Institutional investors – help, please

June 9, 2009 by
Filed under: Credit crunch, Politics, The RSA 

It is a welcome relief to post about matters other than the Labour Party. And today I am asking for help. Tonight I have to respond to Lord Myners after he has spoken on the topic ‘Institutional Investors – The Weakest Link’.

As I will be, by far, the person in the room with the least knowledge of the subject I thought I would share some initial thoughts and implore my readers to help me turn them into something coherent. It should be easier for me as I can predict what the minister will say as he spoke on a similar topic a few weeks ago. The key quotes from that speech, as reported on the excellent Labour and Capital blog were:

Institutional investors are expected to exert the influence and exhibit the values of “owners” but are incentivised to behave as “investors”, with performance scrutinised on a quarterly, monthly or even a daily basis.

In this context, we have almost certainly understated the profound challenges faced by the majority of institutional fund managers in fulfilling expectations in respect of the broader definitions of governance where they relate to ownership (here I exclude those fund managers who place governance at the core of their commercial offering).

To put it simply: most institutions are not set up to act as owners; they don’t have the mindset of owners and are not incentivised by their clients to act as owners. They are investors- leaseholders rather than freeholders.

And:

Short termism, as practised by pension funds, is self-defeating for those charged with delivering pensions over many decades in to the future, and yet it remains a predominant form of behaviour.

A focus on “shareholder value”, as measured by relative share price performance over quite short time periods lies at the heart of a number of behaviours which have delivered less than ideal outcomes, such as:

the ascendancy of momentum investing which discourages contrarian thinking by all but a small minority;

a partiality to merger & acquisition activity which so often fails to deliver the outcomes promised;

the adoption of aggressive and inappropriate capital structures to fend off predatory activity by private equity and others; and

a failure to take account of the longer-term consequences of investment activity, including impact on the broader economy and society.

The problem is that this is exactly the argument I would have made, but much less elegantly.

The only thought I have right now is to suggest that Lord Myners’ arguments, plus the poor average performance and exorbitant costs of actively managed funds (see our Tomorrow’s Investor report),  throw into doubt the whole question of Joe Public gambling their savings and pensions in the stock market. Just as representative democracy is a blunt tool (see post last week), so ordinary small investors have neither the expertise nor the clout to have any influence.

This leads me to go back to some very basic points:

1) Population ageing and our addiction to debt mean that we need more people to save more. To encourage this people need to feel that they are getting reliable returns.  

2) Overall, it is probably better for the British economy for people to save by investing in the market rather than in housing, gold or fine wines?

3) But there is no reliable way to decide how best to invest our billions in the market. As I said before, actively managed funds have actually done worse that indexed funds over the last ten years.  We can – and should – add good governance to shareholder value but let’s remember that two years ago RBS, HBOS etc would probably have argued that they were exemplars of good governance and corporate responsibility.

There is a lot of talk of greater transparency but as many people have pointed out – including John Lanchester in a brilliant polemic in the LRB  – the information about the banks’ dodgy investments in CDOs and sub-prime loans was in their annual reports, albeit opaque to any but the most diligent expert. The problem was that only a few voices in the wilderness were shouting about the risks involved in these investments. And, as we now know from Robert Shiller and others, these warning voices are rarely heard in a bull market.       

4) For most of us – and this may be where I start getting things wrong – a long term rate of return in line with the average growth of the economy (inflation plus 1.5-2%) would be fine. This would be enough to make it worthwhile for people on near or above average earnings to save for a decent pension (as long as they started early and kept up with the payments).

5) So, if we were designing a system from scratch and – this is crucial – we were oblivious to the self interested arguments of the financial services sector what would we build? Would we end up with what we’ve got and simply have to reconcile ourselves to the occasional crash followed by ritual stable door shutting, or would we design a radically different system?

6) If the new framework for pensions is introduced in 2012 (and this is becoming a bigger ‘if’ by the day, I sense) there may an opportunity to use the huge resources that will be administered by the Pensions Authority to reconstruct the architecture of savings and investment but there are big question marks hanging over the viability of the new framework, let alone what its investment strategy should be.

So I guess my big question is this: Don’t we need to bring the debate about pension reform (one that the major parties seem to me to be dodging at present) together with the debate about regulatory reform?     

