Why we need to focus on fund research to fix capitalism's ills

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Fund research is capitalism’s weakest link (Source: Getty)

“We have met the enemy and he is us.” — Walt Kelly

We blame capitalism for most of our modern ills, from climate change to phones that die every two years. Yet we rarely bother to read the sales pitch our accountant, banker, or adviser gives us for the funds to invest our hard-earned money in. I believe these two activities are related. Fund research may well be one of the weakest links in the investment management chain.

Big call, I know. But let me explain how, before proposing what we can do about it.

Companies manage for shareholders rather than stakeholders.

Most economies have adopted capitalism in varying degrees, encouraging private ownership of trade and industry. Individuals pool their skills and money to form companies and appoint professional managers to run them, directing them to maximize profits and shareholder returns.

Unfortunately, most owners neglect to directly specify the time horizon for such profit maximization. Indirectly, shareholders incentivize managers in line with their short-term results. So, it’s not unreasonable for managers to focus on the short term and ignore broader stakeholders who could help produce better long-term results.

Some companies and owners then turn to philanthropy and corporate social responsibility to give back to society, often as a superfluous nod to some of those broader stakeholders.

Visit the CFA Institute blogs for even more insights into the investment industry. 

We don’t trust employers or governments to manage our retirement. We trust funds.

Whatever our views on benevolent companies, the changes in our social structure give away our desires.

We no longer work for the same employer all our lives like our grandparents did. We don’t even want to work in the same profession throughout our careers like our parents did. It’s a gig economy now. We want to work at the intersection of two to three fields, from our laptops, in cafes, while travelling the world. We have replaced the physical villages where our families and neighbours could help in times of need to a global online village where everyone is a so-called friend.

Employers no longer provide defined-benefit health coverage during our working lives or a defined-benefit pension for when we retire. Instead, they transfer a defined contribution into a pension fund and let us worry about whether the accumulated amount is enough.

Of course, we grumble about our retirement savings being locked until retirement age. We complain about the low returns if the deducted amount is put into safe government bonds and returns are smoothed. But we also demand security if it’s put into shares. We certainly don’t trust the government to fund a comprehensive pay-as-you-go social security system — it can’t even provide decent roads.

So while we won’t trust employers or governments, we will trust financial institutions to help manage our cash flows.

We borrow from banks, we buy insurance policies, and we pool our money with other investors in funds. Of these financial service firms, funds stand out because our money does not make it to the balance sheet of the asset management company (AMC). It sits in a pooled trust account and we essentially outsource the investment management to the AMC. Other financial institutions — banks, insurance companies, and pension funds — have also begun to outsource their investment management function to AMCs.

We are the shareholders, funds are our agents.

Over the past two decades, the fund/asset management industry has expanded at an explosive rate. The number of funds now exceeds the number of stocks in some markets. Assets under management (AUM) has grown so much that some regulators are wondering if large names like BlackRock, Vanguard, and Fidelity pose systemic risks to the global financial system.

Is the industry becoming a victim of its own success? As professional fund managers with similar qualifications and analytical tools manage more assets, they essentially compete against each other and are less able to consistently outperform. This has led to the rise of passive investing.

Whether through active or passive funds, pension accounts or banks and insurance companies, AMCs invest our money. We are the shareholders. The funds are our agents. And this is where the story intersects with those of the companies that manage mostly for the short term.

AMCs act as though they don’t need to hold companies accountable for anything other than shareholder returns. Indeed, research in the Annual Review of Financial Economics highlights the anti-competitive and adverse implications of concentrated company ownership through lax incentive structures. In India, while regulatory pressures have increased voting on company resolutions, most institutional investors still vote as the company wants them to, without any opposition or engagement.

Global organizations such as CFA Institute and Principles for Responsible Investment (PRI) are appealing to fund companies and other institutional investors to take a more proactive approach to voting and corporate behaviour in general. But a powerful way to force funds to hold investee corporations more accountable is for investors to first hold funds more accountable.

How?

  • By insisting any investment recommendations, fiduciary or otherwise, be accompanied by competent, independent, and transparent fund research.
  • By requiring fund research to disclose whether the fund in question has a long-term focus by explaining its investment process and proving it with evidence, like turnover and average holding periods, for example.
  • By asking how the fund incorporates such non-financial factors as environmental, social, and governance (ESG) issues into its investment process.

Only when we as investors demand good fund research will the intermediaries produce it.

We can ask for simpler communications, but we also need to commit to learning the basics. Of course, we have to invest for the long term ourselves if we expect funds and companies to manage for the long term. We can’t invest in an equity fund when we intend to use that money in the next two to three years. This is why we have to plan our finances carefully and match our goals to the investment horizons of the funds we choose.

The future of capitalism depends on how well we invest.

Read more insights into the investment management industry and find out how to tackle its ethical dilemmas by visiting the CFA Institute blogs.  

Hansi Mehrotra, CFA, helps institutional investors and wealth managers research investment opportunities through a content site focused on India (MoneyManagementIndia.net), and a due diligence tool (DiligenceVault.com). She also helps retail investors understand the basics of money through TheMoneyHans.com blog. Mehrotra has over 20 years of financial services industry experience, primarily in online delivery of investment research and consulting for the wealth management industry. She set up the wealth management business for Mercer’s Investment Consulting business across Asia Pacific. She also led a number of projects in India including design of the investment options for the New Pension System. She holds a Bachelor of Arts degree from Delhi University, and a Graduate Diploma of Applied Finance and Investments. Mehrotra has been named TopVoice and PowerProfile on LinkedIn.