Innovation in Financial Markets

The recent credit market maelstrom has everyone pointing the finger – some pointing the index finger at alleged wrongdoers (from regulators and ratings agencies to borrowers), and some pointing a different finger at the financial engineers who supposedly played the role of Dr. Frankenstein. While all the excitement has brought the extremists out of the woodwork, most responsible commentators have focused on the right issue: financial innovation is not without risk to the markets and, like all human activity, there is a pendulum of pessimism and optimism which plays out over time.

As financial advisors, we have never had more tools to construct portfolios to participate in profitable economic activity. Since the advent of options, we have been able to selectively target…or avoid…particular segments of the totality of investment returns. Transforming these investment return components and other financial assets (residential and commercial mortgages, credit-card receivables, just about anything) into marketable securities, a process broadly called securitization, led to structured products. We are only recently able to select an underlying market exposure, pair that with a trading strategy (possibly in an entirely different market), and package both in a cost-effective, and tax-efficient structure which trades on an exchange like a stock. Kochis Fitz has demonstrated leadership in this area, most obviously with the creation of the enhanced commodities exchange traded note (ETN).

Innovation is not just about financial engineering. Competition and evolution of the investment management business have opened the doors to new streams of economic activity. Since the end of the dot.com period, venture-funded companies are taking much longer to reach their initial public offering for a number of reasons. Because many top-tier venture capitalists are focused on early-stage rather than later-stage investments, a small but growing industry is now stepping in to make those later stage investments. We have just completed a major research project on late stage venture capital. After analyzing over 3,700 venture-funded companies (it took several months!), we determined that the average returns to later stage venture investments are very attractive and likely to be more attractive than early stage.

This is not to say that increasing complexity comes without additional risks. Northern Rock, Britain’s fifth-largest mortgage lender, does no lending to speak of overseas. And yet it is fighting for its life, savaged by the distant turmoil in our mortgage market. When concerns in our sub-prime market spilled over into the global securities markets, the money markets that Northern Rock had depended on for years dried up in a single day at the start of August.

But the overall risks are manageable and, more importantly, worth bearing. The process of adjustment in the pricing of risk is often disorderly and inflicts some casualties...as it should. It must be the case that some investors, wise or foolish, must suffer losses from time to time, precisely in order to create a risk premium to entice any investors to participate. Regulators and central bankers must stand back — as, by and large, they have done. Every intervention has unintended consequences and now will be taken as a sign of what the regulators will do next time. We continue to evaluate the long-term implications of financial innovations and appreciate the opportunity to work on our clients’ behalf to find…or even create…tax-efficient and low cost ways to expose them to the most attractive investment opportunities around the world..

Jason Thomas, PhD, CFA
Chief Investment Officer