The finance sector is widely recognised as an originator of periodic crises. The last 20 years have seen the bursting of the dot-com bubble, the sub-prime mortgage crisis and the eurozone debt crisis. In each of these episodes, financial markets played a central role in creating the problems that ultimately inflicted significant damage on the wider economy. What is less widely discussed is the unhelpful role that the finance sector can play in amplifying crises that emerge from entirely non-financial origins.

The global pandemic arising from the spread of COVID-19 is just such a crisis. In addition to the cost in human lives, the widespread lockdowns seem likely to give rise to a massive economic shock on a scale comparable with the Great Depression. Perhaps unsurprisingly, the initial response of financial markets was extreme. The equity market sell-off in early March was one of the fastest in history and signs of stress quickly emerged in the US Treasury market and the credit markets.

Dramatic swings in asset prices add to the first order economic effects of any crisis. The negative wealth effect of rapidly falling asset prices depresses aggregate demand. Tighter credit conditions make it more difficult for businesses to refinance loans and to raise new capital. And additional uncertainty around the solvency of financial institutions (typically leveraged to asset prices) contributes to heightened risk aversion. Markets not only reflect the changing economic landscape but also directly affect it.

A large exogenous shock that creates huge uncertainty for businesses and investors is always likely to elicit a severe reaction in financial markets. But is it possible that FTSE 100 and S&P 500 companies were by mid-March worth only two-thirds of their value one month earlier? Even allowing for the fact that some businesses will be pushed to the brink of insolvency by this crisis, and that others will see a large hit to their revenues over the coming year, it is difficult to justify such a significant devaluation, given that the vast majority of the value in any business typically lies in the expected cashflows beyond the next year or two.

Contrary to what efficient markets enthusiasts would have us believe, the scale of the market reaction reflects much more than a rational reassessment of fair value in light of new information. Many will point to behavioural explanations for the large market moves, which will undoubtedly have played a part. But arguably just as important are the procyclical dynamics embedded within financial markets.
There are two primary sources of procyclicality in markets. First, systematic strategies that embed a momentum or trend-following bias; and second, benchmark-induced performance-chasing arising from a principal-agent problem.

Strategies in the first category are procyclical by design. Their popularity derives from the historical evidence showing that momentum strategies have been profitable across regions and asset classes over long periods of time. Strategies that make use of stop-losses (widely used by hedge funds) and those that use volatility as an input (such as risk-parity) also tend to be procyclical in nature, especially when volatility spikes as markets go into freefall.

Benchmark-induced performance-chasing can take a number of different forms. At the asset owner level, the tendency to hire managers after a period of benchmark outperformance and to fire managers after a period of underperformance, creates a flow of funds away from the weakest performing assets and towards the strongest performers. A side-effect of this procyclical bias to hire and fire decisions is an asset management industry that is hyper-sensitive to benchmark-relative performance. This gives rise to “benchmark hugging”, whereby managers seek to ensure that portfolios do not stray too far from their benchmark – often formalised by the use of a tracking error target. This creates a tendency for managers to chase fast-rising stocks or sectors in which they have held an underweight position, or else expose themselves to increased career risk.

When markets are rising, these procyclical dynamics embed a generalised bias to overvaluation and create the potential for asset price bubbles. Furthermore, when investors are primarily concerned with short-term returns, corporate executives respond by prioritising earnings and share price performance in the short run. This often results in a reduced resilience to shocks, evident in rising leverage levels and over-optimised just-in-time supply chains. What in the good times is presented as efficiency, is in tough times exposed as fragility.

In benign market conditions, procyclical strategies therefore create a latent vulnerability in markets and the corporate sector. This vulnerability is then exposed when conditions deteriorate or in the event of a large and unexpected shock to the system. As markets start to fall, procyclical strategies tend to amplify market moves by withdrawing their support from assets that are no longer exhibiting positive price momentum and actively shorting those that are falling fastest. The rapid repricing of markets when faced with bad news therefore reflects a mixture of overvaluation prior to the shock and procyclical selling as markets fall.

