THE KAY REVIEW OF UK EQUITY MARKETS AND LONG-TERM DECISION MAKING…

Some interesting snippets from the report:

Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions. These obligations should be independent of the classification of the client, and should not be capable of being contractually overridden

We question the exaggerated faith which market commentators place in the efficient market hypothesis, arguing that the theory represents a poor basis for either regulation or investment.

Regulatory philosophy influenced by the efficient market hypothesis has placed undue reliance on information disclosure as a response to divergences in knowledge and incentives across the equity investment chain. This approach has led to the provision of large quantities of data, much of which is of little value to users. Such copious data provision may drive damaging short-term decisions by investors, aggravated by well-documented cognitive biases such as excessive optimism, loss aversion and anchoring.

Risk is not short-term volatility of return, or tracking error relative to an index benchmark, and the use of measures and models which rely on such metrics should be discouraged.

Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions. These obligations should be independent of the classification of the client, and should not be capable of being contractually overridden

The level of abstraction of theories such as the strong efficient market hypothesis and capital asset pricing model is high: but their practical influence appears to be considerable, even among people who express general scepticism about this kind of reasoning. Some practitioners to whom we talked displayed an almost mystical faith in market efficiency, expressed in simple maxims such as ‘you can’t buck the market’, and ‘the market knows best’.

Faith in the conclusions of the strong version of the efficient market hypothesis appears to be unaffected by recent experience of persistent asset mispricing in markets such as those for dot.com stocks, securitised debt instruments and sovereign lending, and subsequent abrupt correction of these asset mispricings. The case for the general application of mark to market accounting relies to a substantial extent on the belief that market prices have the informational content implied by similarly strong versions of the efficient market hypothesis: that market prices are the best available estimate of the fundamental value of the relevant assets.

Efficient market theory, and its influence, are relevant both to the diagnosis and prescriptions of this Review. They are relevant to our diagnosis because, if the strong efficient market view were valid, the problem we have been asked to investigate would not exist. While market prices and fundamental values might diverge, nothing could be known or said about the nature of such divergence. If market prices did immediately incorporate all knowable information about long-term decisions and their consequences and prospects, company executives, asset managers and investors would share a common interest in arriving at decisions which would, on the basis of the best available information, maximise the value of the company in both the short and long-term.

This conclusion is derived from the assumptions of the model, not from evidence about the world. The principal value of the model is not in revealing the truth of its conclusions but in drawing attention to the ways in which the assumptions of the model do not hold, and hence the reasons why market prices are likely to diverge from fundamental value.

One important misalignment arises from the bias towards action which is found at almost every point in the equity investment chain. Corporate executives find that they can make a visible difference to the shape and perhaps performance of their companies by reorganisations, acquisitions and disposals; traders and market makers earn returns which are closely related to the volume of activity in the securities in which they deal; analysts are rewarded for the narratives they provide that generate buy or sell recommendations; investment bankers and advisers derive earnings from transactions; independent financial advisers have traditionally been rewarded by commissions and even after the Retail Distribution Review (RDR)21 will recognise that their clients are more likely to be willing to pay for advice to do something than for advice to do nothing. Many people in the financial services industry who claim to be in the business of providing advice are in fact in the business of making sales.

The belief that the best approach to information asymmetry is the provision of additional data may have led to a proliferation of data ill adapted to the needs of users, and to a belief that activities whose attractions are derived from the exploitation of information asymmetry are acceptable if accompanied by full, even if largely incomprehensible, disclosure

All participants in the equity investment chain should observe fiduciary standards in their relationships with their clients and customers. Fiduciary standards require that the client’s interests are put first, that conflict of interest should be avoided, and that the direct and indirect costs of services provided should be reasonable and disclosed. These standards should not require, nor even permit, the agent to depart from generally prevailing standards of decent behaviour. Contractual terms should not claim to override these standards.

The Review does not believe that there could be any sound basis for placing trust in an intermediary who does not recognise these duties of loyalty and prudence, and considers that a relationship that falls short of these standards fails to show appropriate respect for an investing client. Whatever the current legal position governing particular relationships in the equity investment chain, effective stewardship is possible only if trust, confidence and respect are established and the steward proceeds on the basis of obligations of loyalty and prudence. Stewardship implies the management of funds to fiduciary standards. Good practice statements for asset managers or for asset holders should incorporate these fiduciary standards.

Caveat emptor is not a concept compatible with an equity investment chain based on trust and stewardship.

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