control, from risk transference to daily trading— markets have never been more fair or efficient. Markets work best, however, when investors have diverse and diffuse information with uncorrelated biases. Bubbles can occur when investors develop correlated biases—for example, that housing prices only go up or that all Internet companies will succeed. With correlated biases, price discovery can sometimes go awry. But even in the case of these “bubbles,” I could make a convincing case that markets still got the direction right and brought cheap, plentiful capital to industries that generally deserved it (i.e., the Internet and housing). I can make an even stronger case that, despite the occasional bubble, markets still get it more right more often than anyone else—including the Fed, the U.S. Treasury, Warren Buffet, or the Financial Stability Oversight Council. Well, maybe markets are fair in this narrow, technical sense, but they’re still stacked against small investors. Actually, it is quite the opposite: Because markets are fair and efficient, small investors can buy index funds and outperform most of the pros in any given year, and up to 90% of them over a 10-year period. Can small investors earn excess returns by actively trading against hedge funds, high-frequency traders, mutual funds, and other professional investors—with their armies of analysts, numerous data sources, and ever-humming computers, constantly on the lookout for even the smallest opportunity? No, of course not. But because of these hyperSPRING 2016


vigilant sophisticated investors, small investors can confidently buy and sell index funds knowing that they are getting a fair deal, and move on to more important things in their lives. Ok, but it’s hard to see how complex mortgage derivatives have anything to do with capital allocation. Derivatives are for risk shifting. Mortgages themselves are rather tame investments, with low risk and return expectations. This limits the buyer pool to conservative investors. Derivatives and mortgage tranches create higher risk and return securities that appeal to more aggressive investors. They also allow very conservative investors to off load unwanted risks. By expanding the investor pool, derivatives bring more capital into the housing sector, significantly lowering mortgage rates for all borrowers. The same is true for other derivatives: By allowing investors to adjust risk to suit their preferences, they bring more investors into our capital markets, which lowers the cost of capital, leading to improved productivity and faster economic growth. In hindsight, markets probably allocated too much capital to housing, but derivatives weren’t to blame: They simply made it easier for investors to express their views; the views themselves were the problem. Speaking of views, how can companies maintain a long-term focus when speculators only care about next quarter’s earnings? Wall Street is causing myopia in corporate boardrooms. How can this be good for the country? A company’s true value is never certain. Some investors are constantly making trades based on small scraps of information that may not yet be ref lected in prices. They are called speculators. In their activities, speculators uncover new information, bringing prices ever closer to fair value (i.e., ref lecting all information). This is called price discovery. Efficient price discovery means that all investors—from the smallest IRAs to the largest pension funds—can invest with confidence, knowing that prices are generally a fair ref lection of available information. Wall Street should be extremely proud that most active managers underperform the market; it means that markets have done a superb job of price discovery. When investors are confident that market prices are fair, they can focus on the long haul, knowing that their returns will be derived from the impact of long-term fundamentals on market prices. Ironically, then, shortterm speculators, with their myopic focus on quarterly earnings (and other value-revealing information), allow managers, investors, and markets to take a longer-term perspective. SPRING 2016

