Business, Innovation and Skills CommitteeWritten evidence submitted by Dr Paul Woolley ( Providing oral evidence 26 F ebruary 2013)

In his introduction to the Government’s response to the Kay review, Dr Vince Cable talks of “the prevalence of incentives to focus on short-term market movements rather than long-term value creation as the basis for investment decisions”. The standard theory of finance cannot explain mispricing, short-termism and other market failures. That is why solutions have been elusive. My team has been developing a framework that addresses these issues and offers an agenda for reform of investment practice.

Investment Versus Trading

There are basically only two investment strategies: investing based on fundamental value and momentum trading, or trend following. Everything investors do is a variant of one or other strategy, or some combination of the two.

Fundamental investing requires investors to estimate the future cash flows from securities and asset classes. This calls for skill and patience: skill in making the estimates and judging the risks, and patience while waiting for these judgments to be vindicated.

Momentum trading involves investors buying and selling assets simply in accordance with the prevailing trend in prices. It involves a succession of independent bets on the direction of those prices. The investor makes no judgment about the fundamental value of the security.

Investors use momentum either to try to make a quick turn, or to reduce the risk of underperformance in the short run. The distinction between the two strategies lies at the heart of the problem of short-termism and it goes beyond the debate about length of holding period.

Our analysis shows that while momentum traders may gain in the short-term, they lose out to fundamental investors in the medium and long-term. The reasons for this include that they are inevitably late to the party—buying after prices have started to rise and selling after they have begun falling. Momentum locks in losses, whereas the longer-term investor rides the troughs and enjoys the recovery when prices revert to the mean. The trading costs involved in “churning” the portfolios also detract from returns due to the ultimate asset owner.

“Momentum” is not just counter-productive for the medium to long-term investor. It is also a key component of the herd behaviour that leads prices to over- and under-shoot the fundamental value of the underlying assets. This damages market efficiency, making prices prone to excessive volatility, bubbles and crashes.

Given these clear drawbacks, why are pension funds and other long-term investors nevertheless drawn into the momentum game, either explicitly by pursuing short-term performance, or unwittingly via benchmarks and risk measures calculated using market prices? The reasons include:

1. Benchmarking to market-value-based indices. This effectively means buying high and selling low, and accepting prices that are distorted by momentum surges. Index-tracking is thought of as a cheap option, but it ties the investor to benchmarks mispriced by momentum trading.

2. Imposing limits on the divergence of fund returns from the benchmark’s returns (to limit “tracking error”). This requires the fund manager to use momentum to hug the benchmark index to reduce the commercial and professional risks of underperformance.

3. Hiring “quant” managers guarantees that momentum will be part of the package. Similarly, most hedge funds use momentum as a core strategy overtly or covertly. Their high fees make the client impatient for quick results.

4. Paying performance fees based on annual returns encourages a short horizon and, therefore, momentum investing.

5. Focusing on mark-to-market valuations, compounded by regulatory requirements, leads to unnecessary—and often self-defeating—efforts to minimise short-term losses and volatility.

6. Bowing to pressure to measure performance against existing comparator universes can encourage herding in asset classes, pushing funds into the latest fashion (commodities, hedge funds, gilts) often with pleasing short-term results but disastrous longer-term outcomes. So careful choice is needed to ensure the comparators are relevant to the asset owners’ needs.

7. Over-using derivatives (futures, options, structured finance), which are by definition short-term because most instruments expire in less than 12 months. Any fund manager using derivative strategies will be focusing on either short-term gains or short-term risk reduction. The Kay Review failed to refer to the derivatives markets, which have now grown to be many multiples larger than the market in the underlying instruments.

What can be done about it?

We have written a Manifesto (see The Future of Finance, LSE Report 2010) for giant funds, such as pension funds and sovereign wealth funds. The Manifesto is our version of a code of best practice for long-term investors. It goes further than Kay’s proposed statements of best practice for asset managers and asset holders. As is made clear in the G30’s recent publication, “Long-Term Finance and Economic Growth”, this is an international issue. Its number one proposal is that regulators at all levels should “promote long-term horizons in the governance and portfolio management of public pension funds and sovereign wealth funds”.

The main aim of the Manifesto is to show funds how to reduce momentum trading and increase the focus on fundamental investing. If implemented, this would raise the medium- and long-run returns of individual funds irrespective of what other funds do. If large numbers of funds followed suit, markets would become more efficient and less exploitative. The key points of the Manifesto are:

1. Concentrate on investing based on the future cash flows of the assets and their ability to meet the cash obligations dictated by the liabilities.

2. Base all risk metrics for the assets on underlying cash flows, not current market prices.

3. Choose a cash flow-based benchmark tailored to the currency base of the investor, such as real global GDP growth plus local inflation.

4. Avoid investment strategies based implicitly or explicitly on momentum ie bets on price trends, or where buying/selling is prompted by automatic reactions to price movements.

5. Cap annual turnover of the portfolio at an indicative 30%. Managers would have to explain and justify excess turnover and the capping would force managers to focus on long-run value.

6. Design contracts with agents to minimise moral hazard, eg avoiding performance fees other than over the long-term.

We strongly advocate establishing a code of best practice for long-term investors along these lines. This could be backed up with the withdrawal of existing tax concessions for institutions that breach key provisions, such as the 30% limit on portfolio turnover. The authority to withdraw tax exemption if funds are deemed to be trading rather than investing has lain dormant and little used in the UK tax statutes for the past 30 years.

