Andrew Sheng: Pension funds have forgotten how to think
Andrew Sheng, president of Hong Kong think-tank Fung Global Institute, chief adviser to the China Banking Regulatory Commission and former chairman of the Hong Kong Securities and Futures Commission, is imploring managers of pension funds to buck short-term impulses.
This comprises just one component of Sheng’s impassioned plea to financiers to throw out what he believes is the total failure of modern financial theory, delivered last week to the Pacific Pension Institute’s annual regional meeting, held this year in Kuala Lumpur.
Sheng (whose other current roles include serving on the boards of Qatar Financial Centre Regulatory Authority and Khazanah Nasional and as an adviser to China Investment Corporation) says financial theories are wrong. The data used to support models such as Basel III are based on flawed data that doesn’t reach back far enough or take into account fat-tail risks, and on the notion that prices are fully informed.
All prices are massively distorted, however, he argues. The real price of capital has fallen to zero, while low-wage labour is subsidising the rest of the world, and the prices of commodities and real goods are extremely volatile. All of this makes a mockery of discounted cashflow models that account only for slight deviations from the mean.
In a world of zero interest rates, the discounted cashflow model is meaningless, making assets impossible to value. In a world in which sovereign bonds now come with ‘voluntary’ 50% haircuts, and in which all asset classes are highly correlated, there is no safety in diversification or presumed safe havens.
Sheng notes that financial theories are usually based around the words ‘ceteris paribus’, holding ‘all other things being equal’. But with technology and globalisation, finance is so interconnected that there’s no such thing as other things being equal; instead, other things are constantly interacting and bouncing off one another.
As a result of relying on such illusions, the world has allowed financial services to grow too large. Traditional financial assets worldwide total $250 trillion, about four times the size of global GDP (about $63 trillion); the notional derivatives market is 16 times the size of global GDP. Debt accounts for the lion’s share of this explosion of financial assets. In a world where daily average turnover in foreign exchange is $4 trillion, even the biggest foreign-reserve cushion starts to look puny against an onslaught of leveraged speculation.
It is demographics that is bringing this to a conclusion. The rich world overleveraged itself to over-consume, but trading the future of the next generation via debt in return for instant gratification doesn’t work once there are too few young people to pay for your retirement. In other words, what seemed like a burden that could be passed on to another generation is coming back to the Baby Boomer generation as it enters retirement.
Asia is not immune to this, not in an interconnected world. Japan has led the way and many East Asian countries are on the cusp of their own demographic shift, but retirement systems have failed to prepare for this. Sheng cites the Melbourne Mercer Global Pension Index, which finds that all Asian retirement systems are below average in terms of adequacy, sustainability and integrity.
Retail investors have also fled investments. Worldwide flows to asset managers have seen greater institutional flows and net retail outflows. Sheng suggests this is because too many individuals see markets as rigged and therefore have lost confidence in using long-term investment vehicles. If they aren’t investing, and if public pension systems are poor, how will Asians manage as their societies grow old?
Indeed, it’s not just retail investors that have lost faith in markets. So have institutions, which are increasingly turning to private equity and other alternative investments, because traditional equities and bonds aren’t paying real returns, at least not when interest rates are so low.
Pension fund managers don’t seem like major contributors to this state of affairs. They’re not swashbuckling hedge fund types or fancy financial engineers. But Sheng says custodians of long-term capital have also failed, because they have forgotten how to think and act as truly long-term investors. Because they have become caught up in the 24-hour news cycle, they are just part of the herd.
And because too many institutions don’t care much about corporate governance (with a few notable exceptions, such as Calpers), they abrogate their shareholder duties and leave corporate insiders free to plunder, from Enron to investment banks to Olympus.
Sheng doesn’t pretend to have answers to this state of affairs, although he is a proponent of a global financial transaction tax (aka the Tobin tax). However he does urge pension-fund managers to question their role, their models and their assumptions. He exhorts them to return to their roots as true long-term investors and think about what they need to protect against, including inflation, which Sheng predicts is going to make a return in Asia, particularly as wages rise.
“If pension funds don’t look to the long term, then who will?” he wonders.
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