- April 23, 2014
In the January/February issue of the Financial Analysts Journal, Jack Bogle, founder and former chief ... [more]
Delegation is a fundamental obstacle to the alignment of asset-owner and asset-manager goals. However, Sebastien Pouget, professor of finance at the University of Toulouse, believes a combination of customised performance benchmarks and a dual short and long-term fee incentive can help overcome the problems of the principal/agent relationship.
Pouget, who spoke at the recent United Nations-backed Principles for Responsible Investment Academic Conference in Canada, discussed whether aligning the interests of asset owners and asset managers is actually possible.
He believes the motivation shouldn’t be a problem in meeting long-term expectations, as the investors and the assets in which they want to invest both have.
Asset owners, with long-duration liabilities, should be long term and the companies they invest have projects and assets that are also the long term.
“It’s tricky when between the companies and investors you have asset managers who report on quarterly a basis, are evaluated on a yearly basis and after a few years face the risk of being fired,” he says.
Correcting short sight
This “long fight against short sight” has been well documented academically, most recently by the Kay Review, and the industry itself has also tried to come up with solutions, such as the CFA’s report, Breaking the short-term cycle.
One proposal has been to lengthen mandates in terms of management and compensation, but Pouget believes that’s largely futile – there is still an end date that alters behaviour.
“Asset owners face a trade-off between compensating asset managers in the long run, once investment outcomes are known, and offering bonuses based on a short-run performance, so that asset managers do not have to wait too long,” he says. “These different horizons are of a profound nature. There is a long chain of delegation in this industry, so it’s the nature of the relationship in the entire industry that’s at stake.
“Asset owners don’t want to give the keys to the car to a manager for 20 years, it’s a question of talent (or is it trust) that you want to allow yourself room to replace that manager in case they’re not up to it. This is very fundamental, even if you have funds management inhouse, you still need to think about pay, performance and time lines.”
There has been much economic theory studying this delegation and Pouget’s theoretical solution is for asset managers to be paid in the short and long term, and critically for their performance to be measured against a benchmark specifically constructed to be skewed against the long term.
“You can design a performance benchmark that is appropriate. This might mean overweighting assets that are sensitive to long-term issues such as value assets, resource and development-intensive assets, and ESG. Smooth out the short-term asset-price movements.”
In this way, Pouget says short-term incentives can be useful for promoting long-term goals.
“If the manager has overweighted an industry where there’s a bubble, then you won’t compensate them in the short term because you know in the long term the bubble will burst, so there is no long and short-term alignment.
“Short-term incentives are effective to promote long-term goals when the market is liquid enough, so for large caps and mature industries, and when there is a good coordination between long-term investors and subsequent speculators,” he says, noting that short termism is more prevalent when long-term information acquisition is more costly, and more difficult to monitor, for example, in intangible items and ESG issues.
“You can satisfy them in the short term and satisfy you in the long term. But crucial for this mechanism is to know what the level of efficiency in the market is. For example, if you have information of the long-term prospect of a company, then you can pay more of their fee now because it’s priced in the long term anyway,” he says.
He does say that rewarding managers only in the long-term may be detrimental to both asset owners and market efficiency.
Ironically, he says that in the absence of long-term incentives, asset owners may refrain from collecting long-term information, which is short-termism.
Determining market efficiency
A mix of short and long-term compensation may be optimal. If financial markets are perfectly efficient, prices reflect long-term information and short-term incentives are effective.
“Conceptual analysis tells you that you can use short-term bonuses only if the efficiency of the market is good. So as an asset owner, you should do work on the current level of efficiency.”
The big question, then, for asset owners becomes how you determine the level of efficiency of the market.
Pouget says the level of liquidity of market can be a determinant of efficiency, but also that asset owners should use resources similar to traders and invest in research such as microstructure theory, which looks at how specific trading mechanisms affect the price-formation process.
“By studying the behaviour of asset prices, you can determine whether there is asymmetric information or whether there’s information that the market doesn’t know,” he says. “Asset owners could invest in more inhouse research to better monitor managers.
“I am a professor and as an academic you have to be humble. Maybe if it’s not done in practice, there’s a reason why there are limitations.”
Pouget’s paper, Fund managers’ contracts and financial markets’ short-termism, can be accessed here.