The New Dawn of Financial Capitalism
Complexity, greed and short-termism are undermining our financial system, but a rerooting of finance in the real economy could lead to a more sustainable version of capitalism.
In 1882 a 28-year-old financier headed west to open a remote branch for Bank of Ottawa. The local communities on the prairies needed the bank’s services, he was told. So in June of that year, he left Ottawa for Chicago and continued by train to St. Paul, Minnesota, through to Winnipeg. His final destination was a small trading hub in Ontario called Keewatin. Upon arriving he took off the three-piece suit he had worn throughout the long journey, and with a letter opener he made a slit in the lining of his vest. He removed nearly C$50,000 that the bank had entrusted to him. The cash was to be used to establish a local branch and finance the building of the Five Roses flour mill, along with upgrades to the rails connecting to the mill.
For the next few years, he slept above the bank and worked to help Keewatin get the funds it needed to develop and prosper. It was not easy living; the winters could be brutally cold. His first wife fell ill in the harsh environment and later died. But, duty-bound, the young man stayed and delivered. His success led Bank of Ottawa, which would one day become part of the central bank of Canada, to recruit him in running its much larger branch in Winnipeg. Eventually, he left the bank to help develop the local insurance industry. Of all the positions he took over the years, however, he was most proud of his work as a local banker on the prairie. When he died, the Ottawa Journal praised him, first and foremost, as a banker: “John Benning Monk, Manitoba pioneer banker, died at his home early Monday afternoon. He was 92.”
J.B. Monk was my great-grandfather. I first heard his story when I was 18 and living in California. My father, whose job at Hewlett-Packard Co. had taken him from Canada to Silicon Valley, was trying to explain to his teenage son how easy he had it compared with his past relatives, who’d had to walk through waist-deep snow just to get milk and eggs. In trying to toughen me up, my father exposed me to J.B. Monk’s deep and enduring focus on using the tools of finance for the greater good. My father even pulled from an old trunk the vest J.B. had worn on his long journey — with the long slit down the side — and recounted the dangers and sacrifices he had incurred to put the bank’s money to work in the Keewatin community. I’m sure I nodded my head with as much sincerity as an 18-year-old could muster — and then went to the beach.
But the story of J.B. stuck with me. And I came to realize over time that although my great-grandfather may have been a pioneer, he was not unique. Bankers and financiers of many stripes played integral roles in the development of countries around the world. Finance once was a highly personal industry founded on mutual understanding, woven into the very fabric of society. No doubt there were exceptions, such as the robber barons, but trust seemed to be at the heart of finance during J.B.’s time. Local bankers put themselves at the center of communities and sometimes even in harm’s way. J.B. sacrificed considerably for Keewatin, and others in the community no doubt recognized that. At a fundamental level they all shared the same mission: security and prosperity.
Over the past century, however, trust has steadily eroded in the business of finance. In fact, the innovations that were supposed to render finance cheaper, easier, better and more efficient have become some of the most costly in our society. In 1950 the financial services industry enjoyed a 10 percent share of U.S. corporate profits. Today that share is 40 percent. Of the 400 richest Americans ranked by Forbes magazine, 26 got their fortunes from real estate, 28 from media, 28 from energy and 29 from fashion and retail. The big winner would be technology, with 48, if not for banking, finance and investment. The last group takes the prize with a whopping 106 of the richest Americans. Not bad for an industry that doesn’t actually make anything.
Financiers and bankers have lost the public’s trust, in large part because they have sought to use the increasing complexity, sophistication and opacity of corporate and project finance to enrich themselves at the expense of the capitalist system they were originally meant to serve. The business of finance seems to have devolved into a world of rent-seeking and zero-sum games. No doubt some people are doing right by their clients, but the system as a whole is so tilted in the wrong direction that doing right by clients is now akin to not doing wrong by clients. Because finance was, and is, crucial for capitalism to function effectively, its derailment could derail capitalism. With this in mind, it’s important that finance and investment be set on a more sustainable path. This path should be rooted in service to the key players in the capitalist system — savers and developers — and in a commitment to create value within the real economy.