Monetary policy has only served to reinforce the dynamics described above. Ultra-low interest rates incentivised corporates to undertake a large-scale debt for equity swap, amplifying returns on the upside while reducing their ability to withstand negative shocks. And unlimited monetary stimulation over the last decade has fuelled a number of trends, rewarding procyclical strategies and punishing certain categories of fundamental investor. In particular, this cycle has given rise to an extraordinary decade of outperformance for quality, growth and momentum styles of investing over value.

Investors implementing procyclical strategies and policymakers tacitly supporting their use have contributed to fragile markets and a corporate sector myopically focused on the short term. These social costs are increasingly recognised by commentators and the wider public. In order for the finance sector to retain its social license it needs to prioritise long-term value creation over short-term share price maximisation. This will require asset owners to review the types of strategy that they employ and to radically rethink the way that they hire, engage with and monitor their asset managers.

It is time for investors and policymakers to pay attention to the damage done by a dysfunctional finance sector. Reducing the scale of procyclicality in the system would be a good start.

Most institutional investors have long-dated obligations that extend decades into the future. Consistent with their long time-horizon and the need to deliver inflation-beating returns, such investors typically allocate the majority of their capital to public and private equity, real estate and infrastructure assets. Increasingly, such allocations are managed with environmental, social and governance (ESG) concerns to the fore. Indeed, some investors have gone further and now seek to align their investment strategy with the UN Sustainable Development Goals.

Paradoxically, the same investors will often use strategies that are inherently short-term in their approach. The most obvious example is the momentum strategy, which involves buying recent winners and avoiding recent losers. This is a high turnover strategy that has nothing to do with the productive allocation of capital. Moreover, the procyclical nature of the strategy means that it will tend to amplify trends, distort prices and, in the extreme, contribute to bubbles and crashes.

Out-and-out momentum strategies are just the tip of a large procyclical iceberg. The still widespread use of tracking error constraints forces managers to chase the fastest-performing segments of the market to avoid breaching their mandate guidelines. Even in the absence of such constraints, asset managers willingly chase trends in order to manage their own career risk. And performance-driven hire and fire decisions by asset owners further embed a procyclical bias within financial markets.

All this adds up to a situation in which large investors who claim to invest with a long horizon and who wish to be seen as champions of a socially responsible form of capitalism, are in fact contributing to dysfunctional capital markets in which short-termism dominates long-term thinking.

The social costs of asset mispricing and short-termism are less visible than the more widely discussed environmental and social externalities, but may be no less damaging.

Traditional finance theory suggests that in more-or-less efficient markets, a company’s share price is a fair reflection of the fundamental worth of the business. In this idealised world, there is no difference between actions that boost the share price and actions that deliver long-term value. However, in the presence of asset mispricing this no longer holds. As a result, it is possible – and often highly remunerative – for CEOs to engage in financial engineering rather than productivity-enhancing investment. An egregious and widespread example of this arises when share buybacks are used to mask the dilutive impact of stock-based compensation packages under the cover of “returning capital to shareholders”.

Procyclical dynamics also support a tendency towards monopoly: a rising share price confers greater market power on a company, enabling it to buy up competitors, often using their overvalued stock to fund the purchase. Asset owners that employ procyclical strategies are thereby facilitating a gradual shift towards a less competitive, less productive economy in which monopolistic corporations can engage in rent extraction on a vast scale.

Furthermore, procyclical strategies exert positive feedback effects on markets which help inflate asset price bubbles. When these bubbles eventually burst they often inflict significant and long-lasting damage on the economy, resulting in job losses and wage stagnation.

Public calls for institutional investors to recognise the impact of their investment approach have so far been limited to divestment campaigns focused on specific issues – most notably in relation to fossil fuel and tobacco holdings. However, as attention shifts towards broader issues such as excessive corporate power and rising inequality, it seems likely that asset owners will need to justify their investment strategy on much more fundamental grounds.

