This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on Nov 30 – Dec 6, 2015.

Paul Schulte’s The Next Revolution in Our Credit-Driven Economy: The Advent of Financial Technology unbundles how credit markets function to help investment professionals detect and avoid credit crises. In this excerpt, he posits that hedge fund managers seem convinced that the greatest share of rerating and revenue growth will come from advancements in technology.

HEDGE funds are also morphing and offering new forms of capital to businesses. They are diversifying away from public markets and taking on business lines similar to private equity firms, mortgage-backed entities and supporters of financial technology in California. 

To give an idea of how much the hedge funds are moving away from traditional financials and toward technology, I looked at the top 20 tech companies and the top 20 banks in 2007 and tracked their performance. In 2007, the top 20 banks globally had a market capitalisation of about US$1.8 trillion, while the top 20 tech companies had a market capitalisation of US$1.1 trillion. 

Cut to the end of 2014, and the market capitalisation of the banks is US$1.7 trillion. This represents a drop of 6%. At the same time, the market cap of the tech firms moved to US$2.5 trillion, an increase of 127%. In other words, the banks are still below their values of 2007, while the capitalisation of the tech firms has more than doubled. Figure 10.2 shows the evolution of technology firms (and a good part of this is financial technology) relative to the banks.

When I explored the top holdings of the largest hedge funds globally, I discovered that most of the top holdings were in fact technology. Furthermore, the top 20 hedge funds globally held almost no banks at all. They owned Amazon, eBay and American Express. That’s about it. But there were no banks to be seen in virtually any of the major holdings of any of these hedge funds. Shouldn’t that tell us something? These are some of the smartest people in the world of finance.

The holdings of these funds include many stocks in the life sciences. Hedge fund managers seem convinced that the greatest share of rerating and revenue growth will not come from banks, but from (a) an evolution in the human genome; (b) developments in the marriage of biology, chemistry and transistors to create solutions to diseases by way of human implants; (c) new developments in pill-form drugs for cancer, disease and mental disorders; (d) developments in military hardware that reduce human casualties; (e) technology that can allow the consumer to bypass the mall, bank and credit card company and shop cheaply from home; and (f) entertainment and educational systems in the home that are exciting, fun to use and instructive. Banks are simply not on the horizon.

As an example, the top two individual stock holdings of Bridgewater as of late 2014 were Microsoft and Verizon. The top holdings of AQR, the second largest hedge fund globally, are Google, J&J, Microsoft and Apple. And the list goes on. There are just no banks. 

One company that is heavily owned by Och Ziff is China Cinda, an asset management company that is designed to clean up the bad debt of the banks. A few of these large hedge funds own insurance company Metlife and American Express. And that is the extent of the ownership of financials. Is this the sign that it is time to switch? I sincerely doubt it.

As we shall see, there is a real need to clean out the financial system and engage in a fairly radical restructuring of the balance sheet. It is unwise to be an equity shareholder of an industry that is undergoing heavy consolidation. I believe that this is exactly what will happen. Banks like Deutsche Bank, HSBC, Société Générale, BNP and Barclays are simply too big to survive. 

Consider: Dinosaurs very likely got so big because the oxygen levels in the atmosphere allowed them to grow larger. At some point, oxygen levels fell by a few percentage points — meteors, volcanos, whatever — and could not support the size. I submit that is exactly what is happening today. The ecosystem can no longer support the absolute size of these entities, and they must break up into smaller and more flexible and dynamic organisations. Furthermore, firms like BlackRock are building horizontal organisational structures that create separate, smaller units with an entrepreneurial spirit. So far, they have succeeded in creating world-class centres of excellence with groups of about 60 to 100 people. BIackRock is one of the “large” firms that is creating the new enterprise by creating many smaller centres of excellence.

Figure 10.3 shows how large these beasts have become. John McFarlane will enter Barclays in 2015 and will likely break up the banks. Similarly, the FSA is being more aggressive in forcing banks to separate their commercial lending groups from their investment banks. If so, this will cost billions and will force a few banks to close down their investment banks, for the simple reason that the investment bank will no longer have a funding source. 

Equity shareholders of these banks should be aware: This is not a good time to own these banks. They need to avoid simply collapsing under their own weight as they find new businesses, close branches, reduce headcount, deal with prosecutors and write off bad assets. 

See Figure 10.3 for the largest banks in the world. HSBC, Deutsche Bank, Barclays and BNP will be under large pressure to reduce assets going forward, and the Royal Bank of Scotland is probably in this category as well.   

* Reproduced with the permission of John Wiley & Sons

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