IPE at 20: The purpose of investment
This March, I celebrated 30 years in the asset management industry, having joined Mercury Asset Management as an older graduate trainee in March 1987. A decade later, IPE published its first issue.
Much has changed in the industry and within the financial sector. We witnessed the ascendency of Friedman economics, the fall of the Berlin Wall, the demise of the Soviet Union, the single European currency, the rise of technology, the collapse of the tech bubble, the rise and fall of the hedge fund industry, the financial crisis of 2008 and now the rise of populism and political fissures that threaten the fabric of the post cold-war world order.
And yet, for all these changes, one ranks above all others in terms of its profound and long-term effect on the asset management industry.
It started reasonably innocuously when John Bogle, relying on his observations while studying at Princeton, launched the first S&P 500 index fund in 1976 with $11m. Nine years later, when Hermes decided to employ an index fund as part of its strategy, it found no provider of a UK index fund and so asked Prof Elroy Dimpson to create one, which we ran for many years in-house.
The 1980s was the era of alpha and fundamental research. In many ways, the rise of the hedge fund industry to dominance by 2008 was the peak of the belief in stock-picking skill and the justification for paying for that skill. Yet if we survey the asset management scene today, what is clear is the unstoppable advance and dominance of beta investing, and the decline of a belief in skill. Vanguard has become a behemoth that is sweeping up most of the savings flows in the US; BlackRock stands its global equal and in the UK the FCA is clearly minded to push more pension savings into index funds, partly because of their low cost and because the large majority of active managers offer nothing more than index-plus products at high fees.
Others have written about the reasons for this, and I do not aim to repeat what is widely known. But, for the record, I maintain a belief in skilled management, provided the manager builds a portfolio that is as far removed from the index as possible (ie, high active share) and can apply skill to its construction, not least an ability in true long-term investment, which implies integration of environment, social and governance factors into the decision-making process.
“The 1980s was the era of alpha and fundamental research. In many ways, the rise of the hedge fund industry to dominance by 2008 was the peak of the belief in stock-picking skill and the justification for paying for that skill”
However, I believe that such skill is rare, hard to identify and can never be sufficient to meet the demand for investments from savers. The story of the growth of asset management over my career, therefore, has been a story of asset management companies, trying to square the circle of the scarcity of skill and arbitrage opportunity with a business model built on large margins as high as 50% – and growth in assets under management – an impossible endeavour, which they are clearly losing.
Purpose, not function
In a recent white paper1, I argue that the investment industry has concentrated so heavily on the mechanics of its function (beating an index, providing savers with above-inflation nominal returns) over recent decades, rather than its purpose (to allow savers to retire better than they would have otherwise) that in so doing it created a world in which the financial system (both the $75trn (€71trn) of global savings pool and the $230trn of capital this indirectly controls) is entirely separate from the world in which savers live and in which they will retire, even though this capital and the decisions made by professional investors who control it shape this world. This disconnect between the financial and the real world has become so profound that economists such as Prof John Kay – author of a 2012 review on equity markets and long-term decision making for the UK government – have argued that these markets have ceased to fulfil the function they should, according to economic theory, and that the senior executives have more ownership rights over companies than the shareholders.
Why is this disconnect so pernicious? There are three main reasons:
• First, the financial system is not separate from the real world. The lack of governance and a belief in sustainable models, alongside the pursuit of short-term gains in the 2000s, led to the financial crisis. To fully appreciate the cost of this mistake, any rational saver would deduct the cost of the crisis (estimated at €1.2trn) from any gains they would have made since, because the cost is still borne by the self same saver as a citizen through increased public debt and reduced services. We calculate that investors in the UK equity market are collectively still 17% worse off financially than at the 2007 market peak, and each carries some £16,000 (€18,500) of additional debt as their share of the public debt resulting from the bad investment decisions made by the allocators of their capital;
• Second, this disconnect has created an ecosystem where senior executives of large corporations have the ability to shape the societies savers live in and will retire in with no sense of responsibility as to what they are creating, provided they meet narrow short-term financial criteria in the name of shareholder value that effectively allows them to harvest a disproportionate amount of rent (pay) for themselves and, incidentally, for the asset management industry that sets these criteria;
• Third, as a result of the above two factors, popular disaffection with the system has grown exponentially, as evidenced by the Brexit vote, the election of President Trump and the rise of populism, which is creating deep political instability that threatens our social economy.
If left unaltered, the inevitable rise of index funds will only serve to exacerbate the disconnect between the owners of the capital (ordinary savers) and the society in which they live and relegate investment to no more than directional bets on a stock market casino.
I am not advocating a reversal of the trend towards indexation. What I am advocating is a rediscovery of the purpose of investment. That is for savers to grow their wealth but in so doing shape a society that benefits them as workers, citizens and pensioners. To do that we must rethink the purpose of the stock market for the majority of the quoted companies and start to think of shareholdings as a means, not to allocate or raise capital, as in standard economic theory, but of controlling these corporations so that they build businesses that are sustainable, that benefit stakeholders and society and that have a social purpose.
To do that, the index-fund industry must adopt the concept of long-term stewardship that looks to deliver sustainable long-term benefits to all stakeholders within a framework of governance that ensures that those who run these corporations do so for the benefit of the citizens who own them in the long term. This is a difficult and expensive endeavour. It will mean that the asset management industry must undergo a radical change in thinking, retool and acquire the difficult skills of long-term stewardship that are still in their infancy. Inevitably, this means that the cost of index investing will have to rise, but the current super-low cost is a false economy, as I hope my example and white paper demonstrate.
The management industry must therefore evolve to become primarily a stewardship provider or it may lose its social licence to operate. This is not only the right thing to do in terms of our fiduciary duty to the beneficiaries whose monies we hold in trust, but is necessary for survival. The political class has already recognised that there is a problem. Unless we, as an industry act, we may find that society, through its elected governments, will force us to move.
Saker Nusseibeh is chief executive of Hermes Investment Management and a founder of the 300 Club
1 S. Nusseibeh. The Why Question, The 300 Club, March 2017, www.the300club.org/white-papers