Tag Archives: FInancial Times

06.23.16
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Market response to Brexit demonstrates why cheap passive funds aren’t good value for the economy

The volatility and volume of trading in the global market response to the surprise result of the Brexit vote on Friday is an excellent example of why cheap passive funds are not good value for the economy, or the markets.

The crashing market, provoked by the panic of what the vote result might mean, was exacerbated by passive funds scrabbling to meet their investment mandate, which is to replicate particular indices.

Passive investment managers aim to create a portfolio of stocks that replicates the performance of a nominated index, such as the S&P/ASX 200, the FTSE 100 or the S&P 500. Their investment decisions and trading activity only reflect changes to the index, not a considered investment decision by an investment professional. There is no consideration of what each company is doing and the economic value they are creating for shareholders, rather the trading is focused on responding to what other investors are doing.

This trend also reflects the rise of the importance of trading over investing. The desire for the quick return, matched with the short-term quarterly reporting culture rewards the buying and selling of assets rather than investing in companies that will produce longer-term growth.

The funds merely replicate an index, which is just a collection of companies that are acknowledged by size, rather than quality. And trading in and out of them is based on a logarithm that is adjusts to continually reflect the market, which moves based on other people’s decision making. It is not based on an assessment of the future growth of the company, the quality of the management and the value the company adds to the economy.

The rise of the passive fund management industry reflects the belief of quantitative analysis as a ‘cost-effective’ way to invest and not have your returns eaten away by asset management fees.

Indeed one of the great active management houses, Fidelity Investments, has decided to start offering passive funds on third party platforms in response to customer demand.

The Financial Times reported recently that passive funds have risen to have $US6bn, up 230 per cent since 2007 and growing at four times the rate of active fund management, according to Morningstar. The focus of passive investing is on the cost of the investment, rather than the value of the investment. Indeed, the marketing of passive funds has focused on the cheapest of the option to invest in a market, because over the long-term equity markets rise.

Active investors haven’t helped themselves with eye-watering fee structures for often ordinary performance. The ‘long-only’ funds, which are allegedly designed for fund managers to buy and hold equities they believe will grow over the long term, have vast pockets of mediocre performance, sometimes due to mediocre managers, sometimes risk parameters that make it nigh on impossible to produce a decent return and sometimes because the fee structure rewards average performance and robs the end investor.

Hedge fund managers, who market themselves as superior to long-only traders because they also bet against stocks they think will fall, leech about half of pre- fee returns  but very often produce mediocre returns as well.

Passive funds do not participate in corporate governance discussions, they do not add to the public debate about company decisions nor do they invest on the basis of good company management decision making. They may be cheap, but they add no value. Indeed, as the events of the past few days have shown they add to the problem.

Active managers need to be less greedy and prove how they can add the value that company management so desperately needs.

04.05.16
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The Panama Papers reveal the ugliest parts of a bigger transparency problem

The fascinating phrase ‘ultimate beneficial owner’ kept popping up in the coverage after the release of the so-called ‘Panama Papers’ this week. It referred to the masking of the true owners of assets under layers and layers of shell companies and nominee directors.

Tax agencies, legal authorities and fraud investigators have all decried how the web of shell companies camouflaged the ‘ultimate beneficial owners’ making it extremely difficult for these owners to be held accountable for how the assets were acquired, to pay the appropriate tax in the jurisdiction in which their money was earned or to understand their level of influence in the halls of power.

In the outrage at these unidentifiable ‘ultimate beneficial owners’ and the lawyers who help them to set up the structures , the importance of transparency of knowing who owns what, and who has influence was raised again and again.

But before we all get swept up in the outrage of it all, it is worth reflecting that the lack of transparency regarding ‘ultimate beneficial owners’ of any large company is rife throughout the financial system, so much so that it can be argued that it is accepted as the norm.

For example, as part of their commitment to transparency of ownership, Australia’s biggest companies list their top shareholders in their annual reports but a quick flick through these lists shows the laughable nature of this proposition. Most of the names on the list are nominee companies. The biggest ones are HSBC Custody Nominees (Australia) Ltd, JP Morgan Nominees Australia Ltd and National Nominees Ltd.

Australia is not alone; the nominee company system is widespread in the Western financial services sector. Nominee companies are custodian services that allow investments from a number of investors to be aggregated into one entity. According to the Australian Securities and Investments Commission (ASIC) they typically hold securities, arrange the banking of dividends and some form of consolidated reporting. They don’t engage with senior management or boards about how companies are run on behalf of their clients.

In fact, in submissions to a 2008 parliamentary committee inquiry on corporate governance, large listed companies raised the use of nominee companies as a key barrier to the effective engagement with its shareholders. The companies said the use of nominee entities also made finding the ultimate owners of shares difficult. This makes it very hard to align the long-term investment goals of superannuation funds and the short-term remuneration and performance goals of senior management and professional investors.

It makes it easier, however, for those investing to lose the connection between how and where their money is invested and the impact that has on the values reflected in our society.

If it is fair and reasonable that people hiding money in offshore companies should come clean about how they earned it, why they should minimise their tax to avoid funding the infrastructure of a civil society such as education, health and transport systems and what influence they wield, then it is also fair and reasonable that those of us who have a retirement fund know where that money is invested and its ultimate use.

The fund management industry’s use of nominee companies makes this incredibly difficult.

Creating barriers between ownership from investing helps us to disassociate ‘making a return on our investment’ from ‘how we are making a return on our investment’ and the impact that has on the values and culture underpinning our society.

