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Thomas Macpherson
Thomas Macpherson
Articles (165)  | Author's Website |

Responsible Capitalism: A Reply to Howard Marks

Responsible capitalism means not only growing the pie, but growing how many and how much the ordinary investor shares in its rewards

April 11, 2019 | About:

I don’na mind I ain’t rich. And I don’na mind he ain’t poor. I just canna stand it ain’t ever gonna change, that’s all.” - Jock Druery (Fictional Character, 1857)

The greatest threat to capitalism is capitalists. When these individuals lose sight of the fact that capitalism is as much a hope-based system as a capitalist system, then the whole structure is threatened. Recently we’ve heard capitalist thinkers tell us that socialism is about shrinking the pie and that capitalism is about growing the pie. I wouldn’t question that thesis. But I would question whether growing the pie – and having a very select group of people eat greater and greater amounts of this growing pie is any different than their fears of socialism and a shrinking pie. Whether you go hungry because the system doesn’t manufacture enough bread or because an increasing amount of bread was made, and a few lucky individuals got to eat even more than ever, is irrelevant. You’re still hungry, and you still feel screwed. The latter is the threat to western capitalism, not the former. Anyone arguing the former simply has an insatiable hunger for bread.”

- Sandra W. Hall

I was recently reading Howard Marks' (Trades, Portfolio) latest memo in which he took issue with socialism and some of the ideas and recommendations from those in the “Democratic Socialist” wing of the Democratic Party. It’s not my intention to take a stand on any of the issues he brings up or the current political debate, but rather address the issue he never really fleshed out – the meaning of “responsible capitalism”[1].

Capitalism works best when capital is wisely allocated. The purpose of a group of businessmen gathering under a New York City buttonwood tree in May 1792 was to create an environment where companies could get access to capital and shareholders could enjoy the benefits of putting this capital to work. Successful capitalism requires a system where stakeholders – small businesses, vendors, local and state governments see direct – and indirect - benefits from having companies reside within their greater community. When all these individuals and institutions – the company, its employees, its shareholders, its vendors, the communities and people in which excess profits are spent – see the benefits of well-deployed capital, then that (at least to me) is the definition of “responsible capitalism.”

Here I will use Marks’ (along with my) industry – investment management – as a test to see how responsible capitalism has been over the past several decades. One of the roles of the financial investment industry is to allow the American worker to put their hard-earned capital to work and allow the strength of the U.S. and international markets to grow this capital and generate adequate returns to meet their goals – whether it be their child’s education or their future retirement. For generations, workers have expected the financial industry – either through their pension plans or more recently 401k plans – to generate wealth and carry their half of the capitalist bargain – the worker toils to earn their wages and the financial community assists in meeting their long-term goals.

This model worked well for nearly all of the 20th century. It made the American middle class the envy of the world. It’s what brought my family to this country. But somewhere in the latter part of the 20th century, capitalism and the functions the markets play in capital allocation changed. These changes can be summed up in the following ways.

  1. The financial markets went from being a facilitator of corporate ownership (long-term investments) to corporate rentals (day trading and excessive portfolio turnover). The idea of owning a piece of a business went to the idea of trading pieces of paper or clicking on buy and sell keys.
  2. The traditional risk-reward (an American worker invested in the economy through the stock market and was rewarded over time) was replaced by an agency model of 'heads I win, tails I win more.' Over time, more and more individual investors have taken the risk but seen less rewards.
  3. Frictional costs created by agency action (rapid trading, management fees, marketing fees, 2-and020 agreements) are subtracting far more value than adding it to investor returns.

Let’s take a look at these friction-related costs that no one seems to want to discuss yet play a devastating role in reducing the size of the pie. In 2004[2], investment bankers and brokers generated $220 billion, mutual fund fees were roughly $70 billion, pension management fees were $15 billion, hedge fund fees came in around $25 billion, and personal advisor fees around $5 billion. Note that these numbers don’t include investment services fees generated by banks and insurance companies (like the 1% fee layered on by many bank in-house investment management groups). Just these numbers alone come to roughly $350 billion directly deducted from investor returns. Adjusted to 2019 dollars, these numbers are estimated to be nearly $680 billion. That’s nearly two-thirds of a trillion dollars in one year.

As I said earlier, capitalism works best when capital is allocated wisely. In the case of the investment management business -- for all of these hundreds of billions paid -- you would think that capital has flowed to agencies because they provide additional returns to investors. That assumption couldn’t be more wrong. Going through each category we find that each agency has deducted from investor returns and simply made profits for their respective function.

