Author: Paul Woolley

Giant funds must curb short-termism

This article appeared in the Financial Times on 15 October 2020

Many of the problems of present-day finance have their origins in the horizons set along the investment chain.

The key players in this chain are the giant pension, sovereign wealth and endowment funds who appoint external asset managers, who in turn invest in companies. If these funds invest with their eyes set partially or largely on the short term, it sends a clear message down the line and embeds similar standards throughout the capitalist system.

Short-termism has been a recurring concern of policymakers and commentators for decades, but little or nothing has ever been done to address it. The policy horizon of corporations has shortened further over the past decade, leaving them especially vulnerable to extraordinary shocks like Covid-19.

The absence of a remedy can be explained by the failure to adopt an operationally useful definition. I suggest using the motivation for buying securities rather than the length of holding period as the defining difference between long and short horizon investing.

All investing boils down to a choice of two distinct strategies implemented in a variety of ways. One is buying securities that are priced cheaply in relation to their expected future cash flows, which is what everyone assumes is done with their savings.

Bizarrely, the other is almost the exact opposite: buying securities whose prices have recently been on the rise or that have already gone up most, both without reference to fundamental value. Another version of this, though present on a lesser scale, is selling assets that have recently been going down in price.

This second strategy has its origins in what might justifiably be termed “the curse of the benchmarks”. Most large funds delegate to external asset managers by setting index benchmarks, often with limits on how far returns should stray from the index return. Benchmarking is now shown to amplify mispricing by forcing managers to chase prices instead of fundamental value.

Trend-riding momentum investors successfully game this response, pushing prices higher knowing that benchmarkers are likely to come along later and be prepared to pay more. Price-only investing explains much of what is going wrong in financial markets. It is also the essence of short-termism.

When investors obsess about prices, corporate bosses are encouraged to do the same. With the added incentive of early-exercise stock options, they seek to maximise the company’s share price instead of building the business for the future. Among the ways to do that are reducing capital expenditure and research and development, focusing on quick pay-off projects, share buybacks and raised debt levels.

The onus is on giant funds to collectively shift their stance towards longer-term investing in both the public interest and that of their ultimate beneficiaries.

As a first step these big funds should measure and report their use of the two basic strategies. They should assign scores for each sub-portfolio as well as the total fund, with a range from one for price-only to 10 for pure cash flow, broadly matching the implied investment horizon in years.

Separating out the contribution of the two strategies may often be challenging but that is no excuse for not doing it. The trend-riding strategy damages markets while the other improves them. Funds also need a clearer understanding of where manager returns are coming from.

Trading data and changes in portfolio composition are both good indicators of how a portfolio is run. High turnover of holdings is consistent with a short horizon, and so too is a propensity for purchases being made when prices are on the rise.

Any form of close tracking to an index benchmark is effectively a hybrid strategy warranting a score in the middle range. This is because market prices are set by investors using both strategies.

Scoring also helps to establish manager skill. Funds will have a better idea of where the gains and losses come from and what they are paying managers for: the skill of fundamental investing or the luck of trend-following. The analysis will also help to substantiate managers’ claims to be genuinely long-term investors.

The horizon score should become one of the standard metrics for describing a portfolio or fund. Trustees and fund staff mostly recognise the private and social merits of long-term investing and this new measurement will empower them to find ways to move closer to that goal. This will be the best way of dealing with short-termism in the system and far preferable to policy intervention by regulators.

50 years of efficient market thinking

This article appeared in the Financial Times on 2 January 2020

People keep questioning the health of global capitalism. But the damage caused by dysfunctional stock markets is not receiving adequate attention. Fifty years on from the publication of a landmark paper propounding the efficient markets hypothesis — that investors respond rationally to publicly available information — it is time to look again.

Active investing comprises two main strategies. One is based on expectations of the cashflows each asset can generate. The other responds to short-term price movements and ignores fundamental value. Cashflow investing and price-only investing are implemented in a variety of ways, and together they represent the sum of investors’ actions in determining the prices of assets.

The efficient markets hypothesis takes account only of the first strategy, implying that prices reflect the consensus expectations of cashflow investors. Although modified and qualified over the years, the basic proposition remains unchanged.

But consider the evidence of trends and momentum, and bubbles and crashes. Market participants observe the impact of short-term fund flows and are ambivalent — at best — about the idea of markets being efficient. They know that a high proportion of stock market trades bear no relation to fundamental value and that few professional portfolios are actually invested exclusively for long-term cashflows.

Despite these reservations and for lack of an alternative, the efficient markets hypothesis continues to underpin some of the most important decisions taken by investors, from the largest institutional funds to the smallest private saver.

One prime example of the problem is the use of capitalisation-weighted indices as benchmarks for the composition of passive funds, and for the performance of active funds. The comparison of portfolio returns against index returns is deemed good practice, however short the period under review. But treating indices as the neutral default choice makes sense only if pricing is efficient.

For their part, policymakers assume that stock markets reflect the wisdom of crowds and have a hands-off attitude, confining themselves to picking up the pieces after each crash. They use mark-to-market rules in the regulation of financial institutions and approve products that improve liquidity or widen the range of choice. That is sensible in an efficient world, but not otherwise.

A better understanding is needed of why investors use these strategies and how this usage distorts prices. Research at the London School of Economics has focused on agency problems arising when asset owners and fund trustees delegate responsibility to external managers. The main concern here is that trustees are uncertain of the ability of their asset managers.

Accordingly, most trustees impose limits on how far returns should stray from the return of the benchmark index. Even when unconstrained, managers are keen not to let performance slip far below the index return lest their competence is questioned.

Benchmarking pressures come to the fore when prices in a sector, or a class of assets, move strongly ahead. Managers who had previously deemed a sector to be unattractive and had not participated in the rise are obliged to turn buyers at the higher price. That amplifies the initial rise to the point where the assets become high-risk and overpriced.

Below-index weights in stocks or sectors with rising prices have a greater, and potentially unlimited, impact on performance compared with overweight positions in those with falling prices. So the pressure to act is always stronger when markets are rising.

One price-only strategy spawns another, worsening the situation. Benchmarkers must act when prices pass a threshold — but momentum investors buy as soon as a trend becomes apparent. The latter are effectively exploiting benchmarkers who have no alternative but to pay the higher prices.

The outcome is a generalised bias to overvaluation. This analysis is consistent with the longstanding evidence that high-risk stocks have historically given a lower return than their low-risk counterparts.

The price-only strategies overlooked by the efficient markets hypothesis are creating systematic and chronic distortions that are too great to be countered by cashflow investors.

It is no surprise that a theory predicting efficiency cannot explain inefficiency, nor show investors how to act correctly in conditions of inefficiency. On the other hand, a theory of dysfunctional markets points to the source of trouble and can suggest solutions.

These include amending the terms of delegation from trustee to asset manager, so that the latter focuses solely on long-term cashflows, coupled with improved monitoring by trustees to ensure compliance. More efficient markets would deliver private gains for all except the mischief-making momentum players.

But the biggest prize would be the social benefits from a more efficient allocation of capital. That could provide a new lease of life for capitalism.