An initiative that is starting to work
Compared with their predecessors, modern investors concentrate too much on annual, quarterly, or even monthly valuation of what they hold, and on capital appreciation and depreciation generally; and too little either on immediate yield or on future prospects and intrinsic worth," JM Keynes 1938.
Not a great deal has changed in the 70 years since Keynes made this statement. The quality of much contemporary investment research fails to meet the needs of long-term investors. This assertion led, in autumn 2004, to a group of pension funds and fund managers (including USS) to launch a call for better investment analysis to inform better investment decisions. This group, the Enhanced Analytics Initiative (EAI), believes that much of the investment analysis produced is geared towards short-term issues and focuses too heavily on quarterly financial metrics.
Pension funds, on the other hand, by their very nature have a long-term outlook. As Peter Drucker put it "…by definition, pensions are long term. Pension fund management therefore requires long-term strategies for true performance. It is an axiom proven countless times that a series of short-term tactics, no matter how brilliant, will never add up to a successful long-term strategy". In this context, when investing for the long term, research that goes beyond the pure financials and analyses the impact of extra-financial issues (EFIs) becomes increasingly important if one is to adequately assess risk.
Importantly, members of EAI also see these extra financial issues affecting mainstream performance of their funds, and not as ethical or moral issues. Hence, the aim of EAI is to generate analysis so that EFIs are addressed in traditional investment decision making processes.
So what are these extra-financial issues? EFIs, such as corporate governance, climate change, global health issues or human capital management, have a real and quantifiable potential to impact companies' financial performance or reputation; yet comprehensive analysis of these factors is generally not part of traditional fundamental financial analysis. Much financial research has become constrained by an excessive emphasis on quarterly financial metrics. Meanwhile, it is clear that EFIs are important risk factors or value drivers for long-term investors to view comprehensively. This is not just about judging the future. Many of these issues already play a significant role in overall business performance and members of EAI believe that this will only increase.
From the outset, the founders of EAI recognised that asking the research community to change required a mechanism to reward those who were willing to deliver the research that initiative members wanted. Hence, EAI is based upon a credible market incentive to attract the interest of research providers by allocating a minimum of 5% of members' broking or research commissions to those who successfully integrate the analysis of extra financial factors into their evaluations of companies, sectors and issues.
The issues raised and the market approach adopted by the EAI has certainly resonated with other fund managers and asset owners: the numbers of those joining this call has grown significantly since the initiative's launch. In two years, the membership has not only tripled, representing total assets under management of more than €1.2trn, but it has also evolved from a Eurocentric collaboration to a global one, with members from North America, the UK, continental Europe and most recently, Australasia.
To identify and reward the efforts made by individual research houses to integrate EFIs, the initiative conducts a bi-annual independent evaluation of investment analysis. EAI members nominate individual pieces of research which they feel most successfully integrate extra-financial analysis for consideration to receive the 5% brokerage commission. The nominated research is assessed by an independent consultancy and the commended providers are announced at EAI's bi-annual evaluation event.
The results of the latest evaluation were announced in June, and rewarded investment research produced between November 2005 and May 2006. This valuation highlighted a growing breadth and depth of investment research as well as a rising
number of research providers capable of fully integrating extra-financial issues within investment analysis. That is, rising numbers of mainstream (from the traditional broking houses) and independent research providers are demonstrating a capacity to model the impact of extra-financials and are factoring them into traditional company valuations.
The June 2006 evaluation saw a significant increase in providers generating this kind of research, almost three times the number providing comparable research in 2004. The number of reports qualifying for consideration has risen exponentially in the same time frame. The following institutions were evaluated as providing the best analysis of extra-financial factors within mainstream investment research in the period and were eligible for EAI commissions in the second half of 2006: Bernstein Research, Citigroup, CLSA, Deutsche Bank, Goldman Sachs, JP Morgan, Morgan Stanley, Oddo Securities and UBS Investment Research.
In addition, greater numbers of economic research teams are contributing to extra-financial research, incorporating, for example, the impact of demographics, of geopolitical developments, and of regulatory trends on selected sectors. Moreover, the sectors and regions covered by this analysis has broadened to include some emerging markets, where understanding of extra financial risks is arguably even more crucial.
While this growth in the quality and volume of extra financial research has been exceptional, EAI members would like to see more. Several EFIs are conspicuous by their poor coverage. For example:
❏ Although climate change and related technologies are well covered, research on other environmental issues such as those relating to products and processes and depletion of natural resources are far and few between.
❏ There is still insufficient coverage of most emerging markets, impeding a wider consideration of extra-financials in the context of global portfolios.
❏ Extra-financial aspects of mergers and acquisitions, and intellectual and human capital continues to be underrepresented relative to the importance of these issues to the buy side.
❏ A good number of reports still fail to link the theme sector-level analysis and financial analysis at the level of single companies. In some cases it is difficult for the reader to identify a link between analysis at the theme or sector with the company-specific analysis, or is only described in general terms. Greater clarity and depth of insight is needed.
Notwithstanding these concerns, EAI members are pleased with the tangible improvement in investment analysis. The investment research community's potential is remarkable and it employs some of the very brightest in the sector. However, economic forces dictate that research providers will only respond to a financially attractive incentive. EAI provides this incentive enabling the market to meet client expectations of better, more useful research.
The research community is already responding to this new incentive with a refreshing appetite, and while there is still ample room for some research providers to strengthen their offering, the standard of some extra financial investment analysis now being produced is highly commendable.Institutional commitment has been a vital part of this success.
If you are an asset owner or fund manager who would like to see investment research that better addresses extra-financial issues or are otherwise interested in EAI, we would like to hear from you. Please contact David Russell at firstname.lastname@example.org.