(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
April 17 (Reuters) - Fund and pension investors who are watching their biotech and social media stakes melt before their eyes may well feel they’ve had their pockets picked by self-serving investment managers.
But actually they are also helping to fund, if only as an unintended side-effect, useful innovation which might not otherwise happen.
The lesson here: career risk makes the world go round.
William Janeway, economist and venture capital veteran, put it well at the Institute for New Economic Thinking conference last week:
”The question is: how long can you afford to be wrong before they take your money away and you are no longer in the market?
"It does not have to be a psychological propensity for excessive risk taking, it is simply a matter of fact that in the ontologically uncertain world in which market participants live you cannot afford not to follow the crowd. Unless you are Warren Buffett and nobody can take your money away." (here) (here%20and%20Investment%20CIGI-INET%204-11-2014.pdf)
When sectors of the economy surge, this puts pressure on fund managers to get on the train, as funds flow towards and away from those managers who show the strongest and weakest performance. That encourages some to try to front run trends even when they are not confident about valuations. Many more fund managers are likely to feel forced to pile in, as we saw last year, even when they may suspect it is going to be a disaster in the end.
That’s their fault for acting in bad faith and protecting their career over your investment.
But it’s your fault because you often fire money managers who lag in a bull market.
Put it this way, while there are plenty of true believers out there who actually believe that $17 billion or so is a bargain for WhatsApp and Facebook, a whole bunch of other money managers are simply scared into trend following.
Janeway argues that though they may do it cynically, it has some good outcomes. He further believes that in general where the technology has the potential to improve productivity, like the Internet, or radio in the 1920s, and where the speculation stays confined to the capital markets, the fallout when the bubble bursts is usually manageable.
When it infects the banking system, as it did in the housing bubble, the stakes and damage are much higher.
A good example of a beneficial bubble is sometimes said to be the capital that flooded into electricity companies in the 1920s. That ended badly for investors but laid the foundations for a surge in productivity during the 1930s despite the Depression.
Pity about the depression and losing your money, but at least the lights turned on, eh?
There may be parallels today, Janeway points out. Amazon had some crazy money thrown at it, and might not have survived and be delivering us all olive oil by drone in years to come if not for the cynical money managers.
None of this argues for investors passively allowing their money managers to go trend-following. You will still get the Internet and electricity even if you keep your money in an index fund.
Another interesting comparison here is company managers, who seem curiously unwilling to invest in new production despite historically high company margins. While social media companies throw money at seemingly every new idea, much of the rest of corporate America is piling up cash and buying back shares rather than tooling up and hiring people.
That too is because of perverse incentives which drive the behavior of agents, in this instance company managers. The way to get paid as a company manager at a reasonably mature company is not by going all in for growth and innovation, but by making your profit targets reliably in order to hit your share option targets over the next one to three years. That argues for cutting costs and playing safe rather than investing for the long haul.
That’s also why we end up with multiple copycat drugs for heartburn and why movies like Robocop get made over and over again - they are safe bets.
Again, this is not generally in the interests of shareholders, who are usually saving for the long term and who may well see the value of their holdings wither due to low levels of investment in research and development.
Don't get me wrong, I'm grateful for electricity, and Twitter and even Robocop, but it strikes me that somehow we ought to be able to organize this all a bit better. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)