In the recently concluded 6th India Investment Conference conducted by the Indian Association of Investment Professionals, I was fortunate to sit through a talk by Professor John Kay, an eminently respected British economist. Professor Kay’s talk was titled “Other People’s Money…”. The talk intrigued me to delve more into his ideas of financial intermediation and I then came across his work for the UK Government presented in an extensive report called the Kay review of equity markets and long-term decision making. As a financial intermediary myself, reading through the report forced me to face some tough questions – which I feel I must share with you – my clients.
Aroha Capital’s role as a financial intermediary is essentially that of an asset manager. Clients ask us to manage money in accordance to their risk appetite and time horizons. Chapter 5, page 37 of Professor Kay’s report describes at length the role of asset managers. His surmise is that the fundamental role of equity markets is to enable savers to operate on different time horizons than the companies they invest in. In other words, equity markets provide an exit option to investors at the time of their choosing without affecting the underlying capital base of the companies they invest in. While asset managers are hired by investors to identify securities where value discovery has not yet taken place, invariably the value discovery time horizon for securities is significantly longer than the time horizon over which the performance of an asset manager is judged. This leads to asset managers spending resources trying to second guess the market rather than focus on the underlying fundamentals of the securities invested in. The shorter time horizon of the asset manager combined with the exit facility provided by equity markets encourages short term thinking leading to the phenomenon of 'closet indexing', where asset managers begin to behave as a herd and essentially reflect the benchmarks they are supposed to beat.
Professor Kay goes on to say that investors are interested in absolute returns while asset managers are chosen based upon relative performance against a benchmark. Asset managers are thus incentivized to create outperformance. Outperformance for a select few managers can be achieved at the expense of other managers, but the aggregate alpha for all managers will be zero in such a case. Aggregate alpha can be achieved only if managers aim to understand the activities of the companies they invest in and their long-term consequences, and from direct engagement with the companies themselves. He says that this is not only expensive for asset managers but also most of the benefits of engagement will accrue to other people who do not undertake them. So although the individual asset manager bears all the costs, most of the additional return will accrue to people who are not his clients and most of the business benefits will accrue to other firms. Professor Kay says that the structure of the industry favors exit over voice and gives very little incentive for asset managers to analyze and engage.
Professor Kay goes on to to talk about many more pertinent issues, which would be too onerous to talk upon in this blog. Nevertheless the two points covered above are key i.e. : (i) Time horizon to judge asset managers performance and (ii) Analysis and engagement with investee companies to create outperformance. On point (i) I can confidently say that with our practice of retaining 75% of annual billable fees in client accounts and giving client buffers against our future underperformance, forces both us as the asset manager and you as the client to think in the form of a long-term engagement. On point (ii), I confess I have restricted my activity only to company analysis and have done very little to no company 'engagement'. I have gone for very few AGMs, done very little communication with company executives and have asked no questions of them in terms of their business or capital allocation strategies. This no doubt takes up precious resources – but Professor’s Kay point is nevertheless compelling and needs further examination.