Investment bankers and brokers work to bring companies together to conduct mergers and acquisitions. Yet, according to the Harvard Business Review, 70-90% of those mergers and acquisitions are value destroyers for investors[3]. In 2018 alone, the total global value of mergers and acquisitions came to $3.8 trillion[4]. Assuming the HBR failure rate, that’s an extraordinary amount of capital destruction. Who pays for this? Shareholders do as good will is slashed from the balance sheet over time.

Actively managed mutual funds have an abysmal record in outperforming index funds. In my article, “Mutual Fund Survivorship: The Revenge of Abraham Wald,” of Jan. 2 2015, between 1997 and 2011, roughly nine out of 10 actively managed funds underperformed their index fund proxy. Forty-six percent of the funds were simply closed or merged away because they were doing so poorly. Additionally, funds are charging too much to compete with index funds. In another article, “Are Management Fees Coming Down? Yes, Sort Of...”, on April 28, 2015, I wrote that fees are not coming down proportionally to the growth of assets under management (i.e., no economy of scale).

As of September 2018, local and state government pension funds have $4.41 trillion in assets under management. Putting aside the accuracy of pension actuarial assumptions, pension funds have a long history of underperforming due to several reasons. First, their expenses – after layering on fees charged by their holdings such as mutual funds or hedge funds – make it nearly impossible to outperform the general markers. Second, pension fund investments in hedge funds have proven to be an expensive experiment in poor returns (see hedge funds section). The Center for Retirement Research at Boston College (CRR) took a look into the variation of returns to investigate why some plans perform better or worse than others. The study examined the period from 2001 to 2016, during which public plans earned an annualized return of 5.5%, well below the average return assumption of about 7.6%. Who receives either a lower pension payment or increases in deductions? Pension plan participants (i.e., the common worker).

Why this matters

When Howard Marks (Trades, Portfolio) talks about socialism and the danger of a shrinking pie, I think he (and all of us who are professional capitalists) have to take a long hard look at how well we’ve done in both growing the pie and sharing that pie with individual investors. From the college student or blue-collar worker who puts their hard earned $50 into their IRA or 401k, to the retiree who relies on their pension plan to enjoy their retirement, these individuals deserve their share as much as any hedge fund manager making $5 billion a year in New York City. True parity and fairness would require “responsible capitalism.”

Don’t get me wrong. My family came to this country because it was the capitalist engine (combined with a democratic republic) that drove world growth. I couldn’t have been more proud then – or now – to be an American and taking part in a capitalistic system that rewards (generally) hard work, diligence and acquired education. As a professional capitalist, I think it’s the best system in the world. But there are improvements that could improve the system to make it more “responsible,” in Marks’ words. Here are a few ideas I humbly suggest.

Too Many Fees, Not Enough Value: The amount of value extracted from our capitalistic system by the financial industry far exceeds the value it brings to the table. Ranging from ridiculously high management fees to sky-high turnover to even bank ATM fees, individual investors and consumers are increasingly demanding cheap and effective financial solutions. As an active investment manager, I see the warning signs everyday – the growth of passive and index investing, fund withdrawals, continued underperformance. This list goes on and on. If our industry wants to keep extracting so much capital from the markets, then it needs to either find a way to increase value or decrease costs.

Too Much Selling, Not Enough Thinking: In many ways, the investment management business has become like the pharmaceutical business – too much focus of sales and promotion and not enough on R&D and science. It seems every major investment house has become a marketing machine – touting short-term Morningstar star ratings and turning over entire portfolios in six to 12 months. Not enough time is spent on thinking about long-term value, customer needs, and simply being patient and letting the magic of compounding do its work.

Too Much Pie Subtraction, Not Enough Pie Sharing: All too often Wall Street spends its time thinking about new (and of course expensive) ways to convince investors to spend their hard-earned dollars on products that have little chance to deliver outperformance – or even adequate performance. How many individual investors really need a triple leveraged short-based ETF on oil futures? When I was growing up, I had a paper route where I delivered 127 newspapers daily. It took three runs on my bicycle but I realized that if I did my job, delivered the papers on time, in good condition, and treated my customers with respect, then I would do pretty well when it came to payday on Saturday mornings. The editor of the paper said to me once, "The more complicated you make the product or the services, the more the customer pays and the less value they get. And most people aren’t stupid. They’ll find another way to get the news when they realize they’re getting screwed." I tell my clients my services are pretty simple – I allocate their money and charge them a modest rate with the goal of meeting their financial needs. That’s about pie sharing, not about pie consumption.

