Much has been written about investment managers churning stocks, to the detriment of client returns, investee companies and potentially the overall stability of the economy.
Short-termism is a phrase that is used by many, without necessarily clearly defining what it means. It also remains firmly on policy-makers’ agendas, with the European Commission referring to “inappropriate short-termism among investors” in its Green Paper on corporate governance earlier this year.
The IMA’s response to the call for evidence by the UK’s Kay Review seeks to shed light on this issue by looking at investment behaviour, incentives and remuneration across the financial market. In particular, we undertook an analysis of portfolio turnover which shows the behaviour of investment managers in a considerably different light to the picture sometimes painted.
Our starting point was the need to distinguish the investment management industry within the wider market. Investment managers seek to build long-term value for clients through two distinct, but increasingly diverse approaches - active and passive management - with some firms offering a mix of the two. Active equity managers pursue a variety of strategies, starting from the perspective that markets are inherently inefficient and that portfolios built on discretionary stock selection can well serve clients’ needs. A passive manager’s investment in equities mimics a stockmarket index and, depending on the replication techniques used, the stock may be held for as long as it is in the index.
The performance and behaviour of both active and passive investment managers need to be measured and assessed in the right context. A paper from the Bank of England suggests that investors are holding stocks for an average period of only eight months. This might be an accurate reflection of the behaviour of the market as a whole. But what must be remembered is that investment managers, which only account for an estimated 25% of daily turnover in the UK equity market, are one part of a diverse range of market participants, which also includes hedge funds and high-frequency traders.
Indeed, implied average holding periods from stamp duty receipts shows little significant change in the behaviour of long-only investment managers. Looking at the last 10 years, there seems to have been no discernible move to shorter holding periods - the numbers are, if anything, a little higher at the end of the decade than at the beginning. And where turnover does increase, this is unsurprisingly during the highly turbulent times of the dot.com crash (2001-03), and the initial phase of the credit crisis (2008-09). That apart, implied average holding periods are pretty steady at around 3-4 years.
This links to a broader point about incentives and remuneration. Investment managers are generally remunerated via a fee based on a percentage of the assets managed. An investment manager does not have an incentive to over-trade portfolios, because the associated costs reduce its performance (and hence competitiveness in attracting clients and, ultimately, revenue). Thus, an investment manager’s interests are closely aligned with those of its clients and investee companies - the better that companies perform, the better the returns are for clients and the better managers are remunerated.
Of course, both active and passive managers need to make changes as client flows change, as they see specific opportunities in individual companies or as they align holdings according to changes in an index. For these and other reasons, using aggregate turnover levels to interpret holding periods is an unsatisfactory approach. There is a particular tendency to use the UCITS portfolio turnover rate (PTR) in this way, even though the PTR measure was intended to provide a way of understanding the impact of trading costs.
In reality, the actual period an investment manager holds an interest in a particular company gives a better indication of behaviour. We looked at 30 actively-managed UK equity funds and found that 71% of the companies were held for at least one year and, in terms of their market value, accounted for 86% of the funds’ total equity holdings*. Even when looking at five years, the results show that 42% of holdings by value were in companies held within the funds for the entire period. This does not support the frequently publicised picture of constant equity churn, and our research will hopefully contribute towards a different approach to the analysis of investor horizons.
But what about the other side of the investment chain - the investee companies? Here one of the important drivers of behaviour is the incentive structure for executives. Remuneration structures are frequently based on short-term earnings and share price, a problem often compounded by the short tenure of certain executives. This can mean that executives are incentivised to maximise share price or earnings in a short time frame at a cost to the company’s long-term viability. Indeed, even long-term incentive plans rarely extend beyond three years. A way to address this would be to change the horizons over which management is incentivised - for example, by having to hold shares even after leaving the company.
But misaligned incentives also occur with intermediaries in the equity markets; they may be incentivised to encourage behaviour that is not necessarily in the long-term interests of companies. Advisers on mergers and acquisitions, for example, are paid fixed fees contingent upon the deal being completed, thereby creating incentives to ensure that the merger goes through. Indeed, evidence that such deals add long-term value is mixed, at best.
We have urged Professor Kay and his team to look into these issues further. The short-termism in these areas would be addressed by aligning the incentives of both executives and sell-side advisers more closely with the creation of long-term value for the companies concerned. But when it comes to investment managers, are they really as excessively short-term as everyone seems to think? Not according to our numbers.