I’d love to be able to say that my interest in rerooting finance in the real economy grew out of an appreciation for my great-grandfather’s legacy. It didn’t. The truth is, a few hazy years spent in the bowels of the finance world at the height of exorbitance and rent-seeking pushed me in this direction. After graduating from Princeton University with a BA in economics in 2000, I shuffled off to Wall Street to work as an analyst at an investment bank. Assigned to a technology group at the height of the Internet bubble, I saw what the excesses of Wall Street looked like up close. After that melted down in epic fashion, I ended up in a venture capital firm focused on financial services. Yet again this role provided me a rather unique set of insights into the ways financial services companies actually make money. There was a mix of offshore banking and insurance, with a tiny dash of new financial technologies. Much to my parents’ chagrin, I walked away from the high-paying venture capital world and instead chose to do a decade of graduate studies and enjoy the relative poverty that sadly went with it. I went to the Sorbonne in Paris for a master’s in economics and then to the University of Oxford for a doctorate, paying for a verre or a pint with consulting gigs with pension funds. (There will be more on all that later.)
Through these experiences, as a professional and as an academic, I came to believe, perhaps naively, that putting finance and investment on the right path would demand that we wake the industry’s sleeping giants. In the same way that Bank of Ottawa sent one of its own employees off to the frontiers of finance, today’s institutional investors need to develop similar pioneering capabilities. As I saw it, and continue to see it, ushering in a new dawn of capitalism demands that the global community of long-term asset owners — endowments, family offices, insurance companies, pensions and sovereign funds — take the $100 trillion or so that the Organization for Economic Cooperation and Development estimates it oversees and step up, professionalize and act like educated financial consumers. The idea here is for the ultimate principals in the long principal-agent chain of intermediaries — a chain that facilitates the flow of resources between savers and developers in our capitalist system — to take their role more seriously than they have previously. Today the community of asset owners, which should be a potent disciplinary force over intermediaries, doesn’t know how to play its part. I accept that this won’t be easy, but it has to change if we want to put capitalism on a more sustainable trajectory. And by “sustainable,” I specifically mean a capitalist system that is more attuned to the long-term fundamental challenges facing society.
Taking a step back, I see a few obvious reasons asset owners lost touch with the real economy. Starting with the development of Modern Portfolio Theory in the 1950s, a plethora of financial concepts allowed for the mass production of finance. We as a society were told that this mass production, which was based on the deconstruction and repackaging of financial risks into products, was a very good thing. It allowed for risk diversification and widespread access to financial opportunities that had been available only to the most-sophisticated investors. These products were engineered to provide investors with something that seemed to satisfy their risk and return objectives in an easy manner. But although these products were sold as simple, they were anything but. Converting numerous investment risks into standardized return expectations is highly complex. And the top-down models, heuristics and black boxes used for this left local knowledge and trust — the cornerstones upon which investment decisions were made — by the wayside. The ultimate financiers of our entire capitalist system — the asset owners — were attracted by the ease of buying something that purported to offer a predictable return. It was simpler to assess standardized products than to actually study the underlying real assets, which could be quite messy. But few asset owners had the sophistication required to make smart decisions about how to consume the rapidly expanding array of financial products and services. Most didn’t understand the underlying fees, costs, risks and incentives they were accepting, either explicitly or implicitly, in the grand bargain to move toward mass-produced finance.
I went to Oxford to work with Professor Gordon Clark on a thesis that was meant to look at the regulation of offshore financial markets. I can’t recall exactly what I was hoping to learn, but I no doubt had visions of doing fieldwork on tropical islands. But a consulting project for a large U.S. public pension fund right before I started at Oxford set me off in a completely different direction. The goal of the project was to help the pension fund assess permissible equity markets in the world’s emerging economies. I was tasked with traveling to Morocco and Taiwan to run the audits of the countries’ macro and fiscal transparency. I remember, on my first day in Taiwan, coming into a giant boardroom in the Ministry of Finance with my translator and being invited to sit on one side of a long table. On the other side sat 13 representatives of the ministry. For these officials, receiving a thumbs-up from this 28-year-old kid, who barely understood the difference between public and private accounting, could mean hundreds of millions of dollars of additional capital from this fund and billions more from its peers, while a thumbs-down could mean getting nothing. There and then I realized that pensions matter. More significantly, I also realized that pensions should really be using far more experienced consultants to audit countries’ macro and fiscal transparency, especially as it pertained to Morocco and Taiwan. Anyway, much to my Oxford adviser’s great relief, my Ph.D. topic quickly shifted to the design, governance and management of public pensions and other long-term investors. And I’ve never looked back.
