Daily Equity Report

A debate on a controversial topic, “Financial Innovation Boosts Economic Growth” was hosted by The Economist magazine last year. GMO head, Jeremy Grantham went up against Nobel Prize winner Myron Scholes and Robert Reynolds. Grantham’s view was unequivocally that financial innovation has not boosted growth, quite the contrary.

One does not typically hear a very successful fund manager – GMO manages $107 billion - speak up against his own industry, but here are some of the points that he raises.

• The financial services industry is a zero sum game, which collectively adds nothing but costs. At the end of the year, the collective investment community is behind the markets in total by 1%.

• These costs have risen over the years. Despite the investment industry in the US growing tenfold from 1989 to 2007and huge economies of scale, fees per dollar also grew. He attributes this to 2 main reasons
o Agency problems. It’s the management of third party money; and
o Asymmetric information, where the agent has more information than the client.

• Adding new products such as options, futures, CDO’s, hedge funds, private equity etc, only adds layers of fees and additional complication.

• He notes than in 1965, where there was a perfectly adequate financial services industry in the US, finance was 3% of the GDP. It has more than doubled to 7,5%, which is an extra 4,5% load on the real economy.

• His calculation is that the increase in financial services has slowed down the real economy as follows. For 100 year GDP grew at 3,5%. After 1965, GDP ex finance it fell to 3,2%. After 1982 it fell to 3,1% and after 2000 to end of 2007 it fell to 2,5%.

• “The client world pays up precisely in proportion to how bamboozled it is by unnecessary complexity and this, among other negatives, is what the fancy new Instruments were offering: confusion, doubt, and bamboozlement.”

These are strong views indeed. Most private investors would agree wholeheartedly with this sentiment. Because it is a zero sum game, there are certain investment practices that over time add value – conversely others that detract.

Kind regards

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966