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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
Contact
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2
April-23-14

The Finance Industry: Not So Efficient Markets

The financial industry looks expensive and inefficient.

The role of finance is the efficient allocation of capital between lenders and borrowers. In doing so funds are pooled, risks are shared and resources are transferred based on information encapsulated in prices.

A recent study assessed the productivity of the financial industry and concluded that, unlike almost every other industry, today’s finance industry is not any more efficient than the finance industry of a century ago. One hundred years of motor vehicles, aeroplanes, telephones, computers and the internet have not improved the cost of financial intermediaries as a percentage of assets. How can this be?

The finance sector acts as an intermediary between lenders and borrowers. The retail trade (think Wal-Mart) is another intermediary industry which provides a useful comparison. Starting in the 1980s IT expenditure’s share of equipment spending in the retail sector has increased 40 fold and over the same period  the retail sector as a proportion of the economy has shrunk by 25%. This is not because people are buying less “stuff” but simply that IT has made the cost of intermediating between retail buyers and sellers much more efficient. Put another way, IT investment has made the retail sector much more productive.

By comparison the impact of rising IT expenditure in the finance industry has been to increase finance’s share of the total economy, to the extent that the finance industry represents an all time high of 9% of GDP. Why is this occurring and who benefits?

The answer to the first question is trading. Trading of investments has increased 200 fold in the past 35 years, as seen by the chart below.

Ratio of Equity Trading Volume to GDP

Source: Phillipon (2012)

The Guide to the Markets (2014) produced by JP Morgan, an investment bank, assessed the average investor return over the past 18 years to be 2.3%, less than every major asset class and even less than the rate of inflation. The reason: trading. In a 2008 study Ken French estimated the cost of wasted trades trying to outperform the market to be $101.8 billion (in 2006) in the United States. By wasted trades we mean active trading that produced, in aggregate, no net gain for investors, but considerable gain for the finance industry. That is $101.8 billion that could have been used by investors to fund their retirement but instead has been funding their brokers’ and fund managers’ retirement. 

Frankly, all this makes us a bit cross. 

We think owning investments is a creditable and effective process for providing for retirement and for providing capital to companies that can provide employment opportunities for our children. Trading investments, by contrast, more often than not transfers wealth to an expanding financial sector with very little benefit to those whose assets are being traded.

For readers in Waterloo Region, we invite you to join a conversation about how to invest effectively and retain the proceeds.

By: Graham Westmacott | 0 comments