Value Chain: A price worth paying
A better investment value chain would involve lower short-term profitability for providers in return for greater long-term sustainability of relationships, according to Tim Hodgson
The investment chain is a curious thing. In theory, it serves the real world by enabling the creation of wealth and wellbeing. It is therefore not an end in itself. However, it cannot know its purpose because it is not a single entity but, rather, a set of intermediaries that, collectively, link savings and investments to the engines of economic growth and development.
The investment chain was once fairly simple but this is no longer the case. In response to increasing complexity, the number of intermediaries has ballooned. Costs have increased despite the economies of scale afforded by the massive rise in savings and advances in technology. In contrast, other industries have used technology and scale to generate significant cost reductions for customers. It is also questionable whether greater complexity has created more value for the end-investor.
End-investors are increasingly aware of the issue of value for money. Keeping them happy requires a leap of imagination. To build a more sustainable investment industry, individuals and firms must lift their attention from their own small spheres of operation to see and engage with the entire investment value chain. When heads are down, the chain dislocates, creating misalignment and agency issues which get in the way of value creation.
In short, the investment chain needs a narrative, with each part interacting responsibly with other parts and helping to add value to the whole chain, not just to itself.
• Engagement on financial issues. A coherent narrative is not possible without a purposeful effort to create one. There are too many potential dislocations in the value chain for coherence simply to materialise.
Let’s take executive remuneration as a (significant) example. While investors spend considerable time selecting stocks (a negative-sum game, after costs), they tend to spend less time working with the investee companies to improve practices or avoid conflicts of interest that could damage portfolio returns (a positive-sum game).
There are two schools of thought about the rapid rise of pay at the top – it is either justified because companies are bigger and roles have expanded, or it is a result of failings across the value chain. The UK’s Investment Association, for one, is clear about its stance. Its latest report on executive remuneration argues that the current ‘one-size-fits-all’ model does not work. The predominance of long-term incentive plans often results in poor alignment of interests between executives and shareholders. Equally, full disclosure of pay might be used by chief executivess to increase their pay to match their peers. And yet the UK tripartite model of base remuneration plus short-term incentive and equity-based long-term incentive plans is taking root worldwide, with particularly strong adoption in Asia.
The pay issue is far from new, yet little action is in the offing. Proxy advisory firms, while controlling a significant proportion of the voting, do not engage in dialogue with boards and there is a need for shareholders to empower them to do so. Meanwhile, consultants and asset owners need to raise their game in monitoring how asset managers vote and make it a factor in the manager-selection process.
• Engagement on extra-financial issues. Engagement with boards on extra-financial issues, particularly corporate governance, is another example of potential value chain improvement.
Corporate governance and performance are strongly correlated. But who is responsible for engaging on corporate governance? It is an open question whether stewardship and engagement are best carried out by asset managers, asset owners or by a professional engagement service.
The asset owner’s ability to do it is contingent on having the requisite in-house resources. Those that do are ideally placed for the task; they are familiar with the needs of the ultimate beneficiaries, so direct involvement allows them to better understand whether their portfolio companies’ approaches to delivering value match their own liability-related objectives.
From the asset manager’s perspective, engagement on ESG questions can serve as a powerful force for improving the overall quality of earnings which, in turn, attracts a return premium.
How might a mid-sized asset owner approach engagement? In a Willis Towers Watson (WTW)poll of shareholders, 44% favoured an overlay specialist, 33% voted for asset managers, 19% for the asset owner, while 4% elected to ‘free-ride’.
No matter who assumes responsibility, asset owners and asset managers would benefit by seeing themselves as business owners rather than investors, while corporate managements might embrace more of a listening culture.
• Consultants and advisers. Initially, the consultants’ role was to address information asymmetries and agency issues between asset managers and asset owners. However, the distinction between the roles assumed by the three parties has blurred over time and all are expected to create value. Consultants are now expected to demonstrate the skills they bring to the relationship and take more responsibility for outcomes.
• Greater insourcing of previously delegated functions. If the value chain is too long, too expensive or broken, the natural thing is to disintermediate it. This is exactly what some of the larger schemes are doing and will continue to do.
The current low-yield environment poses huge challenges for asset owners in delivering real returns. As a result, insourcing has emerged as an important strategy for large asset owners to reduce costs and agency risks while maintaining a tight grip on investment risk and performance.
Some are also exploring better vertical integration within the investment value chain, with a more dynamic working relationship between asset managers and asset owners. Within this relationship, asset owners can access some of their asset managers’ best ideas beyond the formal mandate, and asset owners are willing to reciprocate with a high level of engagement in the partnership.
• Towards a stronger value chain. Given that only 11% of investors deemed the current value chain as ‘fit for purpose’ in our recent poll, it seems that any economies from scale or technology have been captured by the growth in intermediaries rather than passed on to the saver. This situation cannot endure forever.
We advocate a first-principles assessment of the purpose of the investment industry with reference to the needs of end savers. These principles might be summarised as ‘appropriate portfolios at an appropriate price’.
Within a defined contribution context, financial planning – or the level of contributions – is possibly the biggest challenge for the value chain, with all agents having a responsibility for (and interest in) raising contributions to meaningful levels. Communication around this issue is key.
Might we also dare to imagine genuine collaboration between service providers to deliver better overall solutions? This might require industry players accepting a reduction in short-term profitability in exchange for long-term sustainability.
We would argue this is a price worth paying and we know from conversations that we are not alone.
Tim Hodgson is head of the Thinking Ahead Institute at Willis Towers Watson