The contribution of capital allocation

'There are short-term investors in the stock market and there are long-term investors as well. They both have an important part to play in the provision of capital and in the maintenance of liquid markets.'

An inherent part of the contribution of the investment profession, one that goes hand in hand with seeking the best returns for our clients, is in the effective allocation of capital. However, some stakeholders raise a number of objections to the profession’s claim to contribute to capital efficiency and believe that there are flaws in the way that the profession’s contribution is made.

Professor John Kay is one of the leading commentators on the profession’s contribution to capital allocation. He tackled this issue in the government review that he led between 2011 and 2013 and again, more recently in his book ‘Other people’s money’. Among the arguments made by Professor Kay (and supported by others such as the Bank of England’s chief economist Andy Haldane) is that investment professionals are too short-term, discounting future investment returns too aggressively which causes the future returns to longer-term investment to be underestimated.

He also argues that too much activity takes place in relation to price discovery, such that there is little to no value generated by much of this activity. Some observers suggest that incentive structures within investment management and the high level of competition within the sector encourage investment professionals to value immediate or short-term returns more highly than long-term returns, which impedes the allocation of capital to long-term projects. At the margin this might be true, but there is evidence to suggest that investment professionals can overvalue long-term returns as well as undervaluing them.

The high valuations given to technology, media and telecom stocks in the early 2000s (which then collapsed) was a good example of the investment sector being too optimistic about the outlook for returns. In addition, while the investment sector is an important contributor to capital allocation, it is not the only one. Companies generate their own capital through retained earnings and currently hold high levels of cash on their balance sheets.

Business investment is subdued. It appears that the investment profession and the corporate sector’s views on the outlook for long-term investment are relatively closely aligned. Some stakeholders would suggest that this shared view might be the outcome of each party benefiting from common incentive structures based on similar metrics. One common criticism of the investment profession relating to short-termism is that it trades its portfolios too aggressively and holds its investment in companies for too short a period. This observation often arises from an incorrect reading of the relationship between market turnover and total market capitalisation. Turnover figures might indicate that the whole market must trade three times a year, leading some commentators to conclude that the average holding period for a stock is four months.

To arrive at the correct figure it is necessary to understand that the data is skewed by extremely high levels of turnover in a relatively small part of the market. Empirical data suggests that holding periods are much longer. Most stakeholders from the institutional asset owner community do not raise short-termism as a concern. Possibly, this is because they suffer from the same condition. Another possibility is that they have more pressing concerns to comment on, but it may also be that they do not believe the investment management profession is systematically failing to identify and invest in sound long-term investments.

Company representatives also do not appear overly concerned about short-termism among investment professionals, although they can see that pressure from clients may affect an investment managers’ ability to maintain a long-term perspective. They are interested in the market’s view of the value of their companies’capital, but they report that they do not obsess about their share price in the short-term, accepting that there will be times when the market’s view does not match what they would expect (both on the upside and the downside).

CFA UK’s position is that the key issue is not term, but value generation – how that can best be achieved and how the investment profession can contribute towards that. CFA UK advocates that there is no single optimal time horizon from an investment perspective. The time horizon chosen by an asset owner and applied by an investment professional should appropriately reflect the stakeholder’s preferences and requirements. The time horizon is an outcome of a robust process rather than a driver of the process.


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