The UK government is investigating “short-termism” in the market; what do they mean by that?
An independent review of UK equity markets, to be led by Professor John Kay, an economist from the London School of Business, has been commissioned to tackle a perceived disconnect between the companies that issue stock and the end-investors who buy it.
Vince Cable, secretary of state for business innovation and skills, has been told by UK investors that corporate executives are incentivised to pursue strategies which are not in the long-term interest of their shareholders, while the “ultimate owners of the assets are powerless to intervene” because of the complexity of the investment chain. He also cited a paper written by the Bank of England’s Andrew Haldane as showing “significant evidence of short-termism in investment decisions”. Feedback to a government call for evidence has indicated “the way fund managers are incentivised is short-termist”. Kay must answer the question: is short-termism harming the economic prosperity of the UK?
Another aspect of short-termism’s malign influence, according to Haldane’s recent speech to the International Economic Association Word Congress, is that that firms specifically engaged in high-frequency trading (HFT) can quickly shift disruption in one market onto other connected markets, potentially spreading contagion across exchanges trading the same equity instruments.
Why is short-termism harmful?
There is an argument that too much short-term behaviour tends to create “boom and bust” cycles as large numbers of market participants buy rapidly appreciating assets and then sell rapidly depreciating assets creating volatility in the market. Examples of this can be found in the Tulip-mania of the Dutch market in the 17th century and the dot.com boom of the late 20th and early 21st century.
Although price volatility offers an opportunity for actively traded short-term funds to make money, it can leave long-only investors on the sidelines. One of the challenges for regulators is to identify what constitutes short-term.
If market prices suddenly shift in such a way that a long-only firm is required to change its position unexpectedly, the firm cannot be punished for acting within the interests of its end-investors.
Professor Ian Angell of The London School of Economics, speaking at the 2008 City Debate, a discussion run by industry body the Futures and Options Association, pointed out, “If your business is to survive in the long run, it must first survive in the short-term. This requires dealing with the uncertainty by steering in the flow of events.”
So is HFT a source of short-termism that damages the interests of end-investors?
The business model of many HFT firms is to make profits from intraday price movements and close without a position. They can be said to provide useful liquidity to the market, but some have argued that reliance on HFT flow contains risks.
Liquidity withdrawal was identified by US market regulators as a major component of the “flash crash” on 6 May last year, that caused the Dow Jones Industrial Average to plunge 1000 points in a 20-minute period before recovering.
As Mary Schapiro, chairman of the Securities and Exchange Commission, noted, this had a negative effect on the investor confidence; the US industry body Investment Company Institute reported that US$25 billion was withdrawn from equities by US mutual funds during May 2010.
Will regulators be able to control short-term behaviour?
In his speech announcing the launch of the Kay review, Cable referred to a number of ways in which it might be tackled: addressing directors’ fiduciary duties to prioritise long term goals; giving long-term investors greater voting power than short-term traders; rewarding executive performance based on long-term performance; and using taxes system to penalise short-term trading.
However a clear definition of which short-term behaviour is considered damaging to economic prosperity will need to be identified by the Kay Review; splitting out harmful behaviour from useful activity could be difficult.