As academics studying these funds, and indeed as consultants actively working to help them improve their governance and management, Gordon Clark and I have been given an unvarnished view of their operations. What we’ve learned over the past decade has been profoundly depressing: The big asset owners are often complicit in, and perhaps even responsible for, the short-termism and rent-seeking in the finance industry. Why? Because traditional institutional investors have been outsourcing almost all of the assessment and selection of their investments and rarely possess the expertise and competencies to execute even the most basic financial transactions without the help of some external, and often compromised, adviser. In this respect, the sponsors of these investment organizations have been comfortable with the idea that their funds’ success has been a function of the effective oversight and management of a long chain of principal-agent relationships. The ugly secret of our capitalist system is that the ultimate providers of financial capital today are managing their assets with business, risk and information technology systems that are obsolete or lacking in critical functionality, redundancy and security. That’s scary for anybody interested in preserving the efficiency of capitalism.
To be fair to the sponsors of these funds, the outsourced model was originally supposed to provide cost-effective, flexible and efficient access to markets. Indeed, the academic literature on the subject would tell you that intermediaries are important agents to help minimize transaction costs. No, stop laughing; it’s true. Granted, in finance the increasing use of intermediaries has simply led to an explosion of even more intermediaries. Asset owners have lost trust in their existing intermediaries, and the new ones are meant to hold the old ones accountable. The idea of adding intermediaries to control intermediaries may sound absurd, but it fits with Nobel laureate George Akerlof’s research on information asymmetries. He showed that new institutions inevitably emerge to try to help minimize information asymmetries, especially around the issue of quality control. But Akerlof also showed that as the number of intermediaries grows, people tend to revert to heuristics such as “brand name” to try to ensure quality in the intermediaries they pick. For example, the brand-name coffee shop may not offer you the best cup of coffee in town — in fact, it almost certainly doesn’t — but at least you know what you’re getting. What this meant for finance was that the asset owners would look to established brands to ensure they were buying quality, all the while asking a growing number of these brand-name intermediaries to help them try to hold the entire system together. It was the fox guarding the henhouse. As new research by Kathryn Judge of Columbia Law School shows, financial intermediaries were quite adept at promoting self-serving arrangements that drove high fees and even ensuring that high-fee options were retained despite lower-fee options.
I admit I’m a slow learner, but even for me the problems in the finance industry were starting to crystallize during my doctorate and postdoc work at Oxford. And I was not alone in thinking that one of the biggest problems that needed fixing was the role — or lack thereof — of the asset owners in disciplining the investment chain. For example, both my Ph.D. adviser and Roger Urwin of Towers Watson & Co. have argued that asset owners should adopt governance budgets to help them professionalize. Keith Ambachtsheer of the University of Toronto has been a champion of trustee education and mentorship. Harvard Business School professor Josh Lerner has led efforts, including at the World Economic Forum, to foster long-termism among asset owners. John Rogers, recently retired president and CEO of the CFA Institute, has asserted that institutional investors should take their role in shaping the markets and, indeed, the economy more seriously. Adam Dixon of the University of Bristol has written extensively on the rise of sovereign wealth funds and how these new players can serve to catalyze change in the finance industry more broadly. In an article for Harvard Business Review, McKinsey & Co. global managing partner Dominic Barton and Canada Pension Plan Investment Board CEO Mark Wiseman recently underlined the importance of asset owners to any plan to fix capitalism: “The single most realistic and effective way to move forward is to change the investment strategies and approaches of the players who form the cornerstone of our capitalist system: the big asset owners... If they adopt investment strategies aimed at maximizing long-term results, then other key players — asset managers, corporate boards and company executives — will likely follow suit.” I couldn’t agree more.