This would not require a huge leap from where we stand today. Savers and activists are already asking why their pension savings should support anti-social corporate activity. They might also ask why their savings should support anti-social investment strategies. Regulators across many markets have become increasingly assertive in encouraging funds to consider ESG issues. A natural extension of this – and one very much aligned with the underlying objectives of the sustainability movement – would be to ask large funds to consider the extent to which the strategies they employ contribute to market instability and capital misallocation.

Even in the absence of regulatory pressure, socially responsible asset owners will naturally want to understand the impact that their investment approach has on the wider world. This means going beyond the now commonplace integration of ESG considerations and the use of sustainability-themed strategies at the margin. Indeed, it demands that long-horizon investors avoid strategies that undermine the efficient working of capital markets and which consequently impose an unrecognised cost on wider society. If long-term capital was managed with a genuinely long-term mindset, the private and social benefits could be immense.

The Business Roundtable – a body representing the chief executives of America’s largest companies – announced in August an updated statement on the purpose of a corporation. In broad terms, the statement articulated a shift away from shareholder primacy towards a more stakeholder-oriented vision. Advocates of the move welcomed the recognition of issues such as employee welfare and environmental impact, while critics lamented the apparent downgrading of shareholder interests.

But commentators largely missed the key point: companies will disappoint both stakeholders and shareholders unless the underlying problem of short-termism is addressed. The widespread assumption that corporate activity is today mostly driven by a focus on long-run shareholder value is mistaken. In practice, many corporate leaders are instead focused primarily on short-run share price maximisation.

The fundamental problem to be addressed is therefore not one of broadening the perspective of CEOs away from a narrow focus on shareholders. Rather, it is to address the incentive problem, afflicting the entire investment chain, that results in an obsession with short-term share price performance rather than long-run value creation.

Share price myopia

Today’s crisis of capitalism originates not in the boardroom but in the capital markets, and is a result of the agency issues that arise from a highly intermediated financial system. In the modern publicly listed corporation, shareholders typically stand a number of steps removed from company management. For example, in the case of a pension fund, the end saver’s interests are represented by a group of trustees; those trustees usually delegate the management of the assets to an external asset manager (often further intermediated by a fiduciary manager); and the asset manager builds a portfolio and engages with company management in line with their mandate. Agency issues exist at every stage in this chain, but arguably the critical principal-agent problem arises in the relationship between the trustees and the asset manager.

Facing the challenge of assessing a manager’s ability, trustees typically employ market cap benchmarks to measure the ongoing success of a strategy. However, this creates an incentive for managers to herd around the benchmark and engage in performance-chasing activity to control the risk of short-term benchmark underperformance. Trustees themselves also engage in procyclical decision-making, tending to hire managers after strong performance and fire managers after poor performance. And the clearest example of procyclical behaviour comes from momentum and trend-following strategies that exploit the performance-chasing activity of asset owners and managers for private gain, while amplifying price trends and exacerbating asset mispricing.

With an asset management industry so obsessed with short-term performance, it is hardly surprising that CEOs engage in strategies designed to maximise share prices over the short term. Reinforcing this dynamic, remuneration arrangements that are heavily skewed towards equity-based compensation ensure that CEOs are financially rewarded for actions that boost share prices.

Finance theory must share the blame for this share price myopia. In particular, a paper by Michael Jensen and Kevin Murphy published in 1990, titled “CEO incentives: it’s not how much you pay, but how”, made a forceful argument in favour of remuneration structures that link CEO pay to shareholder wealth. When combined with the idea that share prices are an accurate reflection of the fundamental worth of a company – as embodied in the efficient market hypothesis – the natural conclusion is that CEO pay should be closely linked to share price performance. CEO pay in the US exploded during the 1990s, with stock options quickly becoming the largest share of total remuneration.

