Long-term aims, short-term measures

Every Australian equity fund is stamped with at least a “three to five year investment time horizon” recommendation by the fund manager offering it. Research houses and asset consultants advise their adviser and trustee clients to focus on the longer-term performance of funds. Advisers and the media — the later being the most dominant source of advice for most Australians, according to a recent study — similarly bang the drum.

And yet incentives rewarding short-term performance objectives dominate the Australian funds management scene, says Schroder Investment Management’s head of Australian equities, Martin Conlon. He believes that the dominance of short-term incentive measures for the custodians of investor capital is “reinforcing a misalignment of objectives with the underlying owners of this capital”.

And by custodians, Conlon doesn’t just mean fund managers. “Much of the behaviour of researchers, asset consultants, fund managers and corporate executives is not only short-term in nature, but is probably extremely detrimental to the long-term interests of investors,” he says.

Even worse, Conlon says, is that an examination of trends in the behaviour of these custodians suggests we are unlikely to see any changes in this situation in the near future.

The key issues he identifies as exacerbating short-termism are the increasing dominance of earnings per share (EPS) growth and market value-related measures of performance amongst corporate Australia, while short-term performance measurement, poorly structured performance fees, and the absence of post-tax performance measures are similarly important in the funds management sectors.

The focus of corporate Australia and Australian fund managers (the representatives of the underlying owners of corporate Australia) on EPS growth as a simple measure of corporate performance is obvious, Conlon contends, pointing to aggressive market reactions to earnings revision announcements.

“While in many cases, strong EPS growth is an indicator of solid performance, its simplistic application can disguise some concerning trends.”

In short, all drivers of EPS growth are not of equal value, Conlon says, and in particular, mergers and acquisitions (M&A), and/or leverage are short-term and unsustainable drivers of EPS growth in his view. Organic growth is invariably the most valuable growth for investors, he says, and rewarding it as a driver of EPS growth rather than M&A and/or leverage “is a crucial change required in preserving shareholder value in the long-term”.

Conlon also points to the short-term nature of many forms of executive remuneration — linking pay to the size of the company, the disproportionate use of options, and the focus on increasing market value rather than book value — further encourages executives to pursue high risk, high return strategies to the detriment of long-term sustainable growth.

Meanwhile, in the funds management industry, Conlon points to manager duration as the first major problem.

“Based on Intech surveys at June 30, 2004, of 55 specialist Australian shares managers, 10 per cent did not have a three-year track record and nearly 30 per cent did not have a five-year track record.”

Furthermore, many of the managers in the Intech survey from 10 years ago either no longer exist or have changed hands.

“Almost none would have a significant proportion of consistent personnel in the business,” Conlon points out.

Finding one likely to have better than average performance, and better than average duration [such that that performance is sustained] is very difficult.

Another issue is the focus on monthly and quarterly performance surveys.

“Regular publication of performance figures seems unlikely to have many positive outcomes,” Conlon says. “It cannot change the overall returns of the share market, and seems unlikely to improve the market-timing decisions of those selecting managers. It can generate more leakage to those earning transaction-based fees and generate increasingly short-term behaviour. The key question should presumably concern whether this information results in either improved decision-making or a superior outcome for the client.”

The short-term focus is further exacerbated by the ongoing search for higher returning managers, and the resulting popularity of hedge funds, Conlon contends. While he believes the short-term focus of many of these funds isn’t of itself a bad thing, it does raise some interesting issues, he says — for instance, when the funds are investing exclusively in Australian equities, the only way for these funds to augment their long-term returns is from leverage, which has a risk trade off.

“While such leverage may have benefits, these should flow to the investor,” Conlon says.

However, he questions whether that is in fact the case.

“The fees charged by these funds, and the structures employed, dictates a highly skewed payoff. While the amplified survivor bias and significant risk appetite in the [hedge fund] manager universe will result in a number of spectacularly successful managers, it is unlikely that the average manager will deliver structurally higher returns.”

Another key driver of short-termism is the industry’s focus on pre-tax returns, Conlon says. While conceding that it is a complex issue to report post-tax returns (as different investors pay tax at different rates), he nevertheless advocates the movement to post-tax returns as a useful step in extending time horizons — high turnover (short-term) strategies would be obvious and penalised.

And finally, Conlon says that each type of fund manager remuneration could be improved upon to increase the manager’s incentive to focus on the long-term.

Core active managers, for instance, generally run a moderate tracking error, and so track closely to the index.

“These managers charge relatively low fees and require significant funds under management to run profitable businesses,” he says. “While these managers need to generate sustainable performance to ensure business sustainability, the incentive to deviate materially from the benchmark and take long-term views is questionable.”

Making a proportion of manager remuneration dependent on long-term performance would be a step in the right direction, Conlon argues.

High alpha managers, on the other hand, which have the aim of breaking free of index returns, usually charge higher fees than core active managers. While this is fair enough, he says, they nevertheless should put in place similar fee incentives as core managers to reward long-term performance.

Absolute return and hedge fund managers, on the other hand, often charge fees that are excessive and that encourage substantial risk taking, says Conlon.

“[These] structures would benefit materially from significant risk control and procedures to pay performance fees over extended periods.”

Conlon’s conclusion is that “consistent monitoring of whether incentive structures, risk tolerance and time horizons are truly aligned with investors’ interests must become a more rigorous part of ensuring the accountability of the custodians of investor capital”.

Leeanne Bland is editor of PortfolioConstruction Journal (www.portfolioconstruction.com.au).