This community of thought leaders — and there are many more who deserve to be cited — has begun to realize the importance, for finance and indeed capitalism, of empowering the asset owners of the world to professionalize. And I’m here to tell you: This is starting to happen. I believe we’re about to witness a new dawn of institutional investment, which if it unfolds as planned could deliver a more efficient and effective form of capitalism. And from our respective academic perches at Oxford and Stanford, Professor Clark and I are actively helping to drive some important developments among institutional investors. The very fact that some of the largest pensions, sovereign funds and family offices in the world are supporting a financial research center that sits within Stanford’s engineering school is evidence of the shifting priorities among these asset owners.
The Global Projects Center I run at Stanford, together with engineering professor Raymond Levitt, has for its mandate the rerooting of finance in the real economy. We work directly with some of the largest asset owners on the planet, and we help them think about how to provide the engineers walking our hallways with the long-term financing they require to build real things in the real world. We also work with the engineers to help them think creatively about how to govern their own projects and where to look to find aligned financial partners. In our estimation, if the financing doesn’t come together in the right way, the projects being undertaken may not be successful. For example, if an engineer wants to develop a new type of green building that has a sophisticated energy conservation component, this engineer will likely want long-term investors involved right from the beginning. After all, it’s the terminal investors that will reap much of the value from the energy cost reductions associated with the investment in efficiency. Trying to cobble together short-term financing with high leverage to fund these long-term projects would be inefficient, risky and very expensive in terms of the layering of fees and costs. Intuitively, it’s wrong. Through our work at the center, we’re trying to fix this for the people thinking big thoughts about infrastructure, real estate, computer science, water, energy and so on.
Indeed, one of the many projects we are working on is focused on resolving the infrastructure funding gap through innovative governance vehicles for projects and investors. If the governance of green-field infrastructure can be designed to accommodate the long-term interests of institutional investors, and if the institutional investors can develop the capacity to invest wisely and stay involved in managing large-scale civil and social infrastructure projects, a flood of new capital could be unleashed. This new capital could be deployed to rebuild the infrastructure of mature economies or generate sorely needed infrastructure for both developing and developed economies, and to resolve the constrained financial circumstances that many local, provincial, state and national governments are subject to.
Most people think we’re crazy to put a finance center in an engineering school. But we’re not. We simply believe that bringing engineers together with large asset owners offers powerful insights on ways in which we can strengthen finance and put capitalism on a sturdier footing. This is in large part because these are two of the most important agents in capitalism — the investors and the developers — so it’s incredibly valuable to provide them a space where they can begin thinking about how to make long-term plans and how to follow through on them. If I want to understand the real economy, I just open the door to my office. I may not comprehend 99 percent of what comes through that door, but the 1 percent I do understand makes it all worth my while.
So, with all that we’ve been doing with large asset owners and engineers at Stanford, what have we learned about the business of institutional investment? What is the correct model that will drive high returns and allow for a closer link with the real economy? In my experience, it’s not the widely copied endowment model, which because of its overarching focus on gaining access to external alpha generators puts the asset managers in a position to discipline the asset owners (see “The Alternative Reality of the Endowment Model”). Instead, the model of institutional investment that I’d like to see widely copied is the one that recognizes the inherent competitive advantage that comes with being a long-term investor. Consider this: There’s no portfolio of assets that a short-term investor can hold that a long-term investor cannot hold. Yet long-term investors can and do hold portfolios that short-term investors can’t. That means that being a long-term investor is, thanks to the power of diversification, better than being a short-term investor. If you read the annual reports of the New Zealand Superannuation Fund or the CPP Investment Board — two of the best institutional investors in the world today — you’ll see this advantage articulated. These investors look for opportunities where markets are inefficient. They believe that if an asset fits in a neat box, it’s overbid and overvalued. They instead want to move into markets with minimal competition (see also “How to Be a Better Long-Term Investor”).