However, if share prices can depart substantially from fair value, then the argument in favour of equity-based compensation breaks down. Indeed, in the presence of mispricing, CEOs are incentivised to maximise share prices and simply become another procyclical participant in the system. When executives act with the sole intention of inflating stock prices, this will often be at the expense of long-run value creation. As a result, short- and long-run shareholder interests come into conflict, rendering the concept of shareholder value – when abstracted from time horizon – meaningless. Given the nature of executive incentives, the resolution of this conflict will often favour the short-term over the long-term.

Reconciling shareholder and stakeholder concerns

An excessive focus on share price maximisation is often viewed as a side-effect of the shareholder primacy ideology. The natural corollary of this view is that there needs to be a levelling of the playing field in order to place stakeholder concerns on a par with shareholder interests. This line of thinking places shareholders and stakeholders in opposition to one another and ignores the importance of time horizon.

While it is true that shareholder and stakeholder interests may come into conflict over the short term, their interests are in far greater alignment over the long term. For example, a company that seeks a short-term boost to its bottom line by cutting employee benefits, will suffer from a demotivated workforce and will lose talented staff in the long term. Similarly, a company that squeezes its suppliers for short-term gain, puts at risk its ability to meet customer demand over the long term. In both cases, actions which ignore the value and importance of a company’s stakeholders also undermine the goal of delivering long-term returns to shareholders.

This is to argue that over the long run, shareholder concerns coincide to a large extent with stakeholder concerns. Put differently, well-run businesses that are focused on long-run value creation will generally not exploit their employees, suppliers, customers or wider society. This is especially true given the power of social media to shine a spotlight on corporate behaviour that is deemed to undermine their social license to operate.

The best way to align shareholder and stakeholder interests is therefore to ensure that CEOs are incentivised to deliver long-term value – to customers, shareholders and wider society – rather than seeking to maximise the share price over the short term. This will require a re-setting of relationships along the investment chain and a re-thinking of executive compensation practices.

Extending the investment horizon

An essential precondition for long-term thinking to prevail in boardrooms is for long-term thinking to predominate across the asset management industry. This will only happen if asset owners demand asset management strategies that focus on long-term value creation rather than short-term benchmark outperformance.

A first step in this direction would be for asset owners to recognise the incentives that drive share price myopia across the asset management industry and to counteract their effects. This could include an overhaul of the traditional approach to manager monitoring – with the aim of deterring performance-chasing – as well as a re-framing of the mandate given to asset managers.

From a regulatory perspective, the goal of policymakers should be to foster an asset management sector that is focused on identifying and nurturing sustainable business models. A move in this direction could include an explicit recognition of the damage done by short-horizon strategies that respond primarily to price trends with little concern for business fundamentals.

Returning to the Business Roundtable statement, the shift from shareholder primacy towards a more stakeholder-oriented vision is likely to benefit neither shareholders nor stakeholders unless the underlying disease of short-termism is treated. An excessive focus on share prices by investors and CEOs inflicts long-term damage on shareholders and wider society. Conversely, extending the horizon of asset managers and corporate leaders could benefit shareholders and stakeholders alike. Regulatory interventions will still be required to curtail the negative effects of monopoly power and certain systemic externalities, but a greater focus on long-run value creation in the capital markets – instigated by long-horizon asset owners – could help restore trust in the financial system and deliver meaningful benefits to society.

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”
– Warren Buffett (2014 annual letter to shareholders)

Performance monitoring reports play a central role in supporting investor decision-making, providing a snapshot of the returns achieved on a portfolio over time. While their content and format vary widely, they invariably contain a summary of fund and benchmark performance for each underlying strategy over a range of time periods. By emphasising benchmark-relative performance, these reports encourage procyclical decision-making that reduces returns and contributes to destabilising market dynamics.

In the Intelligent Investor (1942), Ben Graham wrote that “price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” Here Graham hints at a monitoring approach that de-emphasises price data, focusing instead on the underlying health of the businesses within the investor’s portfolio.

