Ethics have gone down a rat hole: Grantham

When a volcanic ash cloud prevents a distinguished speaker from flying in from Europe to address your conference, it’s always good to have a backup. Better still if that backup is Jeremy Grantham, chief investment strategist and founder of GMO LLC, and author of an enormously popular quarterly newsletter.

“I think the financial industry has kind of lost its way, become a rogue industry and is growing out of control,” he told the audience at the CFA Institute’s 63rd Annual Conference, in Boston. “It’s not obeying the usual laws of capitalism that were suspected to be useful, shall we say.”

When Grantham arrived in the U.S. in the mid-1960s, the financial industry accounted for just 3% of GDP, and supported the “real” economy industries. That decade, despite its political and foreign problems, was America’s best economic decade, he says, with growth of 4.5%.

“[Finance] grew steadily from that point to become 7.5%,” he said. “An extra 4% of GDP was going to the financial industry, whose sole function is to facilitate the other 93% [of the economy].”

Along that path of growth, however, the industry was stricken with moral decay, which affected every aspect of the sector, including his own: investment management.

“If we change our fees from half a percent of total assets to one percent, what we do is reach into the balance sheet of everybody else, and instead of saving 7%, the save 6.5%, because we’ve taken an extra half a percent. We turn that half a percent of savings that they would have had, into this year’s GDP.”

This short-term boost to GDP comes at a cost to long-term GDP growth, he said, because the client is left with less to invest, and over time the extra half percent per year in fees compounds. This, in part, explains why GDP growth has slowed so dramatically from the 4.5% rate of the 1960s.

In the 1960s, the U.S. mutual fund industry experienced negative flows, he says, but then growth exploded in the 1970s, and assets under management grew by a factor of 10.

Economics 101 dictates that the massive improvement in economies of scale and increased competition would result in lower fees. And yet the average fee per dollar managed increased.

“Capitalism says that doesn’t happen. If you have huge economies of scale and many players, the fees are passed through the system and ‘competed’ down until you make a normal return on capital,” he said. “But it didn’t work that way, and it never has. There’s never been a real price mechanism in our industry, which is pretty strange.”

But despite the fee issues, Grantham says the investment management industry is actually “pretty ethical.” Especially when compared to other parts of the financial system.

He holds his harshest criticism for propriety trading desks at investment banks.

“It should be illegal, it’s clearly unethical, it’s clearly a conflict,” he says.

“Ethical standards have gone from very high, to non-visible. The ethical standard today is ‘don’t go to jail if you can possibly help it’.”

Just 25 years ago, he says “the leading investment banks were models, in my opinion anyway, of ethics. They wouldn’t dream in those days of having an investment management decision, because that would have meant competing with their own clients. They wouldn’t dream of doing routine trading in their own accounts, which would have meant they were trading against their clients. They look around and they have all the flow from us the clients, which they use to their advantage. That is considered so normal, that it is deemed to be a profitable and exciting trade if they do it themselves.”

Perhaps most shocking is that this ethical lapse is not even an open secret, it is flaunted. To make matters worse, when these trading practices take the banks to the brink of bankruptcy, the taxpayer is then forced to bail them out.

“We have allowed this deterioration in ethical conduct,” “Had you proposed any of these things to management of any of the great investment banks 30 years ago, they’d have shot you on sight.”

Grantham challenged the industry to do something about these practices, pointing out that no one has moved their business from their current investment bank to “the least unethical” firm.

“We have made no protest at this gradual slide into the rat hole that we find ourselves in today. It seems to me an easy thing to do, it just takes the leadership of a few firms to say: we’ll go with the firm with the most obviously ethical behavior, who get rid of their in house trading.”

But so far, no firm has stepped up to lead that charge.

“I think we should be ashamed,” he said. “GMO has not done this and shame on us.”

Photo courtesy of the CFA Institute .

Check back for Advisor.ca’s continuing coverage of all the breaking news from the CFA Institute’s Annual Conference in Boston.