Asset managers must focus on long term to justify their existence
By Fiona Frick, CEO, Unigestion
Published: 30 June 2016
Ensuring financial markets function as an efficient transmission mechanism
The finance industry provides the flow of capital necessary for the economy to grow. Within this system, asset management companies have a vital role to play – European asset managers alone hold equities equivalent to around 40% of the free float of European listed companies. One of the key jobs of the asset management industry is to make sure that the financial markets function as smoothly as possible. How exactly do we do this?
Ensuring appropriate liquidity
First, we must ensure that there is no mismatch between the liquidity of the securities we hold in our investment solutions and the redemption conditions we promise to investors – in other words, our investment funds must not provide more attractive liquidity terms than that of the underlying investments those vehicles allocate to.
If there is a liquidity mismatch and a fund cannot meet redemption demand in a down market, there can be major implications for the markets as prices will diverge from the value of the underlying assets. This was strikingly the case in 2008 when hedge funds could not cope with the redemptions that investors were trying to make.
More recently the rapid rise in flows into and out of exchange-traded funds (ETFs) has also raised some concerns, with two worrying incidents taking place in 2015. First, US shares were sold off sharply at the opening of the market on 24 August 2015, and US equity ETFs saw their prices plunge far below the values of the indices they were designed to track. Second, a gradual sell-off in high-yield bonds in December 2015 turned into a rout for ETFs investing in this asset class. In short, ETFs are an untested market force that may increase selling pressure in a market downturn.
Focusing on the long term to prevent excessive market volatility
Second, asset managers need to play the role of long-term buy-and-hold investors, basing their decisions on their confidence in a company’s valuation and growth potential. Today, an alarming proportion of financial market participants do not invest for the long term, but trade in the hope that they can jump off a profitable bandwagon in as little time as possible.
The danger of this short-termism is that it creates volatility in the stock price, which represents a risk for investors. What’s more, it doesn’t incentivise asset managers or the companies they invest in to adopt long-term strategies as they will not be judged on their success. Instead of encouraging our institutions and leaders to overcome complex, long-term challenges, we’re actually rewarding them to do the opposite. Often, there seems to be a great deal more upside to placing a simple bet for a quick win than in staying the course through difficult times with the aim of creating sustainable gains that can be widely shared across society.
So asset manager incentives should be based on long-term return metrics that incorporate measures of risk. Investors, for their part, must act as the long-term owner of a stock and not as a mere renter who will trade the stock as soon as they can pocket a quick gain – or sooner if there’s no such gain to be made.
In fact, there is far too much short-termism throughout the economy. Companies are judged based not on their long-term financial performance and future potential, but on what happened over the last quarter. Asset managers are assessed by their clients in large part on their year-to-date performance rather than their long-term returns.
But it doesn’t have to be this way, and indeed it wasn’t in the past. It is only in the last 10 years or so that this focus on the short term has become so prevalent – previously, a 3–5-year horizon was much more common. And going further back in time to the very beginnings of the stock market, the whole idea of investing in a share was to benefit from the issuing company’s long-term growth.
So it is important that asset managers invest with the long term in mind and do not pay too much attention to short-term noise. Institutional investors also have a role to play in this respect, as they have long-term liabilities and must move towards assessing their asset managers over a similar horizon, not just on the last few months. We elaborate on this point later on.
Contributing to price discovery and avoiding bubbles
A third way in which asset managers ensure that the markets are efficient is their role in price discovery. But it is only active managers that can perform this role, and it is one of their most important functions.
A decade ago, passive funds accounted for around 5% of global assets invested in public equity. Today, this figure is around 20%. Passive investments provide a great service in terms of keeping a lid on management fees and ensuring liquidity in the markets, but they cannot match the role of active managers in terms of price discovery.
What does this mean in practice? In simple terms, active managers aim to uncover as much information as possible about a stock and these details are incorporated in the share price, which represents the sum of all of their views. Without active managers, no one would have an accurate idea of what the price of a security should be.
Passive investors, in contrast, act as free riders in that they only have to pay the marginal cost of participating in the markets rather than the high costs of a research process whose aim is to accurately assess prices.
What’s more, in general they allocate capital based on the composition of a market index rather than in the belief that a company will grow or that it is an attractive investment. This means a passive approach is like investing by looking in the rear-view mirror. If a company is in the index, passive investors are forced to continue investing even when a company’s valuation has become disconnected from its fundamentals. The result is that the greater the proportion of capital invested in passive strategies, the more likely it is that bubbles will form and that investors will be exposed to sharp reversals in performance.
The purpose of passive investment is not in question but its rapid growth raises the question of whether it has come to lead the market rather than follow it. The cost to society of passive management is a more volatile and less efficient stock market. If all investments were managed passively, the main function of the market – to provide pricing – would cease to exist. Passive investments can also expose investors to undue risk: an investor allocating to a passive fund in 2008 would have been taking exposure to some very risky sectors (such as financials) that were about to collapse and that many active managers avoided entirely. Active management based on exposure to a set of proven risk factors provides the most scope for producing attractive long-term risk-adjusted returns.