There is also little evidence that investors as a whole are shortsighted. In fact, the well-documented “value effect”—which exists in virtually all global markets— would suggest precisely the opposite. The value effect is an empirical anomaly in which growth stocks tend to underperform value stocks over time. A widely accepted explanation for this anomaly is that growth stocks are, on average, overpriced—and therefore that investors generally put too much weight on long-term prospects. In my experience, those who claim “markets are shortsighted” usually mean, “markets aren’t rewarding my favorite companies.” As to the myopic focus of corporate America, CEOs know (or should know) that their long-term compensation (and reputation) will depend on the company’s long-term success. Companies will always try to present quarterly earnings in the most favorable light, but the objective is to maintain investor confidence in the long-term plan. Just because a company focuses on expense management doesn’t mean it’s engaged in short-termism. To stay on the long-term track, managers need to show investors that they not only have the right vision, but also can execute it effectively. There have been far too many cases in which vision without execution meant death. Still, I can’t trust anyone on Wall Street. With all that money flying around, it has to attract a lot of shysters and crooks. Game theory studies human interactions (or “games”) in which people can either cheat or cooperate. Numerous studies and simulations have shown that in repeated games with reputational effects, equilibrium soon develops with about 10% cheaters: If there’s a larger percentage, the system breaks down; a smaller percentage, and the rewards to cheating become too great. Thus, a good rule of thumb is this: For any society, industry, or transaction, about 90% of people are cooperators—or at least are concerned with their reputations. This is true in politics, among lawyers, on Wall Street, and on Main Street, too. In fact, cheaters likely number far less than 10% at the pinnacles of Wall Street. Every day, billions of dollars trade across the globe based largely on trust. Since the system would break down without trust, market participants have developed numerous ways to uncover and punish cheaters. Even rumors of impropriety can ruin a career. Most cheaters are found out well before they can reach the top. Can anyone doubt that Eric Holder’s Justice Department would have prosecuted if they found even a hint of crime in the C-suites of Wall Street? Most of the illegal activity that did occur—and it did occur—was on the fringes of finance: for example, THE JOURNAL OF PORTFOLIO MANAGEMENT

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fraudsters pretending to be investment advisors, illegal Ponzi schemes, rogue traders, liar loans (and lenders), etc. On the main corridors of Wall Street, and for the vast majority of people in our industry, outright fraud is hard to hide and, hence, very rare. Well, maybe the big bosses can cover their butts with legal finery, but the culture of greed that Wall Street promotes is ruining our country. Just look at how banks took advantage of low-income borrowers during the housing bubble. No one needs to promote greed; it’s deeply ingrained in all of us. Wanting more than you need (aka greed) is, for better or worse, human nature. The simple fact is this: People who wanted more were more likely to survive and reproduce than people who were satisfied with what they had. Greed is in our genes. From an evolutionary perspective, we are all descendants of greedy ancestors. And you can’t have a bubble without widespread greed and miscalculation: the homeowners hoping to build instant equity by purchasing overpriced homes with little money down; the brokers hoping to earn commissions by lending them the money; and the ultimate investors buying high-risk tranches of mortgage-backed securities in hopes of earning outsized returns. All are on a quest for more, more, more. (In fact, from the borrower’s perspective, if home prices continue to rise, it’s a great investment; but if prices decline, they can put the home back to the bank. So who took advantage of whom here?) The Fed further inf lated the bubble by throwing easy money at the market for too long, while Congress and the regulatory state did their part by continuing to encourage subprime loans for low-income housing. There is plenty of blame to go around. That’s how bubbles work: they require pervasive forecasting errors. Well, maybe they never admitted guilt, but Wall Street firms paid ungodly sums to settle government charges. Clearly, they were morally at fault. Why would they pay so much if they weren’t guilty? Extortion is definitely a crime, but the victim isn’t at fault. Our regulatory state is so powerful that no business in any regulated industry dares to speak out against its regulator; given their power to destroy your business, there’s just no benefit to antagonizing the Fed or the SEC. As a result, most regulated firms simply toe the line—pay ungodly fines, support silly laws, provide campaign donations, and generally do everything they can to stay on the good side of the 800-pound gorilla. Professor John Cochrane at the Hoover Institution at Stanford University calls this “bureaucratic tyranny,” and it’s an apt description.2 Unelected and often unqualified 4


