Regulation

Reform agenda gains momentum in Europe

Why do regulators think that buy-side firms are short-termist?

The European Commission (EC) was told as much during a consultation on financial market efficiency and has had this feedback reinforced by academic research.

Initially it spoke with representatives from across industries, to determine the issues that drive short-termism and risk-taking in financial markets, which it is determined to reduce as part of the Group of 20 countries' commitment to build more sustainable markets.

In the European Union corporate governance framework green paper, published in April 2011 after the EC's consultation, the Commission said that the agency model that exists between asset managers and asset owners “contributes to capital markets' increasing short-termism and mis-pricing”.

The source for this theory is cited as a paper by Dr Paul Woolley, a senior fellow at the London School of Economics, which draws upon the ”Institutional Theory of Momentum and Reversal' he developed with Dimitris Vayanos, a professor of finance at the London School of Economics.

It explains how momentum builds up behind price changes, with investors reinforcing the behaviour of outperforming fund managers, while assuming that the strategies of underperforming managers are not worth following. As this amplifies the price changes that led to the initial over- or underperformance, it generates momentum.

Woolley says that over the short term, not only does a momentum investment strategy work but it becomes self-fulfilling, as the more investors use momentum strategies, the more likely they are to push values higher. However this increased turnover of stocks comes at a cost, in addition to the effect on asset pricing.

“Active management fees and its associated trading costs based on 100% annual turnover erode the value of a pension fund by around 1.0% per annum,” he says. “Pension funds are having their assets exchanged with other pension funds at a rate of 25 times in the life of the average liability for no collective advantage but at a cost that reduces the end-value of the pension by around 30%.”

One may argue with Woolley's critique of active management but there's no doubt he's caught the attention of the Commission.

Why is the level of churn so high?

Competitive forces. The real pressure appears to be that asset managers think they will be fired if they do not up their performance to the benchmark of their peers.

The EC said that its consultation with institutional investors indicated many asset managers “are selected, evaluated and compensated based on short-term, relative performance” which discourages diversity.

Typically, asset managers are reviewed by their pension fund clients every three years, which lends itself to longer-term investment gains. But they might be dropped sooner if the mandate for a fund changes and they cannot service it, or if their performance is below par over this period.

Performance is reported to the client, assisted by a consultant, on a quarterly basis. That creates shorter-term pressure.

It is worth considering that intermediaries typically get paid for executing change. This applies equally to pension fund consultants, who benchmark and advise on the performance of fund managers, as well as the fund managers themselves.

Although fund managers may not be replaced on a quarterly basis, the stocks they hold may be, if consultants express concern about their investment choices.

At the same time brokers are pushing down the frictional costs of trading, to make changing the portfolio less painful.

What do regulators plan on doing?

Woolley makes a number of recommendations such as measuring portfolio and individual trader performance over three or four years in order to reduce moral hazard, capping portfolio turnover to 30%, removing of performance fees and increasing transparency in investment strategy, trading, markets used and products traded.

The EC's consultation on the corporate governance framework closed on the 22 July 2011; its actions will be determined by the feedback received.

Separately, UK secretary of state for business, innovation and skills Vince Cable said that the country's existing system for equity investment must be “recalibrated to support the long-term interests of companies as well as underlying beneficiaries”.

He has tasked Professor John Kay of The London Business School with a review of the national equity markets, assisted by a panel of experts, to tackle short-termism, examining the fee and pay structures in the investment chain, to ensure they are consistent with the long-term objectives of asset owners. The report is due in 2012.

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