DO your own homework and take greater responsibility for your money: this must become investors’ new motto. They must start to rely less on the opinions of outsiders – auditors, rating agencies and sell-side analysts – and more on their own judgment. Here is how I would change things.
Until the 1970s, credit rating agencies used to be paid for by investors, rather than by the issuers of securities. As so often with what appears to be a market failure, the change was in fact triggered by the US authorities. What is needed is a return to the older model, and a further loosening of regulations that limit the number of authorised agencies. Too many institutional investors must, by law or for other reasons, only invest in securities rated in a certain way. This must also change: rules governing funds should become concept-based and more descriptive: “low risk” should be used rather than “investment grade”, for example. This would be no panacea: some buy-side firms may still wish to use sloppy rating agencies, hoping to boost returns by investing in risky assets wrongly described as safe. Buyers and sellers of debt may sometimes seek to collude against the interests of investors. And it is impossible for any rating firm to get it right all the time. Ultimately, those whose money is at stake must examine investments closely and no longer place as much trust in the ratings of a security, regardless of who has paid for it.
Auditors emerged far better from the crisis: any negligence should be punished, of course, but the industry cannot be blamed for the crunch. Accountancy firms are not meant to reconstruct the entire books of a company – if that is what shareholders want, they will have to pay much more in fees. Auditors are not meant to question the entire business model of an industry, especially when it has been given the green light by regulators. They are not supposed to refuse to sign off books just because there is (say) a two per cent chance of a sovereign crisis in the Eurozone. Adding pages of disclaimers to audit reports won’t help – nobody will read them. Again, the main lesson is that investors need to take greater responsibility – you can’t subcontract everything.
What about sell-side analysts? Their work is very useful – and an essential part of my own daily reading – but the industry is excessively optimistic, as McKinsey has conclusively proved. It is especially too upbeat just before a recession and then too pessimistic at the start of the recovery. There are still far too few sell recommendations. Few analysts predicted the crisis (but neither did most buy-side firms, universities, regulators and media groups).
The answer isn’t more regulation; that was tried after the dot.com collapse. Evolutionary forces inevitably reward trend-followers and penalise dissidents: when the stock market keeps on rising quarter after quarter, the bears get sacked and the bulls rewarded.
Investors must buy more research from ideologically diverse independent research firms and groups specialising in blue skies thinking and scenario planning; or commission forensic research. Buy-side firms must also do more of their own analysis, with an obsessive wariness of the psychology of the herd.
The best way for the City to improve its performance is for buy-side firms and fund managers to take greater responsibility – and for institutional and retail investors to support them. Easier said than done, but vital.
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