All is not well in the stock markets of developed economies. New issues have been declining, returns are being squeezed and “long-only” investors have been departing. Paradoxically, responsibility for this decline – and its reversal – rests mainly with the traditional supporters.
Market price setters can be divided into traders, who seek to profit from price trends, or momentum; and investors, who engage in patient assessment of corporate worth. In recent years, traders have gained the upper hand and short-term price movements have come to dominate both performance measurement and risk management. The change required to redress the balance must be driven by asset owners with a long time horizon – pension funds, insurers, sovereign wealth funds, endowments and charities.
There is no point in simply rubbishing “short-termism”. Momentum trading can deliver quick results, giving fund managers the best hope of meeting the expectations of impatient asset owners. A catalogue of structural changes, including lower dealing costs, has encouraged momentum strategies.
The saddest aspect of this is that long-term investors have been drawn into the momentum game. Symptoms of this include the emphasis on relative performance, leading to risk being equated with tracking error – a recipe for herding. Asset owners cannot duck responsibility for this. To keep their agents on a short leash, performance is invariably compared with a market value-based (in effectively herd-weighted) benchmark and funds are switched from recent poor performers to better ones, amplifying momentum.
When investors who should be patient join the momentum traders, prices are pushed even further away from fundamental values based on cash flow projections. This is despite the fact that it is cash flows that will be needed over future decades to pay pensions and insurance claims and to run charities.
If the bulk of professional investing neglects the value of the assets being traded, capital gets misallocated, markets are volatile and returns are puny. Little wonder that the purpose of equity markets is being seriously questioned.
Of particular importance is the interaction between mispricing and the asset owner’s time horizon. For custodians of funds with long horizons, momentum has real negatives. It means always buying after prices have started to rise and selling after they have started to fall – not a winning formula in the long run. It is sensitive to getting the timing just right – not easy when an institutional process is involved. But worst of all, it means locking in losses.
The patient investor, by contrast, has the choice of holding on to stocks where the fundamentals have not changed but the market price disappoints. This makes cash flow investing best placed to win in the medium and long run. It also reveals a profound truth in investment practice: that the long run adds up to more than the succession of intervening short runs.
How can asset owners take advantage of these principles? First, they should introduce a turnover limit, such as an annual cap on sales or purchases of 30 per cent of a portfolio’s value. Nothing betrays a closet momentum investor more than high and costly turnover. This need not be a hard rule, the point is to force fund managers to explain their motives to asset owners.
Second, funds should replace benchmarks based on market capitalisation with ones that are more stable. These might be linked to gross domestic product growth in the countries in which liabilities will be paid, or based on measures of dividend income.
Total shareholder return has been overused as an annual performance measure because the price change element of TSR overwhelms dividends. If investors obsess about share prices, companies will tend to neglect dividends and resort to share buybacks and other short-term measures to enhance prices. This does not mean that asset owners should never invest in companies that do not pay dividends. Investors must make an attempt to estimate future cash flows. But such shares are more risky.
Third, asset owners should lengthen the performance evaluation period and only pay performance fees on long timescales.
A fund adopting these strategies will gain a private advantage in the form of higher medium- and long-run returns. As more funds follow suit, equity markets will become more stable, encouraging investment. If the market signals improve, there is a better chance of capital being allocated productively. This is a rare case of the private and public interests being in complete alignment.
Paul Woolley is senior fellow at the London School of Economics. This piece was co-written by Dimitri Vayanos, professor at the LSE
