Issue: June 2012 / August 2012


Wrong incentives

There must be a move away from the current environment which doesn’t help pension-fund members. Rob Rusconi discusses recent comments by UK expert John Kay.

Rusconi . . . shorten the chain
In an address to the International Corporate Governance Network, prominent Financial Times columnist John Kay was reported in Investment & Pensions Europe to have said that financial intermediaries are creating “misalignment incentives”. Kay chairs the Kay Review, appointed by the UK government to examine the effect of equity markets on the competitiveness of UK business.

What can we learn from Kay’s comments? Let’s begin by asking what he means by intermediation. Between the members of a pension fund and the bonds and shares purchased on their behalf is a complex chain of decision-making. This chain starts with the trustees of funds who act on the members’ behalf and are generally not paid.

All other participants along the chain are remunerated for their services. These links include custodians, asset managers, fund-of-fund managers, investment consultants, platform providers, financial advisers and distributors. We could add to Kay’s list. Every person employed by these firms is an intermediary; a go-between who ultimately serves fund members.

Kay points out that the proliferation of intermediation, as he calls it, has the advantage that it makes investing more professional. Good. But he considers two significant negative consequences: “It raises the cost of the whole process and, by interposing a long stream of intermediaries between the ultimate beneficiary – the holder of the economic interest in shares and the company that issues equities -- we create the opportunities for misalignment incentives.”

What does he mean by this? An example of consequences relates to asset managers. They seek strong relative performance to expand the size of their business, but good relative performance is nearly always achieved only at the expense of the other asset managers. “The only activity that increases the return of all beneficiaries taken as a whole is improving the underlying performance of companies.”

How is this achieved? Kay suggests that the wrong way is for asset managers continuing to focus on ‘alpha’ (outperformance against a market benchmark) as the overwhelming proportion of active managers are doing and are paid to do. Instead, he believes that the trustees and all intermediaries should focus on ‘beta’ (the benchmark itself) as the measure in which beneficiaries are most interested.

This is not merely about asset allocation but about the way in which investment decisions are made. “We should put more emphasis on investing and less on trading,” argues Kay. “By investing, I mean structures and incentives of asset management activity that are directed towards looking to the underlying earnings, the cash flow the company generates, and less to momentum trading, arbitrage gains and financial engineering as ways of extracting wealth relative to other asset managers.”

This is entirely consistent with much of the thinking that should guide pension fund mandates to their service providers.

  • Pension funds are long-term investors. Investment managers, asset advisors and other members of the servicing community should be similarly incentivised to produce long-term performance to the beneficiaries of these funds.
  • The average performance of all managers cannot be better than the market as a whole. I have yet to see any evidence of asset manager performance, allowing for survivorship bias and the other clever devices that managers use, that disproves the simple point that the sum of all performance is no better than the market itself. This suggests that rewards for active management might be out of kilter with the service delivered.
  • Fund members don’t need alpha. They need a decent pension. The profitable (for some) focus on small quantities of annual performance is meaningless if members are being exposed to the wrong risks at the wrong time or are invested too conservatively to keep up with the real measures of performance that pension assets should deliver.

Ultimately, the boards of trustees that ask relevant questions – in which stocks are we invested? why are these stocks good for our members? are we aiming to hold them for the long-term and if not, why buy them? -- are not around in sufficient number to have the positive impacts on the equities market that Kay seeks.

What are these impacts? If we successfully put more emphasis on investing rather than trading, he contends, it would lead to a more concentrated asset-management sector, a shorter chain running from the ultimate beneficiary to the companies in which the funds are investing, and “it would create supportive long-term relationships between investors, beneficiaries and the companies”. It would also lower funds’ costs.

That’s what investing is supposed to be about. Pension fund members have easily enough clout to exert an influence on the companies in which they choose to invest. To use this clout, however, trustees need to shorten the fund’s chain of intermediaries and pay careful attention to the companies into which they invest member assets for a comfortable retirement.

That’s what Kay proposes. Anybody care to fault him?

Rusconi is general manager of Lombard Life, a long-term insurer in the Hollard group. His discussion paper “Institutional Investors: Whose Money is it Anyway?” remains available for download at