As an example, I recently worked with three sovereign funds on a $1.2 billion collaborative vehicle designed to scoop up promising clean-energy companies that the venture capital industry had failed to carry through to commercialization. Rather than viewing the companies as abiding in the valley of death, these funds saw clean energy as a valley of opportunity. Thus far, they’ve deployed about $700 million on a no-fee and fully aligned basis. Although we don’t yet have visibility on the returns (it’s still very early), this vehicle was a useful step in transitioning the way investors do things. We continue to collaborate on this and other opportunities where the competitive advantages of sovereign funds allow them to invest in underserved markets.
Based on experiences like this, I’ve come to realize the importance of long-termism. If the engineers at Stanford have shared any complaints over the past few years, it’s that most capital is too short-term to maximize the real value of what they are doing. Message received. With this in mind, we’ve come up with four key research and engagement themes to extend the time horizon of institutional investment: the professionalization of asset owners, the reintermediation of finance, the adoption of technology by asset owners and the development of new conceptual models.
Professionalization of Asset Owners
The first thrust of our research is to help empower institutional investors to take greater responsibility for the end-to-end management of their assets. They cannot simply be pass-throughs from the plan sponsor to professional money managers. They have to professionalize themselves. This seems self-evident, but many funds have resisted.
At the most fundamental level, the sponsors and boards of directors have not invested in professionalization because they have not yet seen the true cost of the outsourced investment model. It’s plain to see why: As demonstrated by the recent leaking of private equity limited partnership agreements from the Pennsylvania treasury’s e-contracts library, a key characteristic of a successful finance company is the ability to obfuscate fees and costs. Institutional investors and their boards simply do not know how much they are paying for money management. And this means they are not assessing their organizations’ effectiveness with full information.
Worse still, some asset owners prefer to put their heads in the sand rather than get real transparency on fees and costs. I can think of one executive of a large asset owner who told a senior investment officer to “stand down” on the fee and cost issue for fear of alerting the board and the sponsor. Another told me that he didn’t want to know what he was paying in fees — that it would be too depressing to see how much he was giving away. I can also think of organizations that present incomplete fee pictures in their annual reports. Some focus only on base fees and bury performance fees in net return numbers, whereas others make no attempt to quantify the implicit fees associated with holding, moving or trading assets (despite the fact that the implicit numbers, such as spreads and transaction costs, are often as high as the explicit fees). In addition, many large asset owners suffer from an overconfidence bias, nurtured by insufficient information and lack of appreciation for how costs migrate within mandates and across the entire portfolio. Most institutional investors fail to link payments made to internal staff with payments made to external service providers. This seems bizarre to me, as both payments are costs of running the same business.
For institutional investors to move toward professionalization, they have to start by getting fee and cost transparency. They have to really know the price they’re paying for external service provision. My assumption here is that boards, at least those with sane people on them, would prefer to pay internal staff millions than pay external staff billions for the same service. But if you look at the industry today, that doesn’t happen. And the high fees paid to the finance industry have allowed it to consolidate power and then wield that power to extract a disproportionate share of value from the global economic system. Think of it this way: Paying overly generous fees today is a recipe for paying even higher fees tomorrow.
I recognize that many of the people working in these funds are very happy with the status quo. They prefer to avoid career risk by shifting investment risk to others. They also realize that their domain expertise may not be needed in the next generation of institutional investing, where direct-investment skills may be required. It is thus understandable that they may not want change. After all, if you need new staff, it’s only natural that existing staff would try to thwart the change.
But the reputational risk associated with the current path is growing. Institutional investors do not want to explain to their sponsors, let alone to the general public, that their lack of attention allowed the private industry to accumulate wealth beyond anything remotely reasonable and that their oversight has been complicit and even instrumental in allowing most, if not all, of the scale economies in finance to accrue to the private managers. If that’s not enough to get somebody moving, then how about the carrot of risk-free returns? It’s far easier to save money through smart implementation — call this implementation alpha — than it is to generate alpha returns in the market.
