Justin Fox has an article in the Harvard Business Review assailing the profit motive in financial services. I don’t deny that some banks and brokerage firms have behaved badly—but the logic of the critics is (I think) all wrong. There is a behavior problem that needs fixing perhaps, but I think it can be approached more elegantly. Mr. Fox’s thesis is this:
If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.
I don’t think you can ever force anyone to behave. I was never successful forcing my kids to behave when they were four years old, and I have no more success now that they are teenagers. This thesis leads to some bad logic. Mr. Fox continues:
I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”
Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle.
I have a few issues with this. First, the data argues that low-volatility funds are not the answer. If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t. Holding periods, according to DALBAR data, are only marginally different, around three years in each case, so that argument goes up in flames. Second, investment firms always encourage investors to stay the course, sometimes to a fault. (And they usually end up getting criticized for it later by some Congressional panel with 20/20 hindsight.) Seriously, did you ever read material produced by any reputable investment firm suggesting day-trading or short-term speculation?
Mr. Fox extols Jack Bogle and Vanguard for being great guardians of the investor, yet Vanguard is one of the biggest players in exchange-traded funds, something Mr. Bogle has decried as a terrible product that encourages speculation! Does that make Vanguard evil? (I don’t agree with that either. ETFs don’t kill people; investors shoot themselves.) Reality is a lot messier than an idealogical paradigm.
It all boils down to incentives. Human beings are not all that tractable. It’s certainly not easy to get investors to behave rationally either, and it’s not for lack of pleading by the investment companies. Believe me, every firm would rather you keep your account there permanently! But rather than “forcing” someone to behave, why not give them incentives to behave?
An anecdote might illustrate my point. I worked many years ago at Smith Barney, Harris Upham when it was still private. Share ownership was widely distributed and many people—partners and aspiring partners—felt like they had a stake in how things worked. It was viewed in the industry as a stodgy firm that was not willing to take big risks, which was pretty much true. The partners didn’t want to take big risks with the firm’s money because the firm’s money was their money! Eventually the partners sold out to a public company. The first convertible bond underwriting client that was engaged after the firm became public went bankrupt before it made its first semi-annual interest payment. I can’t prove it, but I suspect that the partners weren’t as concerned about the underlying credit quality of the issuer when it wasn’t their money at stake anymore. (In an interview, John Gutfreund of the old Salomon Brothers said using other people’s money was the beginning of the end.) How many toxic mortgages would have been securitized if the partners’ personal money were at stake, or if even public firms had been required to retain substantial amounts of each pool? Surely much less monkey business would have gone on. (Stupidity you can’t regulate. But if someone knows they have a grenade, they’re not happy about playing catch with it.) Intelligent structuring of incentives will solve many of the problems that Mr. Fox rightly points out.
And, one could argue that incentives are already having an effect. Mr. Fox mentions in passing some good actors in the industry (and I’m sure there are others):
Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests.
And guess what? These firms are now huge because they realized they would have the best chance at sustainable, long-term growth by looking out for investors. Enlightened consideration of their incentives led them to behave in ways that maximized their long-term growth. There are other firms in the industry that have marketed celebrity portfolio managers, or have pushed performance when they were hot, or have launched all manner of ill-conceived products, but they have generally come to grief in the longer run. (Short-termism, by the way, is not limited to for-profit enterprises.)
Could the industry incentivize even better behavior? Possibly, and that is certainly a goal worth pursuing. But to lay the blame for industry problems on the profit motive is just lazy thinking, in my opinion.
HT to Abnormal Returns