Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

The financial system evolved to meet savers’ needs in an uncertain future several decades away. Investment had to be long-term, reasonably liquid and yield an attractive return, particularly to counter inflation’s inevitable corrosion of savings. Pensions are central to such investments, especially in the Anglo-Saxon countries, where they make up about half of wage earners’ retirement funds. Today, it is hard to overstate the importance of pensions for individual beneficiaries and the economy: pensions sustain aggregate demand by enabling the elderly to consume after they retire. But they are also crucial for the whole financial system, partly by virtue of size – the volume of assets held in pension funds – and, even more significantly, because the private pensions industry is driven by profit and returns to shareholders. The number of mutual pension providers – companies owned by their members – has steadily declined as they convert to shareholder-owned companies or consolidate in order to compete with them.

Although the pensions industry existed in the early twentieth century, it came of age in the post-war years with the rise of the welfare state. In an era of full employment, often in large enterprises, compulsory pension schemes to which employers and employees contributed piled up enormous assets. Voluntary pension savings were common too. Life insurance has also been an important savings vehicle, but payments into life insurance policies have not generally been compulsory. In the UK and the US, governments have long given pension savings significant tax advantages, partly to encourage private savings and reduce the burden on state pension provision.

Here, I look at how the investment industry and investment banks, despite seeming to be highly competitive, often behave more like monopolies protected from competition. They extract rent for the benefit of managers and shareholders while the ultimate clients – ordinary customers and investors in shares, pensions and insurance policies – frequently pay fees for mediocre returns that do not pass on the benefits of fund management’s expansion and profitability.

NEW ACTORS IN THE ECONOMY

The post-war accumulation of savings placed asset managers centre-stage. They were not completely new on the scene. Mutual funds, called unit trusts in the UK, had existed before the war, and in the UK investment trusts were a popular form of middle-class saving. But the sheer scale of the investment required – and the social responsibilities that went with it – turned asset managers into a new set of actors in the economy. Their job was not to invest in productive assets like entrepreneurs, but to be the temporary stewards of savings which they invested in liquid and, generally, financial assets (as opposed to, say, property). In the US, assets under management (AUM) grew dramatically from $3.1 billion in 1951 to some $17 trillion in 2015. 13In the UK, the asset management industry accounted for £5.7 trillion by the end of 2015, more than three times the size of GDP in the same year. 14

Changes in regulation played an important role in the expansion of asset management. In the US, pension funds had been obliged to avoid speculative and risky investment, precisely as a prudent man would have done. But in the 1970s, the relaxation of the ‘prudent man’ investment rule allowed pension funds to invest in less conventional ways, such as private equity (PE) and venture capital (VC), while the Employee Retirement Security Act of 1974 permitted pension funds and insurance companies to invest in a greater variety of funds, such as equities, high-yield debt, PE and VC. Fund managers pushed for this relaxation as a way to make higher-returning investments, but governments were keen to allow it because faster-growing private-sector funds would lessen demand for state-provided pensions. During this time, the rise in the number of very wealthy people – dubbed high-net-worth individuals (HNWIs) – also increased demand for professional asset management. An HNWI is now generally defined as someone with net financial assets (excluding property) of more than $1 million. Originally a rich-country phenomenon, it is now global as the ranks of millionaires and billionaires swell in emerging countries, notably in Asia and Latin America. According to the consultancy Capgemini, the number of HNWIs rose from 4.5 million in 1997 to 14.5 million in 2014. China now has more billionaires than the US. 15In 2015 the city with the most HNWIs was London (370,000), followed by New York (320,000). 16

As fund management expanded, so the proportion of private investors shrank. Individual ownership of stocks fell in the US from 92 per cent of the total in 1950 to about 30 per cent today. 17The percentage held by private investors is even lower elsewhere – 18 per cent in Japan and just 11 per cent in the UK. 18In 1963, UK individual investors owned more than 50 per cent of the stock market; insurance groups, pension groups, unit trusts and overseas investors together accounted for about 10 per cent. Since then the trend has reversed: pension funds and, particularly, overseas investors have rapidly acquired a larger stake in the UK stock market, with the latter owning more than 50 per cent of quoted UK companies’ shares in 2014. 19In the US, some 60 per cent of publicly issued shares (equities) are held in mutual funds. Moreover, the fund management industry is now quite concentrated, especially in the US, where about twenty-five fund managers control 60 per cent of all the equities in the hands of investment institutions. 20

In the last two decades the types of fund management have diversified, most noticeably into hedge funds, private equity and venture capital. The US has about 5,000 hedge funds, managing total assets of $2 trillion. Hedge funds have a glamorous image – in London many are clustered in the exclusive enclave of Mayfair – and some hedge fund managers have made a great deal of money: in 2016, forty-two were listed among the world’s billionaires. 21Some are even household names. George Soros shot into the headlines when on 16 September 1992 he reputedly ‘broke the Bank of England’, making $1 billion betting against British membership of the European Exchange Rate Mechanism (ERM), forcing the UK out of the ERM; the day became known as ‘Black Wednesday’.

Hedge funds, though, are a little tricky to define. One of their chief characteristics is shorting (betting on the price of investments falling) as well as going long (betting on the price of investments rising). Ironically, this was originally intended to take the risk out of their speculative investments, by enabling them to ‘hedge’ upwards against downward price movements. In practice, it lets them chase superior returns by placing expensive one-way bets, often using high borrowing (‘leverage’) to multiply their gains from tiny differences in price. Compared to other managed funds, hedge funds also have a high portfolio turnover and invest in a wide range of assets, from property to commodities. Many conventional investment funds are much more restricted in how and where they invest.

Private equity (PE) firms invest in companies, usually to take ownership and manage them, later – typically after three to seven years – selling them at a profit. They make their profit, if successful, from the increase in the equity value of the company after the debt has been paid off. They then realize the equity value by selling the company (sometimes to another PE firm) or through an IPO (initial public offering – in other words, a stock market launch).

These firms are called private equity because the companies they acquire are not quoted on the stock exchange, and because they themselves are also privately owned rather than through shares issued in the (public) stock market. In the US, PE firms control about $3.9 trillion of assets, 5 per cent of the asset management market, 22and own some well-known and large companies. For example, in the UK the American PE firm Kohlberg Kravis Roberts (KKR) paid almost $25 billion to acquire a stake in Alliance Boots, the UK high-street chemist chain. After KKR sold the final part of its stake in Alliance Boots in 2015 it was reported to have quadrupled its money. 23Other prominent PE firms include Bain Capital, BC Partners, Blackstone Capital and Carlyle Group.