Organic Finance in Action: Practical Tools for a New Paradigm

Abstract

The financial services industry, which has ballooned from an 8 to 40% share of all after tax corporate profits created in the American economy over the past 50 years, is undergoing an evolutionary shift. Following a period of sustained growth in assets and power, significant advancements in technology, algorithms and information availability are revising the ways in which long-term investors interact with, and invest in, the capitalist system. We call this new paradigm of long-term investing ‘Organic Finance’, and it refers to a more professional and engaged community of asset owners that are increasingly focused on rooting their investment activities in the real economy. Specifically, Organic Finance asks that asset owners develop the capacity to understand the ingredients and incentives in the financial products they consume, which ensures that the financial derivation inherent in financial products does not negatively distort the risk and return profile of the underlying assets. This paper builds upon the large body of work on risk factors, which highlights the need for investors to clearly understand the underlying risk premia they wish to be exposed to and choose assets accordingly. More specifically, this paper highlights how a missing ‘organic finance factor’, which refers to the distortion/clarity with which a financial product represents the underlying economy, can also drive performance and thus deserves to be included in the factor toolkit. Indeed, we argue that factors apply as much to products as they do to underlying assets. To illustrate, we offer a case study of a newly formed passive investable stock index that uses a ‘systems approach’ to analyze and classify the constituents based on their functional characteristics.

Keywords: Organic Finance, Factor Investing, System Economics, Transparency