Conclusions

It wasn’t my intention to write an article on the issues of improving capitalism, nor make it the longest article I’ve ever written. But as a professional money manager with clients seeking to achieve their financial goals, it’s important that as professionals we take a long hard look at the issues that are causing tectonic shifts in our industry. We can only succeed when our clients succeed. That means getting back to the basics that made capitalism great – getting the largest amount of individuals to share in the risk and rewards of a growing economy and making sure as many feel and see these rewards as possible. In the end, it might just mean eating some humble pie.

As always I look forward to your thoughts and comments.

Disclosures: None.


[1] Ray Dalio (Trades, Portfolio) had a slightly different take than Howard Marks (Trades, Portfolio) in his rather contentious discussion about why capitalism needs to be reformed in an appearance on CNBC April 9 2019. Video can be seen here: https://www.marketwatch.com/story/watch-cnbc-host-get-into-heated-exchange-with-ray-dalio-over-capitalism-2019-04-08

[2] These numbers come from Jack Bogle’s research at the Bogle Financial Markets Research Center at Vanguard Corporation in Valley Forge, PA.

[3] Harvard Business Review, June, 2016. “M&A: The One Thing You Need To Get Right”. In 2015 Microsoft wrote off 96% of the value of the handset business it had acquired from Nokia for $7.9 billion the previous year. HP wrote off $8.8 billion of its $11.1 billion Autonomy acquisition. Finally, in 2011 News Corporation sold MySpace for $35 million after acquiring it for $580 million just six years earlier.

[4] Wall Street Journal, Money Beat http://graphics.wsj.com/investment-banking-scorecard/

About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 3.9/5 (8 votes)

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Comments

Valuator
Valuator - 4 months ago    Report SPAM

So give all of your money away, hypocrite.

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

Hi Valuator. Thanks for your comment. I think it's important that any professional can look objectively at their industry and find ways to improve it. Does that mean - being a professional investent manager - that I give all my money away? You might not have read my earlier article where I outlined Nintai's corporate giving (not including my own). Not only do we eat our own cooking, we also help cook for others. If questioning our business model and looking to improve our profession makes me a hypocrite, then I wear that title proudly. Thanks again. Best - Tom

stephenbaker
Stephenbaker - 4 months ago    Report SPAM

Tom, I believe that the professional money management industry is the exception that proves the rule: risk takers should either fail or be rewarded - certainly not both. That said, your industry does seem to reward mediocrity. The question is, why? I don't mean this as a question of why portfolio managers are highly compensated, but why investors continue to be willing to pay for lousy performance? The obvious answer is they are not, hence the rise in passive and index investing. It seems to me that unless a majority of active managers are somehow able to outperform indices on a regular basis, the public will recognize that, with few exceptions they are throwing their hard-earned money away on empty promises. It looks like this is already happening. Thanks for the article.

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

Hi Stephen. Thanks fo your comment. You ask a very interesting question. There are certainly mechanisms in place for people to choose another manager or move to an index as you point out. It seems to me it's somwhat similar to doctors. It's amazing how much patients will endure with a lousy doctor - bad bedside manners, rude, poor record of correct diagnosis, etc. People seem to accept mediocrity in fields considered very high in level of skill and expertise. In any case, it will be interesting to see how it all works out. Thanks again for your thoughtful reply. Best - Tom

batbeer2
Batbeer2 premium member - 4 months ago

Thanks for sharing your thoughts. I read that memo too and I agree with most of what you say but it is a very complex matter. IMHO Howard Marks (Trades, Portfolio) got it wrong this time. AOC got it wrong too. Both are trying to figure out what makes the US work while living in it and it is simply harder to see the big picture when you're part of it.*

So let me toss in my 2 cents.

Marks says: >> One of the roles of the financial investment industry is to allow the American worker to put their hard-earned capital to work ..... to generate wealth ..... This model worked well for nearly all of the 20th century.

That is the killer argument that is so often used to defend Wall street-style capitalism. 1) America is an economic miracle, 2) America has Wall street so 3) .....

