Issue: June/August 09


Democratic revolution needed

Unless the agent/principal conflict is overcome, there’ll be more financial crises with increasing regularity. ANNE CABOT-ALLETZHAUSER examines the argument. to get equilibrium to get equilibrium

Roughly 90% of all share-market transactions today have some form of agency intermediation. It would be by the trader acting on behalf of the investment bank; the fund manager acting on behalf of the unit trust or pension fund investors; the stockbroker executing trades for individual investors or day-traders, or the analyst making recommendations to the broader public.

With every step distancing the investor from the trade comes an increasing risk that markets will continue to be driven by herd mentality and less by fundamental economic logic. Consider this simple point made by Georges de Nemeskeri-Kiss and Yannick Maleverne of Emylon Business School: If most decisions in modern financial markets are taken by agents and not principals, and agents continue to be evaluated and rewarded on the basis of short-term performance relative to their peers, it will be safest for them to stick with the herd.

The more herd-like the market becomes, the poorer the quality of decision made by the total sum of its participants. Worse, the herd instinct cannot be regulated by law. Unless one tackles the immediate agency conflict at the heart of this dynamic, it will persist with each subsequent market crisis.

Of all the publications that have accompanied the recent financial crisis, perhaps the most thoughtful and thought-provoking is Robert Shiller’s The Sub- Prime Solution. Shiller, an award-winning author and Yale professor of economics, argues that things have the potential to get so bad that “we eventually put aside political and policy differences and fall back on a more social contract – one that dictates that we as a society will protect everyone from misfortune and keep existing problems from spreading”.

Perhaps the election of Barack Obama as US President provides an indication that this point has been reached by America’s citizens. This time, unhampered by manipulations from the sidelines, the American public actually did make an astonishing decision as a collective that no-one who understood the individual participants could have ever anticipated.

So, if Americans are going to put aside bi-partisan politics and maintain this collaborative social contract in meeting the current challenge of the financial crisis, the bottom line is that any bailouts cannot be directed at simply maintaining high asset-class prices. Rather, the focus must be perceived as being to prevent distress among people of modest means. If we can stick to this agenda, there may well be hope.

Shiller is unequivocal that these “bubble” phenomena will repeat themselves, and at increasing regularity, unless we shift our focus to democratising finance. He believes it provides us with our best shot at countering the current endemic agency/principal conflicts. This effectively means ensuring that advice, information and access are widely available to the broadest classes of savers and investors, not just the wealthy or professional.

It suggests, for one thing, that Newsweek contributor Paul Kedorsky was on the right track in his plea for the broader community to demand that the Internet be refined into a far more meaningful aggregator of information that filters the more reliable, quality information at all levels.

But it also demands a return to sanity in terms of how investment professionals are rewarded and to what quantum. John Bogle, founder of the Vanguard mutual fund group, has eloquently argued that individual investors put up 100% of the capital, take 100% of the risk and share in as little as 30% of the takings (if there are any). But investment intermediaries get away with putting up none of the capital, take none of the risk, and walk away with handsome compensation irrespective of whether they win or lose.

Extraordinarily enough, the investment industry has for some time had clear insights as to approximately how much ‘alpha’ (benchmark outperformance) a top active manager could potentially generate over the long term. Yet still it believes it can charge investors, in total, more than this quantum and that the investor will be none the wiser.

One subtle message coming through the turmoil is that investors cannot completely abdicate responsibility for their investment to so-called professional agents. Rather, they need to be assisted in developing strong oversight mechanisms that provide insights and guidance as to how these investments could be most effectively managed. This is where government, regulators and professional associations such as the CFA (Chartered Financial Analyst) Institute can play a critical role.

In truth, if anything is going to re-establish equilibrium to the agent/principal dynamic, push us beyond the current herd mentality of the markets, and restore wisdom to the markets through its collective individuality of purpose and thought, it must surely be that investment professionals need to demonstrate their professionalism.

They’d do it by acknowledging that their fortunes and reputations are inextricably linked with their clients’ success, not with the financial success of the institution which employs them.

• The Sub-Prime Solution by Robert Shiller
(Princeton, 208pp, $16,95).