(July 23, 2012) — Outperformance by equity managers is a fallacy as alpha-creation methods are costly and benefit competitors, a damning report of equity markets in the United Kingdom has claimed.
The widely-accepted view that correctly anticipating which company markets will favour and watching the equity price rise does not result in overall outperformance for the end investor, economist John Kay has claimed.
The Kay Review of UK Equity Markets and Long-Term Decision Making was published today after several months of data collection and market consultation. It slammed the short-termism of many controlling market participants, which it said was detrimental to both companies looking to raise money on public exchanges and the investors funding them in the hopes of making a return.
“Analysis of the fundamentals of a company has no direct impact on the underlying value of a company (just as observing which face is most beautiful has no direct impact on the attractiveness of the faces [reference to Keynesian theory]). But fundamental analysis has an indirect effect, which may be very large, in enabling companies to make long-term decisions with greater confidence that the benefits of such decisions will be recognised by investors.”
The review continued that this level of analysis needed proper engagement with target companies and this was not a cheap exercise. The review said for this reason, it was unpopular with fund managers, even if it is was more likely to garner good returns.
One fund manager responded to the review that “engagement with investor companies requires investment of time and resource which can be seen as an encumbrance in a situation where mandates are being awarded based on fees”.
The problem boils down to the most pressing issue Kay highlighted in fund management: relative performance. The Kay Review said even managers claiming to be driven to produce absolute returns are still measured on a relative basis rather than on how they meet the needs of individual investors.
This one-upmanship means engagement with a company to improve its potential performance is an inefficient route to alpha – and one which may cost a manager while helping its competitors.
The report said: “Even if the benefits of analysis and engagement would be large, for both companies and beneficiaries, the incentives for any individual fund manager to pursue these benefits are weak, since although the individual fund 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.”
This last point is the greatest problem the fund management industry and its clients have to bear, the review stated.
The full Kay Review, with a list of recommendations, can be found here.