Fiduciary duty in dysfunctional markets
Investment theme stock market and financial business analysis stock market with digital tablet
Financial markets play a central role in the capitalist economy, allocating new savings for productive investment, serving as a signaling device to corporate management and providing liquidity to investors.
The efficient markets paradigm claims that competition among investors keeps asset prices close to their fair value, but a new interpretation argues that stock markets have turned into a competition between two groups of investors:. This never-ending battle corrupts prices, creates macroeconomic instability and costs massive amounts of asset management fees.
The new paradigm highlights the role of principal-agent relationships in getting investors and businesses to focus on short-term stock price movements at the expense of long-term cash flow. A cascade of agency issues range from savers to asset owners, asset managers and ultimately corporate boards. Agency problems at all levels of this chain give rise to a pervasive short-termism that reduces long-term returns for savers while imposing substantial costs on society as a whole.
We focus on the key link in this chain: the actions of asset owners by delegating responsibility to asset managers. When setting contract terms, asset owners often impose tracking error constraints that limit the possibilities for deviation from short-term benchmark returns. Even in the absence of such constraints, managers have a strong business incentive to avoid a prolonged period of underperformance. As a result, managing career risk often trumps long-term decision making.
The emphasis on short-term performance is the original sin of investing and leads to many problems in asset valuation and asset management. Managers are responding to the underperformance by reducing underweight positions in rising assets that they previously rejected. These purchases penalize long-term returns and amplify price increases leading to overvaluation.
A related problem is the propensity of asset owners to hire recently successful managers and fire those who fail, thereby creating fund flows that further amplify short-term price changes. These pro-cyclical flows prompt asset managers to seek performance while creating the opportunities that dynamic, trend-following investors exploit.
Poor asset valuation and bubbles damage the real economy, creating macroeconomic convulsions and giving false signals to the corporate sector. If the stock price does not reflect the fundamental value of a company, business leaders are faced with the dilemma of choosing between targeting short-term stock price or long-term cash flow. The actions relating to each objective are for the most part mutually exclusive.
To target the share price, CEOs can reduce capital spending and R&D, focus on projects with quick payoffs, engage in high-priced buyouts, increase leverage to profit short-term profits and use accounting devices to flatter current profits. They can also pursue strategies designed to keep pace with their competition without due consideration of risk – “dancing while the music is still playing” to paraphrase Chuck Prince – the corporate equivalent of a dynamic strategy.
One of the big beneficiaries of the current state of financial markets has been the asset management industry, with annual fees of around $ 300 billion. The industry meets many criteria of a highly competitive industry: a large number of producers, low barriers to entry and low start-up costs. However, the dynamics we describe are leading to excessive turnover, a bloated asset base on which to charge supernormal fees and profits across the industry.
Fiduciary duty obliges the owners of assets to act in the best interests of the final beneficiaries. It can be seen as alleviating some of the problems that arise in the delegation process. However, many asset owners either explicitly allow or tacitly accept the use of short-term tracking of market capitalization benchmarks. Since this activity is likely to reduce returns in the long run, there is a a priori cases where these asset owners breach their fiduciary duty.
The theoretical corpus developed over the last 14 years at the LSE Paul Woolley Center for the Study of Capital Market Dysfunctions and elsewhere suggests that the remedies depend primarily on how large pools of capital are administered: how assets are distributed, the terms under which trustees and other trustees delegate to external asset managers, the strategies they approve, and how they monitor results.
More effective application of fiduciary duty to curb pursuit of performance offers the potential for better long-term returns with the added benefit of more stable and efficient markets. By checking the implicit time horizon of the strategies adopted by the asset managers they employ, asset owners could incentivize to move to longer horizons within financial markets with both private and social benefits.
A more detailed report on which this article is based can be found here.
Philip Edwards and Paul Woolley are co-founders of Ricardo Research