Frogs, football and financial assets

With the stock market hitting new highs, the economy in slow growth and the increasing use of derivatives as a proxy for real assets, there are reasons to worry.

An old adage says that a frog, if thrown into a pot of boiling water, will immediately jump out. If, however, the frog sits in a tepid bath in which the temperature is gradually raised and brought slowly to a boil, the frog, not sensing the dramatic change, will perish in the heat.

The lesson in this adage is twofold.

First, harmful change in small increments can go unnoticed.

Second, not only is it more palatable to the senses, but the dilatory effects can be much worse than a sudden shock. This is true not only in the science lab but also in society, the markets and the economy.

The danger of being lost in the moment without a longer-term market and economic perspective may be a cautionary tale of wealth squandered.

Capital is a resource — it is scarce.

The study of economics is how society allocates its resources and goods. Savings are limited. In a capitalist society, individuals can — and are encouraged to — put their personal capital at risk by investing in business enterprises. This is the classic definition of capital formation.

For taking on capital risk, we expect a fair return.

GREAT CAPITALISTS

The great American industrialists Andrew Carnegie and John D. Rockefeller risked capital and built tangible businesses that changed the U.S. economy and American society forever. With the advent of formalized pooled funds, the opportunity to invest directly in businesses was expanded to the general public.

The first U.S. mutual fund was started in 1924 — Massachusetts Investors Trust (now MFS) — and those that followed were wildly popular, as they afforded the public the opportunity to pool capital efficiently. The passage of the Securities Acts of 1933 and 1934, and then the Investment Company Act of 1940, gave form and permanence to the mass participation in capital formation.

One can romanticize these offerings by arguing that embedded in them is the democratization of our capitalist society. Humble roots can’t stop someone from pooling savings with others to invest in businesses that purchase manufacturing equipment and raw materials, hire employees, and produce goods and services that generate profits. These returns come back to individuals who can invest in more businesses, create more capital and reinvest again. It is the great American story of wealth creation through wide participatory capital formation.

It has raised the standard of living and built our middle class. Central to all of this were financial advisers.

Since the industrial revolution, there has been a necessary and gradual shift in our understanding about how to invest and construct portfolios. We have moved away from the old way of assembling a portfolio of stock and bond holdings. The selection takes time, research and legwork, and the investment is both in the idea and in the management of a company. Over time, with the growing acceptance of modern portfolio theory and asset allocation strategies, stock selection has taken a back seat.

Broad diversification through mutual funds became the preferred method. The “cheese” was moved again when luminaries such as John C. Bogle, founder and former chief executive of the The Vanguard Group Inc., and Charles Ellis, founder of Greenwich Associates, introduced different perspectives that brought a paradigm shift: minimizing investment-related costs and expenses (including the time and energy required to hand-pick companies) as the optimum way to construct portfolios. The march moved — carefully or otherwise — toward index funds. These funds remove much of the frictional costs of investing, apparently to the benefit of everyone.

In fact, trading of index products — in particular, exchange-traded funds — dominates the market. ETFs are about 60% of all equity volumes.

THE EMERGENCE OF DERIVATIVES

The change continued as the emphasis on low-cost investing led naturally to the use of derivatives, whereby a fund can control huge amounts of an asset for a fraction of the cost of the actual equity. Derivatives, designed initially as indispensable tools for hedging risk, managing cash flow for businesses and reducing exposure, are being engineered for the specific purpose of creating asset class and investment strategy exposure.

Derivatives are used not just as a tool that allows farmers to hedge future crop prices or businesses to manage cash flow. They have far outstripped this traditional explanation for their stated use.

We can see the proliferation of investment funds that, extensively and sometimes exclusively, use derivatives to express the investment outlook of the manager and the trillions of dollars in capital they now attract.

Financial assets are now 10 times the value of global output of goods and services. There are $600 trillion in financial assets, versus the U.S. asset base of $210 trillion of real assets and gross domestic product of $63 trillion as of 2010.

Bain and Co. projects that this disparity will increase by 2020 to $900 trillion in financial assets, versus $300 trillion in real assets relative to $90 trillion in GDP. These ratios represent a dramatic change.

For the most part, the development goes unnoticed because it has been 90 years in the making. Once in awhile, derivatives capture the public’s fascination, albeit briefly, as it did three years ago when executives of The Goldman Sachs Group Inc. described synthetic collateralized debt obligations during congressional hearings.

LINES ARE BLURRED

Inexplicably, over close to a century, the desire to invest in tangible companies and assets has waned, replaced by asset class exposure at the lowest frictional cost. The lines between real assets and financial ones have been blurred.

However, there is an important distinction between the two methods of investing. The difference between investing using a derivative versus investing in a business is comparable to the difference between starting a football team and betting on the outcome of the Super Bowl.

Money changes hands in both scenarios. But one course of action creates a team of players which will go on to evolve and grow, perhaps bring in crowds, sell popcorn and beer, employ people and maybe win multiple trophies over years and years.

The other is making a bet that either pans out or doesn’t. After the transaction, the only evidence is the record of money changing hands.

So it is with derivatives.

Derivatives are an essential part of many portfolios and an important tool for many businesses. But they are undoubtedly a zero-sum game, where for every long position, there is a short position. None of the capital is committed to raw goods or equipment. There is a winner and a loser. There is only wealth transfer, no wealth creation.

The economy and the markets are dynamic. Market inefficiencies are found, exploited temporarily and resolved.

As students of the markets and watchers of the economy, we need to understand that change, even if it takes place over a century, can be significant. We know that there is an outcome for shifts in resource allocation. So what is the outcome of capital shifting toward derivatives? Does pricing theory regarding capital being a scarce resource for business suggest that the price for capital in financial assets diverge from real assets?

On average the correlation among all asset classes has more than tripled since 1995. Is the current form of investing in any way connected to the increasing correlation between financial assets? Does the diversion of capital toward financial instruments partly explain why the economy is in a slow-growth mode while the stock market is rising rapidly? Does any of this matter when constructing a client portfolio?

Whatever advisers’ answers to the above, my advice is to be cognizant of incremental change. The water may begin to simmer before long. By then it may be too late.

Mark Goldberg is managing director of W.P. Carey Inc. and president of Carey Financial LLC.