Because of their pro-cyclicality we also discourage the imposition of annual snapshot mark-to-market valuations for long-term funds. The regulation of both pension funds and insurers has moved in the direction of extending the requirement for, and frequency of, mark-to-market valuations. This is a retrograde step that trumps attempts by funds to adopt a long-term strategy. This legislation comes in response to volatile and treacherous markets yet will have the effect of making matters worse, not better.

As funds begin to adopt the new practices, a new comparator universe of long-termist funds would be created. This would ease the concerns of those who fear short-term underperformance in the event of a new momentum-fuelled bubble. The other side of the coin is that members of pension schemes would be able to challenge trustees who fail to comply with the new code and suffer underperformance as a result.

Curbing short-termism would also be a big help in shrinking agency costs. Short-termism and volatility have contributed greatly to agents’ ability to capture rents through moral hazard (heads the agents wins his fees, tails the client loses). More stable markets would make the finance sector less bloated and prone to crisis.

Action along the lines set out above would address several of the problems diagnosed by Kay for the asset owners’ end of the chain. International opinion is also moving in this direction—see the G30 report published this month (as mentioned above).

In the UK, it is clear from the Government’s response to Kay that it not only shares his diagnosis but is keen to see a fundamental change in investment practice. This includes essential regulatory reforms to favour investing over trading. The response also rightly indicates that a new financial framework is needed, since it can no longer be assumed that markets will achieve efficient outcomes. Hence the call for reviews of both metrics and risk management models.

We also welcome the Government¹s defence of the role of equity markets, in paragraphs 2.24 and 2.15 of its response to the Kay Review. Kay¹s dismissal of the value of equity markets as a source of funding may be a correct observation of the current facts, but equity markets are and should be the lifeblood of capitalism. They are failing because of the short-termism of all the players in the market, including corporations, and the rent capture by agents. The current policies of regulators are exacerbating the problem because, like the rest of us, they remain in thrall to the defunct theory of efficient markets, which assumes that market prices represent “fair value” in the sense of rational expectations of future cash flows.

Potential Contribution to Finding Solutions

My colleagues and I have been planning for some time to establish a research forum to work with selected policy-makers, sovereign wealth funds, pension and charitable funds globally (similar to that suggested in Kay). The forum would help policy-makers draft the code of best practice for long-term investors and assist funds in implementing the code. It would also provide the new metrics for setting benchmarks and analysing risks. In addition, it proposes a code that would help companies to invest for the long term, in the context of reforms to the approach of investors.

The issue is a global one and we are addressing things at that level. Our approach is founded on the new framework we are developing for understanding finance (see attached article, “Capital market theory after the efficient market hypothesis”). The principal departure from the prevailing theory of efficient markets is to introduce the real-world feature that asset owners delegate management of their funds to agents such as asset managers, investment banks and brokers. Because the prevailing theory of finance is based on the efficiency of prices, it will never successfully explain price distortions, short-termism or other market failures. It certainly will not provide solutions. In contrast, our framework suggests the causes, consequences and remedies for market failure.

Since the Centre started at the LSE in 2007—before the financial crisis struck—our work has attracted widespread interest from academics, some policymakers and international agencies, journalists around the world and a select few practitioners. Most encouraging has been the reaction of sovereign wealth funds and large funds overseas, notably the Australian pension fund community. In the UK, while a change in approach would clearly be in the interest of pension scheme members, it is early days in the reform process. The outcome of these parliamentary hearings should provide impetus to that.

To get UK pension funds to show interest and even consider action will need a significant catalyst. It will take more than setting up a forum. The development and promulgation of a code of best practice would be a start, whether this comes from the IMF, Financial Stability Forum or some other national or supra-national body. The new code would act as a carrot to action, but it will also need a stick in the form of legislative back-up or the trustees’ fear of challenge by their members.

Other Issues

Company stewardship and engagement with management

We have focused on the asset owners’ end of the chain rather than on the investee listed companies. This is partly because our Manifesto is aimed at funds that will invest in a broad range of asset classes, not just domestic equities. We also believe that if the owners of the assets were focused on the cash flows from them, much of the responsible ownership behavior that Kay calls for would inevitably follow. Where engagement with the management would improve long-term performance, it would make sense to do it.

This would encourage managements to focus on long-term value creation. It would also discourage financial engineering and ill-thought-out takeovers—actions that might enhance short-term earnings but could be counter-productive longer term. It should also encourage management to be more relaxed about cyclical profit volatility or temporary suppression of earnings for investment purposes. This, in turn, might lead to less trading activity by company treasuries in the name of risk management, including in the derivatives markets.

Investment Chain and Costs

Three other elements of the Manifesto (see below) tackle the issue of too many intermediaries between savers and the assets they own, and the cost of those layers. They chime with other calls to make costs transparent and to hold intermediaries more closely to account. Combined with the discouragement of momentum trading, a welcome side effect would be to reduce the number of links in the investment chain.

1. Insist on total transparency by managers with respect to their strategies, costs, leverage and trading.

2. Work with other shareholders and policymakers to secure full transparency of banking and financial service costs borne by companies in which the large funds invest.

3. Provide full disclosure to all stakeholders and allow public scrutiny of each fund¹s compliance with these policies.

I hope that this submission, coupled with evidence given on February 26, will help the committee to achieve Dr Cable’s goal of installing “long-term value creation as the basis for investment decisions”.

Dr Paul Woolley, senior fellow, London School of Economics
The Paul Woolley Centre for the Study of Capital Market Dysfunctionality
25 February 2013

Prepared 24th July 2013