Fairval

Notes on Indian equities, sectors and economy

Financial costs too high, says Grantham

Posted by fairval on February 18, 2010

Interesting point from Jeremy Grantham’s Jan-10 newsletter

It is so obvious in this business that it’s a zero sum game. We collectively add nothing but costs. We produce no widgets; we merely shuffl e the existing value of all stocks and all bonds in a cosmic poker game. At the end of each year, the investment community is behind the markets in total by about 1% costs and individuals by 2%.

And the costs have steadily grown. As our industry’s assets grew tenfold from 1989 to 2007, despite huge economics of scale, the fees per dollar also grew. There was no fee competition, contrary to theory. Why?

  1.  Agency problems – we manage the other guy’s money, and
  2. Asymmetric information – the agent has much more information than the client.

 Clients can’t easily distinguish talent from luck or risk taking. It’s an unfair contest, nothing like the fair fight assumed by standard Economics. As we add new products, options, futures, CDOs, hedge funds, and private equity, aggregate fees per dollar rise. As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

As total fees in the past grew by 0.5%, we agents basically reached into the clients’ balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%. So, we got a short-term GDP kick at the expense of lower long-term growth.

This is true with the whole fi nancial system. Let us say that by 1965 – the middle of one of the best decades in U.S. history – we had perfectly adequate fi nancial services. Of course, adequate tools are vital. That is not the issue here.

We’re debating the razzmatazz of the last 10 to 15 years. Finance was 3% of GDP in 1965; now it is 7.5%. This is an extra 4.5% load that the real economy carries. The financial system is overfeeding on and slowing down the real economy. It is like running with a large, heavy, and growing bloodsucker on your back. It slows you down.

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