Conferences, those somewhat theatrical groupings of friends and foes, competitors and co-operators, of those seeking new opportunities and those there for a ride, are ripe for a sociological study. As a speaker at the recent Global Absolute Return Conference in Boston, I was struck by the ritualistic nature of a cuddly get-together of hedge fund managers, private equity managers and institutional investors.
How should we judge the value of conferences? Are they worth the registration, travel and accommodation costs, and the opportunity costs? The benefits of access to new ideas and new people are easy to overstate. As a newly minted naïve academic, I expected each conference presentation and each new person I met to reveal ultimate truths. Now my expectations are profoundly pragmatic and reflect the difficulty of creating, articulating, extracting and using ideas.
A one hour presentation or panel discussion is time well-spent if I can extract one new (to me) idea, or one fresh insight into an existing idea, or one notion that challenges a belief or bias. In the same spirit, meeting one person with different patterns of thought makes that time well-spent. To identify let alone to absorb a single new notion demands both a prepared mind and constant unrelenting attention, especially as the most challenging notions often spring unexpectedly and sporadically from unprepared off-the-cuff remarks. Yet in our age of distraction those addicted to iGadgets, constantly fixated on their screen, will likely miss the rare gem of insight, as will those listening to people while simultaneously searching the room for someone ‘better’. I asked an addict why he was glued to his iGadget through presentation after presentation. Paradoxically, his response, “because I might miss something”, ensures that he almost certainly will miss something.
And what might that ‘something’ be? It’s unlikely to be an implementable investment opportunity or something that will quickly make you smarter, richer or more attractive. More likely it will be singularly irritating, something that exposes your inadequacies and your lack of understanding. The ‘something’ may be no more than a vague hint of an unlikely possibility.
One such arose during a discussion on the supposed failure of diversification due to the convergence of correlations - a consequence of massive institutional herding. One panellist stepped away from the safety of prepared well-understood remarks and speculated (how refreshing is that?) that, as Irving Fisher might have put it, correlations are reaching “a permanently high plateau”. Were that the case, we could reconsider the simplicity of a Capital Asset Pricing Model approach with but a single risky asset class (‘the market’) where an investor has a single decision - the weight in ‘the market’ and the (possibly negative) weight in cash. That’s an irritating notion to play with ... and inchoate thinking is indistinguishable from playing.
Economic system complexity defies influence and control
Another ‘something’ was thrown out by the OECD’s William White, an ex-governor of the Bank of Canada, who claimed that central bankers know not what they’re doing, a frank admission made not in a pejorative sense but more as a recognition that the system they try to influence and control may be beyond their influence and control. Because our models derive from misguided attempts to make economics ‘scientific’, central bankers’ implicit metaphor is an engineering control system like air conditioning, a stimulus and response system in which negative feedback mechanisms eventually result in stable dynamic equilibrium; a system where intelligent informed human turning-of-the-dials (think QE II) will eventually lead to desired outcomes.
But what if that metaphor fails because the system’s complexity undermines and defies influence and control? White called for a quite different metaphor, one where the market is akin to an evolving, adapting imperfect biological organism, more like a forest or a coral reef or an English country garden where human involvement is a mixed blessing. One irritating question is whether that metaphor can be extended into a more explicit model, perhaps with practical insights? More irritating still: Is it true that complexity induces stability in ecological systems yet instability in financial systems?
At the conference there were hints of the tension recently exposed by the Nobel awards to Gene Fama, an economic positivist who showed the world to be flat and efficient, and Bob Shiller, a normative economist, who showed the world to be craggy and inefficient. No surprise that the positivists dominated a conference of hedge funds and their supporters. Nonetheless the belief that economics or finance is a value-free science driven by rational expectations was occasionally challenged. The Canadian banker made an explicit plea for economics to return to the principles of its founders - Smith, Bentham and Mill - as a humanist discipline. Barney Frank, the only left-wing, left-handed, gay, Jewish ex congressman, he of Dodd-Frank, was even more explicit in his call for more and better regulation and increased taxes. My similar appeal, part of a proposed solution to the underfunding of public sector pension plans, included the US adopting a simple tax-funded universal health care system, the effect of which would be to cut public pension liabilities by 45%. Later I was told a bunch of gentlemen were waiting to see me dressed in white sheets and carrying a noose and burning crosses.
Fees can’t fall when we all believe we’re uniquely gifted
Most revealing were the responses to “why is there (almost) no variation in hedge fund fee levels.” Hedgies instantly justified 2&20 (2% per annum management fee plus 20% performance fee) on the usual grounds of paying for talent, an attribute they all claim to have in abundance, a justification that for painfully obvious reasons, was strongly supported by their clients. The real answer was left unsaid. In an open free market with no informational asymmetry, competition should force prices down towards the marginal cost of production, as happens with index funds. By comparison, the market for hedge funds suffers from massive informational asymmetry in which the buyer cannot determine quality (nor in truth can the vendor.) In such markets, pricing uniformity should be expected as any lowering of price will be interpreted as a signal of low quality, just as it is for women’s haute fashion.
It’s not only the hedge funds that have an abundance of rare talent. Pension fund executives solemnly declared that they too have a ‘truly gifted and talented team’ and a ‘wonderful board’. Why is it beyond us to openly discuss our inadequacies and failures? Especially in the faux science of economics and finance, we can learn most from revealed inadequacies and failures.
Dr Jack Gray is a Director at the Paul Woolley Centre for Capital Market Dysfunctionality, Faculty of Business, University of Technology, Sydney, and was recently voted one of the Top 10 most influential academics in the world for institutional investing.