Reintermediation of Finance
The second thrust of our research focuses on reintermediation, which we define as the fostering of a new generation of aligned intermediaries. Rerooting a public pension fund in the real economy will inevitably create strains on already resource-starved organizations. As such, a new generation of intermediaries to support the professionalization movement is required. In my view, this begins with institutional investors deepening their collaboration with one another but extends into a whole host of new managers, service providers and consultants. If you’re going to move away from the existing set of intermediaries and all the economies of scale they enjoy, then you have to replace them with something else.
One of the new intermediaries of finance that we’re focused on is the collaborative organization. I’ve been lucky to help launch and grow a variety of these peer-to-peer groups. For example, I worked to launch the Innovation Alliance, which helped a handful of sovereign funds share deals in growth-stage, capital-intensive venture-backed companies, largely in energy innovation. In addition, I helped to grow the Institutional Investors Roundtable, a Quebec-based not-for-profit group focused on seeding new collaborative platforms that was founded by some of the largest direct investors in the world. I’ve aided in building Institutional Investor’s Sovereign Investor Institute, a membership group that meets six times a year in six different global locations and brings more than 100 asset owners together for knowledge exchange. Last but not least, there’s the affiliate program of the Global Projects Center, which gathers 12 or so asset owners together a few times a year to think deep thoughts about the future of investing. None of these collaborative platforms has been anywhere near as easy to put together as I thought on the way in, but all have delivered significant value to the asset owners participating, helping to connect like-minded investors.
Moving beyond the asset owners and their collaboration, there will still have to be outside intermediaries to serve the long-term interests of these funds. One of the big research projects we’re working on right now at Stanford is focused on best practices and policies for seeding new managers. As David Swensen, CIO of Yale University, has said: “Attractive investment management organizations encourage decisions directed toward creating investment returns, not toward generating fee income for the manager. Such principal-oriented advisers tend to be small, entrepreneurial and independent.” And to find such managers, you may have to seed them.
You can think of seeding as the venture capital of asset management. The objective is to maximize the alignment of interests between the asset owners and the asset managers and to minimize fees, which means the institutional investor can get the same or higher net returns on a lower base of gross returns. Importantly, there is plenty of research that demonstrates the outperformance of new and emerging managers. I can think of more than 15 large asset owners that are seeding in the domains of hedge funds, private equity, real estate, infrastructure and venture capital.
The third thrust of our research agenda is centered on the adoption of innovative technologies among asset owners. To date, a widespread lack of technological sophistication has served to disempower institutional investors. With the computing revolution the private financial services industry has accumulated and consolidated its economic power. However, a new generation of technology entrepreneurs are focusing their sights on helping institutional investors better do their jobs.
For the sake of transparency, I should add that I believe in this trend so much that, much to my wife’s chagrin, I have invested considerably in, and advise a handful of, these “invest tech” start-ups. In all cases I view my role as pushing rather aggressively for the asset owners. What I want is for technology entrepreneurs to understand the importance of institutional investors and build products to help them. Anyway, there’s a lot happening, much of it within what I call the three D’s of investment technology: disintermediation, dissemination and democratization.
- Disintermediation: What AngelList did for high-net-worth individuals, new platforms soon will be doing for institutional investors. Powerful matchmaking and correlation engines will help institutional investors connect with unique and thoughtfully identified investment opportunities (for example, companies that match up with the comparative advantages, networks and geographies of institutional investors). Those companies that made their money in financial services because they sat at the intersection of networks (brokerages, bankers and even some asset managers) should be nervous. Think of it this way: When was the last time you went to a travel agent? Now apply that same idea to an entire segment of the financial services industry.
- Dissemination: Installing a robust IT system means faster dissemination of data, which you’d think would mean better investment decisions and performance. If only it were so simple. Building the sorts of IT backbones required to move reliable data quickly is time-consuming, expensive and painful. Moreover, getting data from one risk or analytics engine or service provider to talk to other engines and providers is extremely difficult. Can you build these types of systems using spreadsheets? No chance. The processing power required to chug through the complex equations and big data would crush your laptop. But isn’t this just what you get with a Bloomberg terminal? No. This is about intelligently overlaying a fund’s proprietary portfolio data on market and third-party data to develop unique investment insights that are truly real-time and bespoke. These companies will offer the equivalent of a financial iPhone; you’ll run all your apps on their standards and data.
