Asset managers should fully disclose all the costs, including transaction fees, of investing in their funds to help restore trust and confidence in UK equity markets, according to the Kay Review.
The government-sponsored Kay Review examined the short-termism of investment due to the perceived misalignment of incentives in the UK equity market. It was commissioned by Vince Cable, the UK’s secretary of state for Business, Innovation and Skills, in June 2011 and conducted by economist Professor John Kay of the London School of Economics.
The report contains 17 recommendations, one of which encourages the full transparency of costs, including performance fees and estimated or actual trading costs, that are charged to a fund.
As part of its recommendation to provide greater visibility of costs, the Kay report suggests that good practice for asset managers should be to ensure that income generated from lending securities is rebated in full to the fund, with any related costs disclosed separately. The UK’s Pension Regulator has previously expressed concern that revenue from securities lending is not always returned to the asset owner and that end investors can be unaware that their securities are out on loan.
Kay also considered the nature of investment decisions made by asset managers, noting that the short time horizons on which individual portfolio managers performance is judged diminish the attention paid to the fundamental long-term prospects of a stock.
Uncovering value
He explained that if the performance horizon is short compared to the ‘value discovery horizon’, i.e. the time it takes for a security to revert back to its fundamental value after a significant event, asset managers will likely pay more attention to the views of other investors, rather than company performance.
“Asset managers are now competing against each, basing trading decisions that guess company performance in the short term,” said Kay, during a presentation of his report in London on Monday afternoon.
This pressure on asset managers to respond to short-term events would naturally increase the turnover of stocks in a portfolio, thereby adding to the transaction costs that are passed down to the end-investor.
Kay’s view on improving the transparency of the costs associated with investing is aligned with a recent policy review paper by the UK’s Labour party. The paper stated that asset managers typically only disclose annual management fees, which can make up less than a third of overall investment costs.
UK buy-side trade body the Investment Management Association rejected the Labour party’s claim, referring to it as “irresponsible scaremongering” and claimed there was no evidence undisclosed costs were causing investors to lose out.
HFT scepticism
While the UK government is conducting a separate examination of the effect that high-frequency trading (HFT) has on equity markets – the Foresight project led by the government’s chief scientific adviser Sir John Beddington – it did not completely escape the scope of Kay’s report.
Based on estimates from TABB Group, the Kay report noted that hedge funds, high-frequency and proprietary trading firms account for 72% of market turnover, but a small proportion of actual shareholdings.
“[Respondents] were sceptical about the claimed benefits of this activity in providing liquidity, and about whether these benefits would actually exist in the periods of acute market uncertainty when such liquidity might actually be required,” read the report.
However, speaking yesterday, Kay regarded HFT as a “symptom, rather than a source” of the wider issues investors face as a result of the short-term market dynamics.
Among Kay’s other recommendations included the creation of an investors’ forum to facilitate collective engagement by investors in UK companies, the need for companies to disengage from the process of managing short-term earnings expectations and announcements and the restructuring of incentives paid to asset managers and corporate directors to reward longer-terms performance.