POSIWID II: What does the investment industry actually do?

In our thought piece, POSIWID (the purpose of a system is what is does), we argued that:

  1. It is beyond the power of any sole agent, even a regulator or a government, to impose a social purpose on the investment industry; and

  2. If we want the investment industry to pursue a better social purpose, then we need to change what the industry does.

These assertions beg the question: what does the investment industry actually do?

The primary functions of the investment industry

The myth of capital allocation versus the reality of risk management

Commentators often describe the core function of the investment industry as “the efficient allocation of capital”, but as we, and many, have argued, adaptation by the system means that the focus of what the industry does now looks very different.

The Bank for International Settlements (BIS) notes that since the early 2000s, there has been a reduction in the amount of equity capital raised by corporations. This follows a global trend in developed countries where funds withdrawn from the market through acquisitions for cash and share buybacks have routinely and considerably exceeded the amounts raised in rights issues and IPOs. Many large firms quoted on the stock exchange no longer rely on the equity markets to raise cash to fund capital expenditure and indeed, over the 20-year period to 2016, the number of listed equities in the US has fallen by almost 50% and in the UK by 26% (or by 57% if you include the AIM market). A powerful case study of this shift is the capital expenditure of four of the world’s largest tech companies: Alphabet’s Google, Amazon, Facebook and Microsoft. Over the 12-month period to March 2018, Bloomberg reported that these companies collectively spent $60bn on capital expenditure and capital leasing – up by 48% on the equivalent figure from 2017. The bulk of this was directed towards so-called hyperscale computing, which enables rapid access to heavy duty processing power on demand, and is vital to the tech behemoths’ pursuit of dominance of the cloud. From a financial point of view, the remarkable aspect of this vignette is that the firms were able to deploy this amount without tapping equity markets. According to John Kay “as a source of capital for business, equity markets no longer register on the radar screen”.

Over the past two years, S&P 500 companies have spent $1.1tn on share repurchase programmes according to a recent FT article. Proposed changes to the US tax regime expected to trigger a repatriation of offshore funds are likely to increase this number significantly. The BIS argues that “share buyback booms in the US have typically coincided with surges in net bond issuance, suggesting that the former have been financed, at least in part, through the latter”. Professor Mihir Desai, in his article Capitalism the Apple way vs capitalism the Google way, points to the corporate trend of using borrowed funds to distribute cash to investors. In response to shareholder pressure to distribute more earnings, Apple began to issue debt and borrow funds. Over the 4-year period to March 2017, Apple released $200bn via dividends and buybacks, partially financed by $99bn in new debt. Apple has not been alone in this approach. According to Desai, “the dominant corporate-finance pattern for the last decade has been Apple’s. Companies have been distributing cash via share buybacks and have borrowed money to finance these distributions at a rapid rate. As American stalwarts such as Deere, IBM, Amgen, and 3M cede power to investors, it’s like watching leveraged buyouts unfold in slow motion”.

According to a Fitch ratings report, share buybacks have exceeded free cash flow after dividends since 2014, “with most companies using debt to cover the shortfall, underscoring a more aggressive stance across the sector”. In other words, the managements of listed companies have inflicted financial engineering on themselves in the same way that private equity firms inflicted it on non-listed companies[1].

So what exactly is going on? There was a time where the purpose of the investment industry was acknowledged to be the efficient allocation of capital. Money directed to an equity portfolio is predominantly applied to buy ownership rights in the secondary market[2]. Bonds that are issued are increasingly being used for financial engineering versus investment in real growth. If investors are no longer performing the oft told tale of efficient capital allocation directly, we go back to our first question, what does the investment industry actually do?

We would suggest that the most significant observed activity within the industry is risk management – specifically the construction of portfolios to suit the asset owner’s risk budget, or risk tolerance. While it is true that asset managers can influence the use of retained earnings by companies through stewardship and governance, it is difficult to suggest that they are directly responsible for the generation of return as this is done by the investee companies themselves[3]. Arguably, the business model of asset managers of private securities means that they have a greater influence over the return received by investors. These managers are often able to control the use of investee company earnings, typically by having representatives on the board of directors. However, given that private equity assets under management hovered at around $2.5trn compared to the approximately $69.1trn total run by the asset manager universe, even if this was all used for primary investment, this would represent only a small fraction of total activity.

