Engaging for alpha
how more involved fund managers can create better returns for all
‘Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns: decisions which we subsequently regret. We speak and act in the heat of the moment, we eat and drink too much, and we do not save enough. In business, short-termism occurs when companies invest too little, either in the physical assets of the business or in the intangibles which are generally the source of their competitive advantage – their reputation, their capacity for innovation, and in the skills and capabilities of their employees.’
Professor John Kay, ‘Kay Review of UK Equity Markets and Long-Term Decision Making’, July 2012
The travails of the past five years have prompted much soul-searching amongst active managers. Many have failed not only their clients but the wider society in which they operate. Too often, particularly in the ‘Anglo-Saxon’ markets of the UK and US, they have equated clients’ interests (and their own) with instant gratification. Good companies, shareholders’ returns and industrial strategy have suffered as a result. We think there is a better way, which can create better results for clients, companies and society at large, but it will require an honest appreciation of what went wrong and what needs to change.
For now, despite last year’s strong market returns, we are still living very much in the shadow of the boom and bust of 2008 and 2009, when the market’s fixation with the short term led to a familiar cult of leverage. Strong companies were sold to over-borrowed bidders, creating immediate ‘shareholder value’ for the sellers, but sometimes also new structures whose instability meant they were doomed to failure. Or pressure was applied to companies to improve the ‘efficiency’ of their balance sheets. Encouraged to take on debt to pay dividends or mount share buybacks, companies may have enhanced the level of income paid to their investors but sometimes also distorted their business goals and pushed their shares to unsustainable levels.
We believe that the heart of this problem is the market’s repeated mispricing of risk. With investors’ gaze fixed on the immediate share price, the real, intrinsic, value of companies is often allowed to drift. This became egregious during the global financial crisis. Just before it collapsed with over $600 billion of debt, Lehman Brothers was able to report net assets of over $26 billion. Elsewhere, investors’ faith in Citigroup was badly shaken by the emergence of its interests in $1.2 trillion in ‘special purpose vehicles’1
established to hide borrowings from the market. The wider tale of how banks in the US and Europe built
up debts of trillions of dollars unchecked by either investors or management is now well known.
Equity owners have been major losers from this mispricing. For the first decade of the 21st century, shares produced minimal returns and it is only since 2010 that equity returns have started to catch up with the rise in GDP. Collectively, most fund managers regularly underperform the wider market when fees are taken into account (see Figure 1). Not surprisingly, many clients have sought refuge in different investment approaches, including hedge funds, high-frequency trading and indexation. But new risks, high fees and pedestrian returns are leading to disillusion here too.
We think that change is now in the air. There is a growing feeling that the neo-liberalism that led us into the problems of 2008 and 2009 doesn’t work any more and we need a new, more progressive, model of capitalism. This is already seeing a move towards a more active and constructive form of engagement with companies, and one which is starting to generate good results for investors.2 We believe this process has much further to go. Indeed, we believe there is a direct relationship between better engagement and sustainable alpha of a sort that many managers – and not just hedge funds focused on the short term – currently fail to achieve. But to maintain progress, everyone involved in markets must tackle a number of misaligned incentives which underpin the current obsession with the short term.
1 Extraordinary Financial Assistance Provided to Citigroup, Inc., Special Inspector General for the Troubled Asset Relief Program, 13 January 2011 2A recent study of activist investing by Cambridge Associates, the consultancy, suggested that the median manager out of the 14 it surveyed had produced annual compound returns of 2.1% in the five years to June 2012, compared with falls of 3.0% for the MSCI World Index and 0.7% for the HFRI Equity Hedge (Total) Index.
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