Surely greater transparency across the whole of the financial system, not just the ugly, dark corners will benefit us as a society.

03.16.16
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Peanuts, monkeys and why the idea of investing for the longer term is a no brainer

As part of my multi-disciplinary Master’s degree, I did one unit in the Business School about business strategy. There I sat in a lecture room full of keen-eyed, shiny business students and me, the curious arts student whose entire career has been in the private sector, a large chunk working in investment.

As with many clichés that were trotted out during that course, the one that just made my heart sink due to its sheer lack of critical thinking, was the old chestnut “if you pay peanuts, you get monkeys”. I countered that actually, sometimes if your incentive packages have large sums of money tied to short-term performance at its centre, you create the perfect environment for monkeying around. Sub-prime mortgages and the GFC anyone?

So imagine my reaction when I read last month that some of the gorillas of the investment world were holding secret summit meetings to “encourage longer-term investment and reduce friction with shareholders”. The Financial Times’ supplement FTfm reported that meetings were held with Warren Buffet, the chief executive of JPMorgan Chase Jamie Dimon and the heads of heavyweight investment houses Fidelity, Vanguard, BlackRock and Capital Group.

The investment industry were obviously concerned that they were not aligned with the requirements of listed companies looking to grow their business; or their actual end-customers, you and me, who invest for long-term wealth development. At the top of the companies’ complaint list was the institutional shareholders focus on short-term returns, compared to long-term growth goals of companies.

The problem is that the investment industry markets its short-term performance to get more of the real capital owners, you and me, in the door and boost their funds under management. It then also creates incentives for its investment staff based on their short-term performance. They are not all like that, the best active fund managers do take long-term views and engage with companies and their trading volumes tend to be less. But many others churn through trades in passive or shadow-passive funds just trying to replicate an index to make their performance targets, which are very often tied to their performance versus the index. It would be more useful for the investment industry to tie incentives to longer term performance, in line with us, the customers, many of whom are saving over the long-term for retirement.

The Association of Superannuation Funds of Australia estimates there is $AUD2 trillion invested in superannuation, of which $AU317 billion is invested in Australian equities with a further $AU183 in Australian fixed interest. Australia is the fourth largest superannuation market in the world, behind the United States, Japan and the United Kingdom.

The United States had an estimated $US23.5 trillion in retirement savings as at 30 September 2015, according to the Investment Company Institute inside a variety of retirement savings vehicles. This does not include other investment savings, just the money in vehicles designed for long-term investing. According to Goldman Sachs, 69% of the US stock market is owned by US households, mutual funds and government and pension funds. The remaining 31% is made up of predominantly international investors (16%) with the much-talked-about hedge funds holding only 4%.

The British Investment Association stated that 38% of the £5.5 trillion of funds under management are British pension funds in 2013. According to Towers Watson, the Japanese pensions funds had $US2.8 trillion under management.

That is a lot of people looking for long-term investments to give them financial security at retirement. Surely the stewards of their money should align their activities with their end-customers.

11.27.13
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Only a reassessment of our values will avert another crisis

Most financial service professionals believe tighter regulation of financial markets will not stop another financial crisis, according to a recent survey.

Perhaps a reminder of what happens when greed overtakes reason might help. Today the ratings agency Standard and Poor’s said it estimates that the biggest US banks may still have to pay out more than $US100 billion to settle legal issues surrounding the rush for sub-prime mortgage products that started the global financial crisis in the first place. Not a great long-term return for the banks’ investors.

Or maybe a reality check about what their rampaging greed has meant for the rest of the citizens of the world. The Organisation for Economic Co-operation and Development (OECD) is warning that the fallout of the financial crisis, is starting to affect the elderly with lower and delayed pension payments and the gap between the highest and lowest income households in developed countries widened in the three years since the crisis.

Sadly, the only way to affect real change in behaviour is to change the values of those in power, because it is those in power that set the agenda. Kinetic Partners, the same group that conducted the survey mentioned above also did research that found that most believed it was the culture set by the CEO that influenced whether good decisions were made and another financial crisis could be averted. This is backed by a whole swathe of academic research pointing to the powerful elite prioritising the values of our society.

So what are the most prominent values? Academics Bruno Dyck and David Schroeder suggest materialism and individualism are the twin hallmarks of the moral point of view that underpins management thought. The Protestant focus on work and individual struggle for salvation and emphasis on material success has become normalised in western management and is the ‘incontestable, objective, morally neutral reality’ adopted as the natural facts of life, rather than the moral facts of life. This translates into modern management’s focus on efficiency, productivity, profitability relative to other comparable companies and the expectations of the market.

The central criterion for managerial rhetoric is concerned with economic growth, organisational survival, profit and productivity. In academic texts on corporate finance this belief is reinforced.  According to the Principles of Corporate Finance, ‘the goal of maximising shareholder value is widely accepted in both theory and practice’ because, the authors argue that shareholders want three things, the first of which is ‘to be as rich as possible’. Another perspective on this is offered by Jill McMillan who argues that companies are held captive by ‘the tyranny of the bottom line’ and profits are for the benefit of the ‘privileged class of organisational shareholders who possess the dominant right to maximise return on their investment and the commitment of management to pursue that goal.’

But if much of the money is invested with ‘organisational shareholders’ (meaning institutional investors) comes from citizens investing for their retirement, then it should be us that guides which values dominate investment, and given a chance to have a say, I believe many people would have not ‘profit at all cost’ as their number one value.

Below is a simplified version of my suggested model for a two-way communication system with their members.Model for engagement

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