regulators have way too much power over the industries they oversee, and indeed over the economy itself, often with little or no legislative oversight. It often seems as if the primary role of regulators is to impose burdensome and expensive regulations that effectively protect existing competitors from new entrants. Regulated companies end up trading their independence for a comfy life free from disruptive competition. This can’t be good for consumers, or the economy. How can you complain about overregulation? Wall Street money owns D.C. Wall Street is one of the most regulated industries on earth. It also spends vast sums of money on lobbying and political campaigns. These two facts are not unrelated. Wall Street tries to inf luence D.C. precisely because D.C. sets the rules that determine success on Wall Street. If you want to keep Wall Street out of D.C., reduce the impact of D.C. on Wall Street. It’s that simple. The same, of course, can be said of all lobbyists: They wouldn’t exist without constant government interference in their industries. And they’d lobby a whole lot less if governments weren’t constantly changing regulations and tax codes. In fact, all of this activity might make one think that, despite their protestations, politicians actually like being lobbied. Certainly, many members of Congress leave government with far more wealth than when they entered. Furthermore, overly specific microregulations only encourage game playing and workarounds; if it’s not specifically illegal, it must be allowed—leading to further microregulations ad infinitum. Higher capital requirements and broader laws against fraud and misrepresentation would likely prove more effective. In addition, most of those touting policies on how to fix Wall Street—from both wings of both parties—have little understanding of how markets work, and they are usually advancing a personal or political agenda. Markets are complex adaptive systems3 that pursue the will of the people and the wisdom of crowds; as such, they are generally resistant to centralized control. New rules simply spur markets to develop new methods to achieve the same ends, often with unintended and unpredictable consequences. But when the chickens came home to roost, all of that lobbying paid off: The Fed bailed out the banks, not the people who bought overpriced homes. True, the Fed (and the Treasury, through the Troubled Asset Relief Program [TARP]) lent emergency funds to banks during the credit crunch, but this is exactly what the Fed was designed to do as the lender of last resort. Since banks borrow short and lend long, they can find themselves SPRING 2016


in a temporary liquidity squeeze when investors want to withdraw funds faster than banks are earning interest and retiring loans. With too little cash on hand, banks can be forced to liquidate investments, often at distressed prices, to meet demand for redemptions. This can lead to a “positive feedback loop” that artificially depresses prices for all investors, leading to further economic weakness. By stepping in to help cover a temporary liquidity shortage, the Fed prevented a wider panic, and probably a deeper recession. The best way to reduce “bailout risk” is to significantly raise liquidity requirements for banks. But setting capital requirements to weather a 20-year storm would mean less bank lending, less risk taking in the economy, and probably slower economic growth in normal times. When risks don’t pan out, such as in recessions, everyone is in favor of taking less risk. The opposite is true during economic booms, as evidenced by the widespread encouragement of risky subprime lending before and during the housing bubble. Risk will always be a double-edged sword, but on average the U.S. economy has benefitted from banks’ lending long and taking more risk. In addition, because these loans were paid back with interest, the Fed (and TARP) didn’t really bail out the banks; they simply lent them funds to meet a temporary cash crunch. When the panic subsided, few banks were actually insolvent (assets less than liabilities). This was not a transfer of wealth from Main Street to Wall Street. In fact, when you consider the huge penalties banks paid for supposed misdeeds, the transfer was definitely in the other direction (or more precisely, from Wall Street to Pennsylvania Avenue). To the extent that the Fed/TARP loans constituted a bailout, however, it was of the banks’ depositors and lenders, not their owners: Many bank equities quickly lost more than 90% of their value during the crisis—although investors who hung on recovered some of this—while depositors and other lenders were mostly kept whole. Although it’s nominally true that the Fed bailed out creditors, not equityholders, most of those creditors were from Wall Street, and the bailout allowed equityholders to keep their shares, and Wall Streeters to keep their jobs. Many of those creditors, and many of the equityholders as well, were pension funds, mutual funds, and other institutions that are beneficially owned by the general public. So Main Street was “bailed out” (or better said, “insured”), too. And the vast majority of Wall Streeters had nothing to do with mortgages or the financial crisis. Should they all lose their jobs because of a liquidity crisis SPRING 2016

