The past decade has been dismal for the financial industry, what with the great recession, the rise of index funds and demands for increased transparency. One thing that hasn't changed: the amount of money the industry takes in from its clients.
The industry's success at keeping the cash flowing shouldn't be a surprise. Essentially, banks, brokers and money managers have managed to keep their revenue fairly steady for an impressive 130 years.
That analysis comes from Thomas Philippon, an MIT-trained French economist and New York University finance professor who advises the New York Fed on monetary policy. He lumped together all parts of finance — traditional banks, stockbrokers, fund managers, investment banks and others — and measured the industry's share of GDP against the amount of assets it handled.
His conclusion: From the era of railroads and the telegraph to that the internet and smartphones, the price charged by the finance industry to turn a dollar of savings into a dollar of investment has mostly remained between 1.5 cents and 2 cents for every dollar that passes through the finance industry.
The industry has done lots of things to keep the cash flowing in from its clients. But through the years, as products get simpler, more transparent or cheaper, the financial industry finds new ones that are more risky or complex and usually more costly.
The global asset-management industry, for example, has been hit by the extraordinary rise of index funds, which charge minuscule fees. But while investors seized these cheap options, they have also thrown cash at high-fee hedge funds, private equity and structured products.
The result? In 2003, the industry got 36 cents in revenue for every $100 of money it managed. In 2016, all fund managers globally got 37 cents for every $100 managed, according to Boston Consulting Group.
Most other industries produce things that are either much cheaper or higher quality than they were 130 years ago. In an earlier paper, “Finance vs. Walmart,” Mr. Philippon found that technology investments by retailers and wholesalers over the past 50 years gave those industries better productivity and a lower share of GDP.
Finance mainly got bigger and more complicated. Some of this may have been socially useful. When the safest lending became more efficient and less profitable, financiers looked for higher fees and interest income from riskier borrowers, extending loans to people and firms previously excluded. Such financial deepening helps economies, but can run too far. Rapid growth in subprime mortgages and junk bonds brought big financial crashes.
Instruments such as CDOs simply repackaged the same loans, sometimes many times over, adding fees and hiding rather than mitigating risks. Other activity, such as highspeed trading that just shifts profit between traders, may not hurt the economy but adds no value.
The latest income-boosting effort is private equity and private lending, which takes transactions out of well-lit stock and bond markets and well-regulated banks and into less transparent and less efficient direct transactions. When assets are less liquid, prices harder to discover and information less available, more profit can be baked in. Assets in private capital markets have tripled to $4.8 trillion since 2006.
The best private funds can produce fabulous returns, but the worst lose large sums of investors' cash. On average, it is arguable whether they beat public stock markets. Both alternative funds that invest in private markets and passive funds that track indexes have taken market share from traditional active managers. But passive funds earned just 6% of industry revenue in 2016, whereas alternative managers took 42% even though they manage fewer assets—and that revenue excludes their hefty performance fees.
In wealth management, the rise of fee-based accounts has helped banks and brokers sidestep pressure on commissions and fund fees. Michael Spellacy, lead partner on Accenture's global wealth practice, says brokers with $500 million in assets who charge a 1% annual fee will likely clear more from charging commissions on stock trades (typically $5-$6 at discount brokers, or $25-$30 at full-service firms). “How many trades would [the adviser] need to do to match that fee revenue?” he asks. “A lot!”
Some people have complex financial lives and need this kind of advice. But in many cases, investors are paying more for products or advice they don't need because very smart people are paid very well to convince them that they do. The finance industry has many talents. One of the most impressive may be its gift for self-preservation.
Note: Global asset management data currency conversions done at end 2016 rates to dollar.
Sources: Boston Consulting Group (global asset mgmt.); Thomas Philippon, NYU Stern School (cost of intermediation); Accenture (wealth-manager accounts).
BY PAUL J. DAVIES