Friday, May 17, 2013

A Defense of the Financial Sector

The financial sector needs some defenders, and John H. Cochrane steps forward with a bracing essay,
"Finance: Function Matters, Not Size," in a symposium in the Spring 2013 issue of the Journal of Economic Perspectives.  (Full disclosure: I've worked as Managing Editor of the JEP since 1987.) Here, I'll list some of the main points that I took away from Cochrane's essay in boldface type, with quotations from the article following.

Economists have been arguing for a half-century that active portfolio management isn't worth the fees paid for it (for example, see my post from yesterday). But when high-fee active portfolio management has persisted for decades in the face of such criticism, perhaps it's the critics who should be wondering if they are correct. 

"High-fee active management and underlying active trading have been deplored by academic finance for a generation. ... It seems the average investor should save 60 basis points a year and just buy a passive index such as Vanguard’s Total Stock Market Portfolio. It seems that the stock pickers should do something more productive, like drive cabs. Active management and its fees seem like a total private, and social, waste. Yet this hallowed view—and its antithesis—do not completely make sense. After all, active management and fees have survived 40 years of efficient-market disdain. Economists who would dismiss “people are stupid” as an “explanation” for a pricing anomaly that lasts 40 years surely cannot use the same “explanation” for the persistence of active management."

There are lots of inefficiencies in financial markets that can be exploited, at least for a time, to make profits.

"But the last 20 years of finance research is as clear as empirical research in economics can be: There is alpha relative to the market portfolio—there are strategies that deliver average returns larger than the covariation of their returns with the market portfolio justifies—lots of it, and all over the place. ... Examples of such strategies include value (stocks with low market value relative to accounting book value), momentum (stocks that have risen in the previous year), stocks of companies that repurchase shares, stocks of companies with accounting measures of high expected earnings, and stocks with low betas. The “carry trade” in maturities, currencies and, credit—buy high-yield securities, sell low-yield securities—and writing options, especially the “disaster insurance” of out-of-the-money put options, all generate alpha. Expected returns on the market and most of the anomaly strategies vary predictably over time, implying profitable dynamic trading strategies."

Highly sophisticated investors pay for active management of their financial assets, and apparently believe they are getting a good deal.  

"Delegating active management and paying large fees is common and increasing among large, completely unconstrained, and very sophisticated investors. For example, the Harvard endowment was in 2012 about two-thirds externally managed by fee investors and was 30 percent invested in “private equity” and “absolute return,” largely meaning hedge funds. The University of Chicago endowment is similarly invested  in private equity and “absolute return.” Apparently, whatever qualms some of its curmudgeonly faculty express about alphas, fees, and active management are not shared by the endowment. ... Why have these decision procedures become standard practice? Vague reference to “agency problems” and “naiveté” seem unpersuasive. Harvard’s endowment was overseen by a high-powered board, including its president Larry Summers, possibly the least naive investor on the planet. The picture that Summers and his board, or the high-powered talent on Chicago’s Investment Committee are simply too naive to demand passive investing, or that they really want the endowments to be invested in the Vanguard total market index, but some “agency problem” with the managers they hire and fire with alacrity prevents that outcome from happening, simply does not wash."

The existence of financial bubbles suggests that markets are inefficient, too. But many of those who are most insistent that financial markets are inefficient often shy away from the logical implication that if the market is inefficient, it might benefit from additional trading. 

"The common complaints “the financial crisis proves markets aren’t efficient,” or that tech and mortgages represented “bubbles,” are at heart complaints that there was not enough active information-based trading. All a more “efficient” market could have done is to crash sooner, by better expressing the pessimist’s views. ... If information is not incorporated into market prices and to such an extent that simple strategies with big alphas can be published in the Journal of Finance, there are not enough arbitrageurs. If asset prices fall in “fire sales,” only to rebound later, there are not enough buyers following the fire trucks. If credit constraints are impeding the flow of capital, there is a social benefit to loosening those constraints."

Do we care about the size of the financial sector or the instability of the financial sector? (And no, they aren't the same thing.)

"The increase in fees for residential loan origination is easily digested as the response to an increase in demand. The increase in housing demand may indeed not have been “socially optimal” (!). There are plenty of government policies and perhaps a few market dislocations to blame. But it doesn’t make much sense to criticize growth in the financial industry for responding to this increase in demand, whatever its source, or for passing along the subsidized credit—which was and remains the government’s explicit intention to increase—with the customary fee. ... There was a lot of financial innovation in mortgage-backed securities, some of which notoriously exploded. But here again, whether we spend a bit of GDP filling out forms or paying fees is clearly the least of the social benefit and cost questions. The “shadow banking” system was prone to a textbook systemic run, which happened. This fragility, not the size or fraction of GDP, is the important issue."
We don't really understand the process of price discovery in financial markets, and as a result, passive investing may be less intuitively attractive on a second glance.

"The fact staring us in the face is that “price discovery,” the process by which information becomes embedded in market prices, uses a lot of trading volume, and a lot of time, effort, and resources. And we are only beginning to understand it.... [P]erhaps we should work just a little harder before dismissing the hundreds of years of trading activity, and the entire existence of the New York Stock Exchange, Chicago Mercantile Exchange, and other markets, as monuments to human folly, or before advocating regulations such as transactions taxes —the perennial favorite answer in search of a question—to reduce trading volume whose size, function, and operation we do not understand. Are we sure that they should not be transactions subsidies? And before we deplore, it’s worth remembering just how crazy passive indexing sounds to any market participant. “What,” they might respond, “would you walk in to a wine store and say ‘I can’t tell good from bad, and the arbitrageurs are out in force. I sure won’t pay you 1 percent for recommendations. Just give me one of everything’?”"

The important aspects of the financial sector that we don't understand are a good basis for research, but in the real world of political economy, they could well be a bad basis for additional regulation.

"Surveying the current economic literature on these issues, it is certain that we
do not very well understand the price-discovery and trading mechanism, nor the
economic forces that allowed high-fee active management to survive so long.
Unless we adopt the arrogant view that what we don’t understand must be bad,
it is clearly far too early to make pronouncements such as “There is likely too much
high-cost, active asset management,” or “Society would be better off if the cost of
this management could be reduced.” Such statements are not supported by theory
or evidence. Nor is their not-so-subtle implication that resources devoted to greater
regulation—by politicians and regulators no less naive than current investors, no
less behaviorally-biased, armed with no better understanding than academic economists,
and with much larger agency problems and institutional constraints—will
improve matters."

Cochrane's paper is part of a five-paper symposium on "The Growth of the Financial Sector" in the Spring 2013 issue of the Journal of Economic Perspectives.