In short, the industry spends less of its time efficiently allocating capital and more on (facilitating) financial engineering and the shuffling of ownership rights. Pitt-Watson and Mann describe the management of risk as one of the core functions of finance, whether it be to provide us with a pension until we die or to control the risk of failure to meet an investment return objective. One of the key roles of the industry is manage investors’ risk through time, an activity conducted to a greater or lesser extent by asset owners, fiduciaries, asset managers and consultants within the industry. We would suggest, however, that the incentive structures and mandates prevalent in the industry mean the vast majority of effort goes into managing cross-sectional, or point-in-time, risk – rather than through-time risk. Capital allocation does occur at the margin, but this is subservient to the behemoth of risk management.

Stewardship is gaining traction but can be done better

As John Kay argues in his book, Other people’s money, even if there were no new investment in capital stock, there would still be a need for the investment industry to nurture and maintain the existing stock of assets through a stewardship function. Society needs mechanisms for transferring wealth over time and trade in securities is one such mechanism. As previously argued, most large quoted companies are self-financing and so the relationship between these companies and the long-term investor must be one of stewardship. In other words, one of the key roles of the investment industry should arguably be to engage with company management on the best ways to generate sustainable long-term growth, and manage the risks that might impair a company’s prospects. 

So how does the investment industry fare against this objective?

While difficult to measure, there is increasing empirical evidence to support the value of stewardship[4].This has led to a growing number of investors exercising active ownership policies, fuelled by the growing adoption of stewardship codes in many countries such as the US, UK, Switzerland, Japan and the EU. At the same time, the number of signatories to the UN Principles for Responsible Investment (UN PRI) continues to rise. However while a number of asset owners integrate stewardship into their investment practices, more work is needed to be done. According to the 2017 Future Fund and Willis Towers Watson global research of the ‘Top 15’ asset owners, opportunities are being missed by asset owners in the overlapping areas of sustainability, ESG, stewardship and long-horizon investing. Additionally, the UK’s Investment Association notes that while most asset managers and asset owners consider influencing business strategy as a key priority for engagement, most actual engagements with companies are around executive remuneration. This is consistent with the trend that executive remuneration continues to dominate the dialogue between investors and companies.

Grewal et al., in their 2016 working paper on Shareholder activism on sustainability issues, note that while a growing number of investors are engaging with companies, 58% of the shareholder proposals studied were filed on immaterial ESG issues (filtered using guidance from SASB) suggesting that a significant number of shareholders were unaware of the materiality or were pursing objectives other than enhancing firm value. The paper argues that pressure on companies to address ESG issues that are not financially material destroys financial value. While the rise in stewardship and engagement activity is welcome, investment firms need to continuously distinguish between material and immaterial sustainability factors to avoid destroying value.

The ‘meta’ functions of the industry

We recognise the interconnectedness of the investment industry and its role in providing wider societal value. For example, the industry contributes to the wider economy through supporting jobs, communities, product innovation and capital and infrastructure spending. However, the fulfilment of the industry’s purpose should be judged by the net value it creates, a function of how aligned its participants are to the end saver, how much they cost the system relative to their value and how effectively they operate. In March 2018 the Thinking Ahead Institute conducted a joint investment industry survey with the International Integrated Reporting Council (IIRC) to better understand how the investment industry delivered its value proposition across these areas. The score of 4.2 out of 10 by the investment professionals surveyed suggests that the industry still has substantial room for improvement.

Conclusion

If the above represents what the investment industry is actually doing (primarily risk management), then this provides a challenge for investment professionals to consider the question: what should the industry be doing? This question is likely to require consideration of individual, organisational and industry purpose – and the notion of a licence to operate. We discuss this further in the related thought pieces, Creating systems value and The purposeful investment professional.

 

[1] These actions are often deemed to be ‘efficient’ as bond interest is paid before tax but equity dividends are paid after tax. However, borrowing necessarily reduces the resiliency of the organisation and the system. Managements and shareholders are therefore changing the shape of the return distribution (increasing returns a little in most outcomes; massively increasing losses in tail outcomes) rather than creating value in aggregate. The call by some for interest and dividends to be treated equally appears to have merit.

[2] As a brief aside, the accumulation of large pools of internal capital seems to be an evolutionary phenomenon, and is far more noticeable in developed than emerging markets, where equity is still a major source of financing for new capital projects.

[3] The role of investee companies is to allocate capital provided by stakeholders to generate wealth and improved well-being. These ‘asset creators’ fund new assets from retained earnings or the sale of securities to raise cash.

[4] See “Active Ownership”, Dimson, Karakas, Li, Review of Financial Studies, 2015. Also, “ESG Engagement in Extractive Industries: return and risk”, Hoepner, Oikonomou, Zhou, 2015