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Kay review slams short-termism within asset management

An independent review into the UK equity market has criticised the dominance of short-term thinking and emphasis on relative performance within the asset management industry.

John Kay, a professor at the London School of Economics, warns of a “misalignment of incentives” between asset managers and their clients, arguing that this creates a number of problems for the industry and the wider markets.

“The interests of beneficiaries are largely interests in long-term absolute performance,” the Kay review says. “The concern of asset managers – and the basis on which they are monitored by many asset holders, and by advisers to asset holders and retail investors – is short-term relative performance.”

The study warns that investors’ performance horizons – or the time horizon over which the performance of asset managers is judged – is too short while the value discovery horizons – or the speed at which the prices of securities revert to fundamental value – is too long.

The consequence of this, Kay says, is that fund managers will become more inclined to act on views of other market participants in order to outperform their peers. This means returns are based on managers’ skill in anticipating their competitors’ actions rather than identifying the fundamental value of companies.

Kay also claims the close attention to short-term performance by investors encourages benchmark-hugging by fund managers, as this is the only way they can be sure of avoiding lengthly periods of underperformance when being measured on a monthly or quarterly basis.

“Savers, and asset holders, who make decisions to reallocate funds to asset managers who have recently outperformed their competitors are anchoring on noisy but copiously available quantitative information in the face of considerable uncertainty,” the review says.

Furthermore, the paper suggests that defining ‘risk’ as tracking error relative to a benchmark, when combined with regulation and other external pressures to increase the use of set risk management systems and expand disclosure, is reducing the level of genuine active management undertaken by the industry.

“We were told that the result of all these pressures was frequent resort to ‘closet indexation’,” the review adds. “Although those who appointed asset managers were seeking – and paying for – active management, the portfolios that were constructed for them tended closely to follow the index.”

The review also makes a number of recommendations to asset managers to promote long-term behaviour in the equity market.

These include asking active managers to build more concentrated portfolios with a greater degree of differentiation from benchmark indices and their peers, so they are more inclined to engage with their holdings. Meanwhile, passive managers “should recognise a special responsibility to improve the performance of the index they track”.

IMA director of corporate governance and reporting Liz Murrall comments: “The Kay review is a welcome contribution to the debate about the effectiveness of UK equity markets. It sets out some very clear recommendations and we will be looking carefully at the detail.

“The report’s main conclusion is that short-termism is a problem in the UK equity markets. It recognises the distinction between investors and traders, but this is not taken into account in the analysis of short termism. IMA does not consider asset managers contribute to short-termism.”

The Kay Review of UK Equity Markets and Long-Term Decision Making was commissioned by business secretary Vince Cable on June 22 last year, following the Department for Business, Innovation and Skills’ exploration of economic short-termism in October 2010.


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