From economist-blogger Arnold Kling’s 50-page paper on the financial crisis:
James Kwak, who writes “The Baseline Scenario” with economist-blogger Simon Johnson, explains:
Basically, Kling says that the crisis was composed of the things along the top, which were caused by the things on the left. You can see that he places the blame squarely on poor capital requirements regulations, which gave various banks incentives to (a) originate-to-distribute instead of originate-to-hold; (b) securitize every which way they could; (c) use credit default swaps to reduce capital requirements even further; (d) stuff toxic securities into SIVs; etc.
Because he believes that weak capital requirements (which determine how much capital banks must have on hand in relation to their liabilities) were central to the crisis, Kling thinks we should “encourage financial structures that involve less debt, so that resolution of failures is less complicated” and try to “foster a set of small, diverse financial institutions.” Kwak mostly agrees with Kling’s recommendations, but thinks that Kling should have put more emphasis on making “key institutions” smaller. In any case, you should be reading both of them.
You probably already know this, but here’s yet another paper that demonstrates the foolishness of putting money into actively managed mutual funds. The authors used historical data and simulations to figure out if actively managed funds performed better than passive investments, and the chart on the right shows the answer: the blue line represents active funds and the red line represents the average distribution of passive investments. The zero point on the x-axis represents average performance.
Along the entire curve, the authors found that a higher percentage of funds performed worse than passive investments. For example, about 70% of active funds perform at zero or worse, compared to only 50% of passive invesetments. 90% perform under +1.0 compared to only 80% of passive investments.
If you drop out fees, active funds do slightly better: there are still more big losers than with passive investments but there are also a few more big winners. When you add in fees, though, this small effect is completely swamped and active funds are lousy investments all the way around. Don’t waste your money.
Next up: could somebody please do with hedge funds? I suspect the results would be about the same. Via Felix Salmon.