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Other people’s money

What is the role of the financial sector? The answer to this question would have been clear 50 years ago.

The traditional view was that banks provided a useful function by transferring savings and deposits from the public to businesses as a way to drive investment and growth. Today, it is less clear whether the public believes that remains the function of banks.

Over the last 40 years, the financial system has increasingly traded with itself, and we believe the numbers are staggering. The global volume of trading in foreign exchange (FX) is about 100 times the global volume of trade in goods and services. Total outstanding global derivatives exposure is $700 trillion - approximately three times the global value of assets, according to the Bank for International Settlements.

Equity markets were founded in the early 19th century as a means to finance railways and railroad construction. These were highly capital-intensive businesses whose investment was financed by the savings of private investors. The stock market provided a secondary market for trading these stocks, thus providing liquidity to the market. This model worked well and was used to fund breweries, automobile plants, petrochemical plants and other manufacturing industries into the increasingly industrialized 20th century.

Fast forward to today. In contrast, many of today’s largest companies such as Apple, Facebook and Google are much less capital intensive. Apple, for example, has a market capitalization of $700 billion but physical assets of only $20 billion. Modern businesses do not require large-scale equity finance. Indeed, over the last few years, more money has been coming out of stock markets than into them.

What is the role of asset management in this environment?

The answer is two-fold: search and stewardship. Search involves researching new investment opportunities and providing capital to new start-ups that have yet to generate cash. Stewardship involves the effective management of existing physical and corporate assets. Rather than an afterthought, stewardship should be integral to the whole asset management function.

To fulfill this role, asset managers must act like owners of companies, rather than tenants. Holding companies accountable by attending annual general meetings, reviewing board structures and monitoring senior management succession planning are vital components.

Asset managers must act like owners of companies, rather than tenants.

This requires managers and clients to agree that long-term metrics are much more important than short-term ones. We believe investors should be evaluating their managers using five-year rolling absolute returns and not short-term relative benchmarks. As part of this, we believe asset managers should avoid focusing on trying to outperform their peers. Instead, they should primarily aim to enhance absolute returns above relative returns.

Sensible solutions

Large-scale shifts in regulation have added to the complexity of the financial sector. Tackling the challenges financial firms face may require drastic solutions. For example, breaking up large financial conglomerates and replacing them with focused institutions would better meet the needs of particular users. Part of this would involve forcing banks to separate their investment banking and retail activities. This is logical from an investment perspective – it is very difficult to make accurate assessments of the standalone value of a bank’s investment banking and retail arms.

Private investors have struggled to evaluate the value they obtain from financial service providers. To regain that trust over time, the financial industry needs to provide investors with better information and greater transparency. For example, financial service providers can give full disclosures and explanations of asset management fees. This can empower investors to assess how well their investments are performing. This can also enable investors to make better decisions about their own money and whether they are investing with the right providers.

The solutions to these issues may need to be imposed by governments, as the entire financial industry is unlikely to undertake such large-scale structural reform on its own. It would be unfortunate if it took another financial crisis to make these changes happen.

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