This article appeared in the Financial Times on 18 April 2019
The asset management industry is horribly conflicted. On the one hand, it is supporting the grassroots drive for big business to adopt sustainable and responsible policies. On the other, the majority of investors and asset managers are following strategies that destabilise asset prices and promote short-termism. This short-term mindset not only undermines the shift toward sustainability but does untold damage to the macroeconomy.
Over the past decade public opinion has sought to encourage businesses to adopt strategies that are environmentally friendly, socially aware and observe good governance. Asset managers have taken up the cause, steering customer funds towards companies that follow this philosophy, bringing about a definite change in ethos and some improvement in practice along the way.
But this trend is coming into conflict with the priorities of the average asset manager. Sustainable companies must take the long view in planning decisions and be prepared to sacrifice short-term profits in the interests of private and social returns. In complete contrast, competitive pressures ensure that most portfolio investment is made with an eye to the next quarterly or annual return.
So why are asset managers so focused on the short term and what does that imply for the way markets behave? Despite the scale and complexity of the industry, asset management really has only two drivers for managing money: cashflow and price.
Cashflow investors focus on the fundamental worth of companies represented by the future stream of cashflows expected from securities. This approach calls for patience while waiting for prices to adjust or earnings to come through and is the essence of long-termism.
Price-only investors exploit the trends caused by tidal surges of funds constantly sluicing through security markets. Momentum and trend-following strategies are the most obvious examples. In simple terms, such strategies buy (or overweight) recent winners and sell (or underweight) recent losers. This is a short-term strategy in which investors pay no regard to fundamental value, simply hoping to sell around the peak.
In practice, most active funds use a combination of these approaches, due to the pressures of the performance reporting cycle. By convention, fund performance is measured against the returns on a market cap index or by peer group comparison. Asset managers are either explicitly instructed to keep performance within a close range of the benchmark or do so anyway for fear of falling behind the pack.
Add momentum-only funds and high-frequency traders, together with hedge funds looking for quick wins, into the mix and the full scale of assets being actively managed with short horizons and without reference to fundamentals becomes apparent. Bearing in mind the high turnover needed for any momentum strategy, estimates that about 90 per cent of stock market trades bear no relation to fundamentals do not look unreasonable.1
The impact on the corporate sector and its hoped-for drive to sustainability is clearly negative. If a company’s share price does not come close to estimates of fundamental value, company CEOs and their boards face a dilemma. Do they seek to maximise long-term cashflows or short-term share price? The policies needed in each case are mostly mutually exclusive.
Just as asset managers need to keep short-term performance flying high, CEOs are expected to keep their stock prices and profits in line with competitor firms or face the sack or takeover. Chuck Prince’s maxim “as long as the music is playing, you’ve got to get up and dance” is every bit a momentum strategy. Short-termism is then reinforced by a reward system of early-exercise stock options. Long-term objectives are abandoned. Capital expenditure and R&D may be cut, leverage increased (which may haunt the business in a downturn), and accruals used to flatter the current profits and balance sheet. This is not fertile ground for firms seeking to take on long-term sustainability programmes.
This is the sad situation in which capitalism finds itself. The first step towards reform is that this scenario should be accepted as reality by all players: trustees of funds, investment advisers, policymakers, the asset managers and business leaders themselves.
If progress in sustainability is to be made, the onus is on large funds to revise manager contracts and guidelines with the aim of minimising quarterly performance-chasing. Performance could then be checked against other cashflow-focused asset managers to establish ability with greater confidence than currently possible with mixed strategies. There is both private and social gain from extending the investment horizon and even the bonus of an early mover advantage.
Sustainability programmes will always take second place so long as asset managers invest without reference to long-run cashflows. Reformers should look beyond sustainability to reforming the whole approach to asset management, where the social gains would be immense.