Long-term financing of the economy
Asset managers are ideally placed to provide long-term funding
Asset managers should increase their involvement in the long-term financing of the economy, and there could be some considerable advantages to them doing so. Unlike banks, which use short-term funding to allocate capital, asset managers use the long-term funding provided by institutional investors (with the caveat that those investors must remain invested), so they provide a crucial link between investors and the financing needs of the real economy. What’s more, history shows that very few of them have gone bust or needed state bail-outs in order to survive. Active asset managers allocate capital among competing uses so, if they do so properly, economic growth will be enhanced as those activities that generate the best risk-adjusted returns should attract the most investment.
So asset managers have an important role to play in society in terms of channelling capital to finance growth. But not any kind of growth. The real end goal should be sustainable economic expansion that minimises the risk of another major financial crisis.
How can we achieve this goal? Again, institutional investors and asset managers must work together to allocate to companies with a sustainable growth model rather than looking for a short-term jump in price. Institutional investors (mainly pension funds and insurance companies) account for around 75% of the asset management client base in Europe, so they have a major role to play in ensuring the companies they invest in act responsibly and implement good corporate governance practices.
Given that the liabilities of our biggest clients – pension funds and insurance companies – are rather long term in nature, asset managers are well placed to act as a source of long-term finance to the economy, mainly by investing in equity and debt securities issued by companies and governments.
This holds true for investments in private as well as public equity. The idea of private equity is to inject working capital into a promising business and help refine its products, operations or management, while suitably compensating shareholders for the risk this involves. As private equity investments are long term in nature, investors have even more time to make sure the strategy of the underlying companies meet a relevant societal purpose.
A change in mind-set
But at the moment, adopting a long-term approach is easier said than done because of the current focus on short-termism, which we discussed above. For example, the average holding period of a stock has fallen from eight years in the 1960s to around one year today. Meanwhile, the tenure of the average CEO is just three years. Under these circumstances, what kind of motivation do company managers have to put forward a long-term strategy? As it stands, they will just be judged on day-to-day events.
We see evidence of this in the financial news on a regular basis. Short-term financial engineering efforts, such as buybacks, dividends, spin-offs and sales, are increasing in frequency, and they generally cause shares to spike in the short term. But such activities can have unwanted effects over the longer term, leaving a company’s finances more vulnerable, especially if it uses borrowed money to buy its own shares. This is harming the long-term creation of value and may ultimately be doing companies and their investors a disservice, even if stock prices rise impressively temporarily.
We can see this in a 2015 report published by McKinsey Global Institute, which showed that the average variance in return on capital for North American companies is over 60% higher today than it was between 1965–1980. What’s more, a focus on short-termism could see public companies lose ground to other kinds of firm, compelling some to move back to private ownership so they can implement a long-term strategy without worrying too much about quarterly earnings. In the US, the number of listed shares has fallen from 8000 in 1996 to half that number now.
To avoid this kind of situation, asset managers must act as long-term investors who make sure that companies do not focus too much on the daily fluctuations of their stock prices and that they plan for and invest enough in their long-term futures. Meanwhile, company CEOs must be incentivised to invest in research, innovation, and training their staff, and to make the capital expenditure that is vital to ensure long-term growth and ongoing relevance of the company as the needs of its customers evolve.
Investors need to be on board
The caveat of all this is that institutional investors must also take a long-term view when they choose their asset managers and evaluate their investment performance. This could be achieved by setting out a fee structure based on long-term performance objectives – we believe that a horizon of five years is appropriate given that this is approximately the length of an investment cycle.
Internal managers working at institutional investors must also be judged over the long term. If they are assessed on their one-year performance, even though the goal of the pension fund is to meet its long-term liabilities, there is no way they will judge their asset manager based on long-term returns.
While a shift to a long-term focus would represent a big change from much current practice, it would be in the interests of investors themselves. As most institutional investors themselves have long-term horizons, ensuring the sustainable long-term growth of the companies they invest in is clearly in their benefit.
With the fallout from the 2008 crisis still affecting the lives of millions of people across the world, it is unsurprising that the financial industry is still viewed with considerable suspicion by much of the general public. But we believe it can be a powerful force for good.
Asset managers in particular have a major role to play in helping solve some of the most pressing problems that the world currently faces, and we must demonstrate our capacity to develop meaningful investment solutions that meet today’s challenges and help finance sustainable economic growth.
We are in a privileged position in terms of our position as a link between the providers of and those who need funding, and we must make the most of the opportunity we have to improve the world we live in as well as grow the value of our clients’ assets. If we do so successfully, we will once more be able to justify our existence as an industry to a sceptical public.