- Democratization: When the computational revolution really kicked off, three decades ago, hedge funds and savvy asset managers accumulated power because they had technology nobody else had. Today that authoritarian control of computation is being democratized. The processing power that cost $100 million in 1980 now costs a few thousand dollars. Although in the past only the most-sophisticated asset managers possessed the tools required to manage complex global portfolios, soon the most-sophisticated systems on earth will be available to all. As a result, new companies are emerging to provide black boxes to the masses.
As institutional investors adopt these innovative technologies, they will have the power to dispense with antiquated rules in the investment industry. The rule that seems most prone for dispensation is the one that says managers should get paid a percentage of assets under management. Managers would like institutional investors to believe that moving money is similar to moving dirt in trucks from point A to point B — that it requires a constant fee that escalates in parallel with the rise in total assets under management. But as it turns out, moving a nine-digit number from computer A to computer B is as costly as moving an 11-digit number. Yes, big trades are harder to place and certain investment strategies have capacity constraints, which may warrant higher fees. But in these exceptions the service provider should be forced to justify the management fee; it should not be the standard upon which all investment contracts are based.
Ultimately, technology will help institutional investors streamline and strengthen operations, manage and distribute knowledge, access unique (and currently expensive) markets and level the playing field with the private financial services industry.
Development of New Conceptual Tools
The fourth thrust of our research has to do with the adoption of new theories and concepts by institutional investors. My interest in studying conceptual tools and their adoption was sparked by sociologist Donald MacKenzie. His research shows that financial theories do not just describe financial markets, they also shape them by influencing the behavior of the actors. They are endogenous. “Man has become the tool of his tools,” as Henry David Thoreau said. If we can change the finance and investment tools, we can change the investment man and his world.
Because of the recent crises, there’s a real opportunity to change or at least supplement the existing tools. To quote another philosopher, Marshall McLuhan, “Most of our assumptions have outlived their uselessness.” Indeed, the recipes of institutional investment inherited from the past — Modern Portfolio Theory, the Capital Asset Pricing Model, the Efficient Market Hypothesis, Mean-Variance Optimization and Value at Risk, among others — no longer seem to match up with the ingredients in today’s financial markets. Some investors are already operating in a post-MPT world, supplementing the existing models with new conceptual tools so as not to be shaped by models with unrealistic assumptions.
For those investors looking to move beyond traditional theories and dogmas, “investment beliefs” have become quite popular. Beliefs refer to accepted truths about the world and financial markets that an institutional investor’s management team and board have agreed should guide their behavior. These can include such beliefs as “alpha is rare” or “environmental sustainability will add value in the long run.” These beliefs are not necessarily theoretically proven (yet), but investors collectively choose that these beliefs should guide their thinking. In so doing, the beliefs provide long-term investors with rigor while allowing for more flexibility than traditional, often short-term, theories. I was lucky to be invited to give a presentation on investment beliefs to the California Public Employees’ Retirement System board a few years ago and was quite surprised to see that these beliefs were being taken as key signposts for long-term decisions.
Other conceptual models are growing in importance, such as real options approaches for dealing with long-term uncertainty, which borrow the tools of financial options for real-world contracts. There’s also the Universal Owner Hypothesis framework, which helps guide investors’ engagement with the broader economy. Last, investors are increasingly interested in using an impact lens as a means of guiding long-term capital to its most productive uses, which in turn can (in the right contexts) drive high returns. For example, Malaysia’s Khazanah Nasional generated 14 percent dollar returns for more than a decade using a developmental objective overlay.
