Tuesday, July 31, 2012

Trust and the Stock Market


Domestic equity mutual funds have seen outflows for the past five years, and last week saw the largest redemption activity from stock funds so in 2012.

Institutional allocations to publicly traded equities is in many cases at multi-year lows, as investment committees find alternative investments more appealing (despite the relatively poor track record of recent returns from hedge funds and private equity).

Bond funds, meanwhile, are still seeing net inflows despite historically low yields. The fact that the relative valuation of stocks compared to bonds makes little difference, it seems, to most of the investing public.

Investors, it seems, simply don't trust the equity markets to deliver the types of returns that historically has been the case.  Restoring investor trust in the stock market, then, will play an important role not only in the investing world, but economically as well.

Professor John Kay (who also writes for the Financial Times) has produced a report for the UK government addressing the issue of trying to restore trust in the capital markets. It's a very long report totaling more than 100 pages, but fortunately he has also produced a summary.

The interesting part of Professor Kay's thoughts are the fact that he is not calling for any new rules or regulations.  Instead, he is proposing more of a change in the way that investors view their relation with their asset managers, and the time horizon with which they invest.

This is easier said than done, of course.  Most investors claim to have a long term time horizon yet they continue to monitor investment performance on a monthly or quarterly basis.

Part of the problem is the incredible ease with which data can be obtained.  In the "old days" investors would buy a stock based on their view that the company fundamentals were promising, and that the share price would eventually rise to reflect a prospering business.

Today, however, most market participants are buying a stock based on the belief that the stock price will rise.  Here's how Professor Kay describes it:

On top of that, the asset manager is judged, not just on his short term performance, but on his short term performance relative to other asset managers. He is being judged, by reference to the quality of his guess at other asset managers’ assessment of the event. This is, of course, Keynes’ famous beauty contest, in which contestants are speculating, not on which face is most beautiful, but on which face other contestants will think other contestants will think is most beautiful. 

The shorter the performance horizon relative to the value discovery horizon, the more important is the understanding of the psychology of other asset managers, and the less important the understanding of the impact of events on the fundamental value of the company. And that is true for asset managers, for prospective investors and for traders – and for corporate managers who focus on the price of their company’s shares, or are incentivised to do so.


And here's an excerpt from his conclusion:

The central figure in the chain is, and should be, the asset manager. Indeed in my ideal world, the simple chain of intermediation would be one in which the saver places funds with an asset manager in whom he or she has trust and confidence, and the asset manager invested in companies with whom he or she enjoyed a sustained relationship of trust and confidence. I should acknowledge that only a proportion of total equity holdings can, or should, be actively managed in this way – it is likely that passive holdings will constitute a large part of the overall market