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.

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.

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.