Benchmark myopia

As we have described elsewhere, we believe that procyclical dynamics in financial markets are both privately and socially damaging. A powerful driver of procyclicality is the tendency for asset owners to hire managers after a period of strong performance and fire managers after a period of disappointing performance. One of the primary inputs into this decision-making process is the manager’s performance versus their stated benchmark, often reported to investment committees on a quarterly basis.

Such performance monitoring reports are often adopted without much thought given to the usefulness of the data provided. Do the benchmark-relative performance numbers provide information on whether the manager is doing a good job? Do they provide any insight on the manager’s skill level? Do they provide a useful trigger for reviewing the mandate? Over anything less than a five-year period it is difficult to answer “yes” to any of these questions.

The fact that managers know that performance data is presented to asset owners on a regular basis also creates a commercial incentive to ensure that short- to medium-term benchmark-relative performance is controlled, to avoid the appearance of incompetence. This in effect embeds procyclicality within asset managers’ decision-making, since to avoid significant underperformance, a manager will at times need to chase the best-performing securities or sectors within their benchmark.

As a result, traditional performance monitoring reports do more harm than good. They encourage an excessive focus on performance data and contribute to procyclicality in decision-making by asset owners and asset managers. Some have suggested that altering the presentation of performance data – to give greater prominence to longer-term figures – might help address the issue. However, minor tweaks to the existing approach are unlikely to achieve very much. Instead, a more fundamental re-think is necessary.

Monitoring without procyclicality

The first step towards developing an effective monitoring framework is to recognise that short-term performance data has very little informational content for strategies that have long-term objectives. Whether the manager or the benchmark has produced a greater return over the last quarter or year tells us more about market sentiment than it does about the manager’s ability. Even over periods of five years or longer we should be wary of drawing overly strong conclusions.

We suggest that instead of trying to gauge manager success based on regularly updated performance data, investors seek to make an assessment of whether the underlying portfolio is delivering what might be expected, given the manager’s stated philosophy and approach. This requires investors to shift their sights away from performance numbers and towards the fundamental characteristics of the stocks held in the portfolio.

This can be broken into two parts:

1. Has portfolio activity been consistent with the stated philosophy?
2. Do the fundamentals of portfolio holdings provide evidence of skill in stock selection?

The first element is a backward-looking analysis intended to confirm that the mandate is being managed in line with expectations. In relation to a listed equity mandate, important elements of this assessment would include turnover statistics, active share, an analysis of changes to portfolio holdings over time, and stewardship activity. The portfolio holdings analysis would primarily be intended to determine whether the manager has an unstated momentum (performance-chasing) bias that could be motivated by career risk or commercial considerations.

The second element builds on Graham’s suggestion that investors focus more on the operating performance of their holdings than on price movements. For an equity mandate, the characteristics of interest could include measures such as the growth in cashflow, earnings, book value or dividends of the portfolio. These measures are likely to be less volatile than performance data driven largely by market prices, while providing a more useful indicator of the ongoing success of the strategy.

It is important to note that the most relevant measures of success will vary from one manager to the next – the objective here is not to achieve total uniformity in the monitoring approach. Indeed, performance-chasing at the asset owner and asset manager levels can be traced, at least in part, to the homogenous performance monitoring reports produced across the industry on a quarterly basis.

In some respects, the proposed approach mirrors the way in which a private equity general partner has to monitor their portfolio. Without access to a frequently updated market valuation, the private equity owner instead focuses on the operating performance of the underlying businesses and their ability to influence outcomes by engaging with management. While there is plenty to criticise about the private equity business model, public market investors could become better long-term investors by borrowing some elements from their private market counterparts.

There is no perfect way to monitor an asset manager. Separating luck from skill will remain deeply challenging and it is impossible to eliminate all principal-agent problems. However, it would be difficult to design a performance monitoring system more likely to encourage procyclical decision-making than the current one. By looking less at the scoreboard and focusing more on the playing field, we believe that investors can incentivise a shift towards longer horizons within financial markets that will be both privately and socially beneficial.