Of course, capitalism is not equal to Wall street but l'd like to get a bit more precise. Let's design a society that improves the wealth of a large fraction of the people in a short time. We start by taking a look at some societies that have achieved that:

US 1917 - 1929

Nazi Germany 1933 - 1940

Israel 1947 -

US 1950 -

West Germany 1950 -

Singapore 1950 -

Uruguay 1985 -

China 1990 -

Then you take some variables like corruption (rule of law), education/literacy, agricultural mechanization, the existence of sophisticated securities market, women participating in the labor market, tax rates, etc. etc. You then figure out which of those variables correlates most with high per-capita GDP growth. It becomes obvious that a highly developed securities market is not the cause of high per-capita GDP growth. Neither is the political "philosphy"; conservative/capitalist versus progressive/socialist.** I would bet good money that it is the rule of law, women and higher taxes on labor (lower some forms of capital) that correlate strongest with the emergence of a wealthy middle class.

In any case, I am confident that you can have satisfactory per-capita GDP growth without the overhyped liquidity created by Wall street. Conversely, an efficient capital market and/or a well developed money-management industry won't save the middle class if you have a corrupt government. It would be easier to prove that these industries create economic volatility than to prove that they generate wealth.

I'm doing this off the top of my head so feel free to poke holes in my reasoning or "data".

Just some thoughts.

*If I'm not mistaken, AOC and Howard Marks are both from planet NYC. This makes it even more difficult to understand the tribulations of sublunary mortals :-)

** I believe Marxism (<> socialism) inevitably leads to a corrupt government so these variables are not totally independent.

Thomas Macpherson
Thomas Macpherson premium member - 4 months ago

Hey Batbeer. Thanks for your comment! In regards to poking holes in your data, I will leave that to much brighter people than me. In that quote, what I was simply saying was that for a 6 year old kid from Scotland where unemployment was in the mod-20s in some neighborhoods, the Amerixan dream was a terrific magnet to a kid who wanted to climb the greasy pole.

stephenbaker
Stephenbaker - 4 months ago    Report SPAM

We don't need a "wealthy middle class". What we need is the opportunity for a wealthy middle class. Capitalism provides that opportunity better than any existing alternative. What people do with the opportunity is largely up to them. "Progressives" who criticize capitalism should ask themseles who they are seeking to protect and why. They should also ask whether the people they are trying to protect are doing all they can to better their own lives. The policies that have been proffered suggest that the protected class is somehow an entitled class. Entitlement is not the underlying principle that allowed this country to achieve unparalelled success for its first 200+ plus years, nor has it ever been the basis of any form of success.

batbeer2
Batbeer2 premium member - 4 months ago

>> We don't need a "wealthy middle class". What we need is the opportunity for a wealthy middle class.

Fair enough, there is some truth to the notion that it is the wanting that motivates whereas the having does not. But I don't think it is wise to extend this thinking to its logical extreme.

The logical conclusion would be that we should promote the illusion of opportunity and/or pass laws against inheriting anything from your parents.

I'll assume you were born in the US and you were raised speaking English. In that case, your society gave you a totally undeserved bonus worth at least $50k the day you were born. Same for Buffett and Gates by the way. They have been very good at compounding that value over the course of their lifetime.

How do I get to $50k? Imagine the US was selling citizenship at $50k apiece. Do you think there would be buyers? Well... you got that for free the day you were born. You did nothing to deserve that "socialist" gift from your government. In a radically capitalist society, the government should be selling citizenship to the highest bidder.

US citizens should count their (not always deserved) blessings.

stephenbaker
Stephenbaker - 4 months ago    Report SPAM

Batbeer, I think you are taking my words to an illogical extreme. The issue is quite simple: Do we encourage people to succeed or not? My position is that we discourage success by providing more than necessary free goods and services that people are capable of generating for themselves.

batbeer2
Batbeer2 premium member - 4 months ago

Batbeer, I think you are taking my words to an illogical extreme.

You are right, I did.

Not illogical though, just extreme. I have no problems with capitalism and I agree with your point. I consider myself a capitalist. But it is important to realize that it should not be taken to extremes (that's why I did it). The question then becomes where those limits are. I think AOC took it over the limit in one direction and Marks took it over another limit.

stephenbaker
Stephenbaker - 4 months ago    Report SPAM

I suspect that what prompted Marks' position is not so much that he wholeheartedly endorses capitalism in its present form. Rather, I think he is chastising supporters of AOC for pretending to support the end of capitalism when they are really just seeking to move the needle for political gains. The fact of the matter is, most people in this country are just right or left of center. Extreme positions garner headlines but as we have seen lately, headlines quickly come and go and are just as quickly forgotten.

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