Monday, 6 September 2010

Investment Banks and Hedge Funds: the Bubble of the Past Quarter Century?

The Credit Bubble leading to the Crash of 2008. Who profited and where did all the money go? That's a question I have been asking myself since 2007 and the start of the credit / financial crisis. The answer I now believe is a) employees of investment banking; b) managers / employees of hedge funds; c) shareholders with stakes (i.e. whether as separate entities or whose profits flow up to a parent entity) in investment banking and hedge funds.

The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."

In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the website - N.B. I have added to Research Affiliate's chart the red Bubble line)

The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.

When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.

I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.

What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:
  • USA - in Vanguard's Market Cap VTI, Financial Services = 16.4% as of 31 July 2010 vs Powershares RAFI PRF = 20.9% as of 31 Aug 2010
  • Canada - iShares TSX Composite XIC = 29.6% vs Claymore Canadian Fundamental Index CRQ = 45% as of 3 Sep 2010
  • World - Vanguard All-World ex-US VEU = 25.8% as of 30 April vs PowerShares Developed RAFI ex-US PXF = 28.9% as of 3 Sep 2010
Regulators will impose new regulation to control and to deliberately reduce the size of Financial Services (as the Paper of the Year post reports, regulation is the only thing that effectively controls the size of the sector, not market forces). But the authorities don't know how much to reduce -
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".

And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at, others at, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).

It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.

Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.

Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.

Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.

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