they had nothing to do with? Admittedly, many people lost their jobs in the economic turmoil that ensued, but Wall Street certainly wasn’t spared. In fact, it sank more and recovered less than the rest of the economy. Whereas most industries now equal or exceed their pre-crisis highs, both employment and stock prices for Wall Street firms remain depressed. The Treasury and Fed did a lot to inf late the bubble. They also managed the crisis with a strange mixture of panic and vindictiveness. But stepping in to end a credit crunch is an acceptable role for government, as the “lender of last resort” (especially since the Fed helped to inf late the bubble with easy money). There is a big difference between bailing out favored companies or industries and stopping a widespread panic that threatens the entire global economy. In any case, if you don’t like the “bailout,” blame the government, not the banks. Come on. We both know that banks don’t really lend money anymore. They get most of their profits from prop trading and packaging derivatives. It’s time to re-introduce Glass-Steagall and get banks back to the business of lending. If banks are becoming regulated utilities in which the government dictates how much they can lend, to whom, and at what interest rate, then, yes—it makes sense to separate lending from other capital market activities. But otherwise, markets should be free to evolve organically from the bottom up, not be told how to organize themselves from the top down. If combining commercial and investment banking is an unsuccessful or risky business model, it will die on its own. The fact that this combined business model is found in most developed nations, however, would argue for its success. In any case, prop trading and investment banking had nothing to do with the mortgage crisis. Conversely, one of the prime causes of the crisis was that no one did adequate due diligence on borrowers. Banks often securitized and sold loans—and they were therefore less concerned with the borrower’s credit worthiness. Mortgage investors relied on rating agencies, diversification, and the long-term upward drift in home prices to mitigate credit risk. The rating agencies themselves leaned too heavily on the prior history of subprime loans, which had generally been tame up until the crisis. It’s as if investors were buying index funds, but there were no active managers or speculators to assure that stocks were fairly priced. I suspect that the market learned its lesson: Investors will likely rely less on credit ratings and conduct more of their own due diligence going forward. They will also require more information from banks on the creditworTHE JOURNAL OF PORTFOLIO MANAGEMENT

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thiness of mortgage-pool participants. These are positive developments. In fact, one of the key features of complex adaptive systems (such as markets) is that they learn, adapt, and move forward. Conversely, regulators usually focus on solving yesterday’s problems. Maybe, but we still need to break up the banks to create more competition on Wall Street. Actually, Wall Street is hypercompetitive, with literally thousands of firms offering a plethora of products. For almost any service—data, research, trade execution, loans, hedge funds, private equity funds, venture capital, mutual funds, ETFs, IRAs, etc.—there are dozens, if not thousands, of competitors. Concentration is only a problem among highly regulated, “systemically important” banks. It is well documented that regulation protects existing competitors by raising barriers to entry. In virtually every regulated industry, more regulation brings more concentration. In banking, this trend has been going on for decades, but has accelerated since the passage of Dodd–Frank in 2010: Big banks now control an even larger share of assets than before the crisis. Furthermore, in almost every highly regulated or government controlled industry—including education, health care, utilities, transportation, energy, and defense— there has been more concentration, less innovation, and/or higher inf lation than in the broader economy. Is this what we really want for banking? If so, we will continue to see funds (and funding) leave the banking system for hedge funds, private equity funds, ETFs, money market funds, crowd sourcing, and other less regulated and more competitive alternatives. Conversely, if regulators really want to end “too big to fail,” they should eliminate burdensome regulations that make it nearly impossible for small banks with new business models to compete. Nonetheless, I think it’s unhealthy for finance to be such a big slice of our economy. Well, it’s certainly smaller than it was, but history shows that dominant economic and political powers also dominate finance. If the United States wants to remain a dominant world power—and a true champion of economic and political freedom—it will need to remain a dominant financial center. History has also shown that finance grows as a proportion of the economy during periods of intense capital accumulation. With billions of people in the developing world emerging from poverty—all needing more capital to do so—there is a huge labor surplus and capital shortage across the globe. Capital accumulation will remain 6