In addition to conceptual tools for guiding investments, many investors are developing new tools for managing organizational and investment risk. These include the development of risk budgets, the hiring of risk officers and the use of innovative models for assessing and dealing with risk. The work that Richard Bookstaber is doing at the U.S. Treasury’s Office of Financial Research is quite important in advancing the mainstream appeal of new risk models. There’s also a growing trend among investors to think in terms of governance budgets, similar to risk budgets. For Oxford’s Clark and Towers Watson’s Urwin, governance is a finite and measurable resource, and a fund’s investment style and strategy should match its governance budget.
Within our community at Stanford, we’re hoping that our work to develop new professional capabilities, new aligned intermediaries, new technological tools and new conceptual reference points will help asset owners extend their time horizons and reroot themselves in the real economy. It should be noted that it’s in their interest to do so. Recent research by Toronto-based CEM Benchmarking shows that the institutional investors that take this approach — in-sourcing some of their assets — outperform those that don’t. This is new research that merits additional study to verify its accuracy, but even if it is an anomaly, it’s at least anomalous in the right direction.
The new generation of long-term investors that I’m working with — as an academic, investor, consultant and often therapist — should have the ability to take end-to-end management of their assets. They may not choose to invest directly, but they will at least be able to weigh an internal option against the services being offered in the marketplace. And when those services are too expensive (that is, almost all of the time), they will have a credible alternative. Moreover, having the capacity to do direct deals will build a culture of risk and responsibility, and trigger a whole series of insights that all institutional investors should have. The more you know, the more you know what you don’t know.
By innovating and having direct capabilities, institutional investors will be able to use local competitive advantages to develop structural alpha opportunities. Many institutional investors have advantages they aren’t leveraging today. These investors will also be able to take countercyclical positions. When markets are crashing as a result of illiquidity, they can step in and catch the falling knife — not because they think it’s right for society (though it is) but because they’re going to get compensated for doing so when markets rebound (which they usually do). In a similar vein, these investors can allocate into markets that might otherwise be deemed inefficient or illiquid. They can get paid for lockups. They can sell insurance. They can play in markets that short-term investors cannot. You get the idea. What I’m trying to say here is that the long-term investing that I want to foster is not (necessarily) about buying and holding. It’s being smart about the intrinsic long-term competitive advantages that institutional investors have and using them to the maximum effect.
The mass production of finance undoubtedly served to bring finance to more people. But it came with underappreciated costs for capitalism and society. And in the same way that society has begun to revolt against the mass production of food, in part represented by the wild success of Whole Foods Market and the organic food industry, a small group of asset owners are starting to move away from overly processed and engineered products and mandates, and instead are working to get access to real assets in the real economy — let’s call this whole finance. These investors are reducing the layers of complexity and abstraction that have served to enrich the financial services providers and are finding ways to access the real economy in more-aligned and cost-effective structures and vehicles. This, we can only hope, will help to put our economy on the right track.
What I find most interesting about this new dawn of financial capitalism is how we are coming back full circle to some of the themes and concepts that marked my great-grandfather’s experiences. The technological advances — such as the one that allowed wire transfers to replace young bankers stuffing their vests with cash and traveling across the country — were viewed as universally positive. For a long time there wasn’t recognition that we were losing something in the process of gaining so much. We lost the personal interactions that led to the development of trust. They were replaced with diversification, productization and homogenization. But now technology is becoming powerful enough that we might get back to some of those roots: local knowledge (big data), communities (crowd sourcing) and trust-based relationships (networks). This is encouraging because the next generation may live with a form of finance and capitalism that is far more aligned with and interested in what the local community wants and needs than it has been for decades.
When I look at J.B. Monk’s vest with the slit down the side today, I’m reminded that changing finance, and indeed capitalism, won’t happen through words alone. At some point, like J.B did, you have to be willing to head out to the frontier and be a pioneer in this business. It’s for this reason that I’ve been on partial leave from Stanford for the past few years. For every three days I spend at the university as an academic studying large asset owners, I spend another three days as a consultant working with and for large asset owners on innovative models of investment. For me, today’s pioneering investors, willing to entertain many innovative models to get greater alignment with the real economy, are just as much of an inspiration as J.B. Monk. • •