I know this is a hopelessly ill-informed ramble so I look forward to getting advice from all of you who know a great deal more……

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7 Comments on Institutional investors – help, please

  1. Duncan on Tue, 9th Jun 2009 12:13 pm

    2. Matthew,

    I think you’re certainly on the right lines here.

    I sketched out some thoughts on both ownership:

    http://duncanseconomicblog.wordpress.com/2009/03/18/ownership/

    And regulation:

    http://duncanseconomicblog.wordpress.com/2009/03/18/52/

    But I think one of the key points here is the conflict between fund managers acting as ‘good owners’ and acting as ‘good investors’.

    Take the case of RBS – most shareholders voted in favour of the takeover of ABN Amro – but of course they did, anyone who really disliked the look of the deal sold their shares and walked away.

    Essentially we must recognise the conflict. If I held RBS shares for the past two years (as they fall 90%) but continue to act as a ‘responsible owner’ engaging with management, attending meetings and offering advice – will the ultimate investors (the pension holders) be happy with me or not?

    Whilst I agree that many fund managers are indeed rubbish, and costs are certainly to high, the blame does not entirely rest with them. Pension fund trustees demand quarterly reporting which pressures FMs to be short termist.

    What we really have is a huge and complex principal-agent problem. The ultimate owners, the pension fund holders, rely upon their trustees. The Trustees employ investment consultants to pick fund managers. The fund managers then rely upon company management.

    ‘Activist’ investors, which we really should welcome, now have a bad name. Associated as they are with hedge funds.

    There is a real need for people to be realistic about the sort of returns that can be made. 5-6% seems about right to me. Crucially long term returns come from good asset allocation (between stocks, bonds, cash, property, other assets) not excellent and skillful fund managers.

  2. Simon Watson on Tue, 9th Jun 2009 1:18 pm

    3. How about a tax-on-trade rate that depreciates over time? Not unlike a Tobin Tax, this could incentivise long term ownership, reduce volatility and lengthen the reporting cycle.

    The capital gains on short owned stock could be 5%, medium term stock could be 3% and long term stock gains 1%.

    The tax rate from the short and medium term gains should be ring-fenced and ploughed into a sovereign wealth fund. The gains from the SWF could then be reinvested for the benefit of pension relief or national state pension allowances.

  3. Duncan on Tue, 9th Jun 2009 1:21 pm

    4. Simon,

    I’ve argued in the past that the best way to influence behaviour through tax is stamp duty. Call it 5% on all transactions (buying and selling). So a fund manager knows a purchase and sale will cost them 10%. They’ve got to be pretty sure before changing the portfolio.

    Another option is say that owners are only entitled to dividends if they’ve been on the shareholders register for at least one year.

  4. Simon Watson on Tue, 9th Jun 2009 3:08 pm

    5. Hi Duncan

    Would the time limit on the shareholders register do anything to reduce day trading on price fluctations?

    I suppose one other considering is the lending of shares for shorting – would the time-on-register proposal affect this?

    S

  5. Michael on Tue, 9th Jun 2009 3:16 pm

    6. The Government Pension Fund of Norway is the second largest sovereign wealth fund in the world after that of the United Arab Emirate. It is managed by a civil servant with a team of just 13 staff (see link). Something to learn from there perhaps – here in Britain so much managment status and salary accrues from growing the number of people “reporting” to you.
    http://news.bbc.co.uk/1/hi/business/7961100.stm

  6. Duncan on Tue, 9th Jun 2009 3:28 pm

    7. Simon,

    The dividend time period plan would do less to stop day trading than increased stamp duty would.

    Equally though ‘some’ day trading is no bad thing as it adds to liquidity.

    As for shorting, again the details could be done either way – it would be simple to say that if shares were on loan then the holder lost dividend entitlement.

    Again though, some shorting is usual.

  7. Colin on Tue, 9th Jun 2009 9:21 pm

    8. I work in regeneration and there was a time when pension funds where quite well disposed to the long term, high growth rates that regeneration schemes can deliver if properly managed with appropriate public and private sector support.

    This may return but one other route to encourage investment in these types of schemes – which definately require a long term stake to maximise benefits and returns – is to market to Self Invest Pension holders as a form of private investor. Getting the volume of interest maybe an obstacle given the size of the SIP market and the difficulty in marketing to such a diverse group, though.

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