intensive as global development unfolds. The world also needs additional capital to fund the explosion of innovation in areas as diverse as media, materials, genetics, artificial intelligence, robotics, and nanotechnology. Finance will remain a critical (and large) sector of the economy for the foreseeable future. In addition, finance offers a perfect cure for what ails America’s middle class: clean, safe, well-paying, challenging, fulfilling, and engaging jobs. Instead of trying to regulate Wall Street into abject submission, our government should be doing all it can to keep U.S. markets the most vibrant, open, free, and transparent in the world. Well, I still think you’re all a bunch of fat cats who are way overpaid. Maybe, but that’s a personal value judgment. Compensation levels (and all market prices) ref lect private transactions between consenting adults; they are not, and should not be, set by public debate. This is just basic information theory: The parties to a transaction are in the best position to assess its relative merits, which are inherently personal and subjective. If both parties agree to the terms of the contract, both will be subjectively better off, and aggregate wealth will be higher. You may think that bankers, traders, and fund managers are grossly overpaid relative to their value added, in which case you don’t have to buy their services. Others disagree and willingly pay these rates. In any case, capital allocation and price discovery are critical functions in a capitalist society, and those who excel at them deserve high compensation (and our thanks). There is also little evidence that if Wall Streeters were paid less, Main Streeters would be paid more. In any voluntary transaction, such as an employment contract, the price tends to settle between the value to the seller (employee) and the value to the buyer (employer), usually close to the midpoint. Reducing (or ultrataxing) compensation for some employees will not change this calculation for other workers. Compensation is not a zero-sum game that divides a fixed pie among various employees, but rather a series of positive-sum games between specific employers and employees, in which each new contract expands the pie ever so slightly for everyone. Finally, calling bankers “fat cats” is just as unfair as calling unemployed, single mothers “welfare queens,” calling black teenagers “thugs,” calling Muslims “terrorists,” or calling cops “fascist pigs.” These may be apt descriptions for tiny, yet highly visible subsets of each group, but to apply them to the whole category is just plain wrong—both morally and mathematically. In my experience, roughly 90% of the people I’ve met on Wall SPRING 2016


Street are honest, hardworking, bright, and dedicated to serving their clients. The same can be said of most people in most professions, including politicians and lawyers. This type of stereotyping and name-calling has no place in civilized debate. I guess you’re right. My views of Wall Street were misinformed and based primarily on Hollywood stereotypes. Theory and evidence show that open capital markets are efficient, fair, and inherently democratic; they fuel our economy by channeling the will of the people and the wisdom of crowds. I now see that sustained economic development requires open capital markets. I’ll also admit that market forecasts contain more information and less noise than private forecasts. Accordingly, markets are the best way to set prices (including compensation) and allocate capital. They also provide an efficient place to invest, thereby greasing the wheels of commerce. It’s also clear that both Wall Street and Main Street contribute to bubbles, and that the “bailout” was consistent with the Fed’s role as lender of last resort (especially since it did so much to inflate the bubble). In fact, we should all be extremely grateful for our marketbased global financial system, which led the developed world out of poverty, and promises to bring prosperity to the developing world as well.

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OK, our detractors are unlikely to concede quite so easily. And you can probably think of even better arguments to answer our critics. My point is simply that it’s time for us to quit apologizing for our profession and start defending the Wall. Otherwise, winter may indeed be coming. ENDNOTES 1

See https://en.wikipedia.org/wiki/Wisdom_of_the_crowd. See johnhcochrane.blogspot.com/2015/08/rule-of-lawin-regulatory-state.html#more. 3 See https://en.wikipedia.org/wiki/Complex_adaptive_system. 2

Robert C. Jones is the chairman and CIO of System Two Advisors in Summit, NJ. [email protected]

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