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UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE
To be published as HC 969-iii
House of COMMONS
TAKEN BEFORE the
BUSINESS, INNOVATION AND SKILLS Committee
THE KAY REVIEW OF UK EQUITY MARKETS
AND LONG-TERM DECISION MAKING
tUEsday 26 FEBRUARY 2013
CATHERINE HOWARTH, CHRISTINE BERRY,
SIMON WONG and DR PAUL WOOLLEY
DOMINIC ROSSI, ANNE RICHARDS, HARLAN ZIMMERMAN and roger gray
Evidence heard in Public Questions 134 - 180
USE OF THE TRANSCRIPT
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Taken before the Business, Innovation and Skills Committee
on Tuesday 26 February 2013
Mr Adrian Bailey (Chair)
Mr Robin Walker
Examination of Witnesses
Witnesses: Catherine Howarth, Chief Executive Officer, FairPensions, Christine Berry, Head of Policy and Research, FairPensions, Simon Wong, Visiting Fellow, LSE and Partner, Governance for Owners, and Dr Paul Woolley, Head of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, gave evidence.
Q134Chair: Can I welcome you here today? Thank you for agreeing to share your thoughts with the Committee. Can I also apologise for the slight delay in starting? We had quite a lot of urgent business to get through before we started this session, but we will crack on. I know who you are, but for voice transcription purposes could you introduce yourselves and the organisations you represent?
Christine Berry: I am Christine Berry, Head of Policy and Research at FairPensions.
Catherine Howarth: I am Catherine Howarth, Chief Executive of FairPensions.
Simon Wong: I am Simon Wong, a partner at Governance for Owners and I also hold appointments at the London School of Economics and Northwestern University.
Dr Woolley: I am Paul Woolley, a senior fellow at the London School of Economics.
Q135Chair: I will open the questions. Can I make it clear that some will be person-specific and others will be to the panel? Obviously, that does not preclude anybody from speaking on a question directed at somebody else if they feel they have something to add to or subtract from it. Equally, if somebody else has said what you agree with, do not feel that you have to repeat it. I am conscious that all of you have been prolific contributors to this debate, and we are limited in time, so try to keep your responses as short as possible.
If I can start with a question to Dr Woolley, you have written a lot about the myth of market efficiency. Do you assign the rise of financial intermediaries and institutional shareholders to be a cure for market failure or a cause of it?
Dr Woolley: The main cause is that we have a misunderstanding of how finance works. The prevailing paradigm of market efficiency, which has been with us now for 40-odd years, is deeply misleading. It says, as you know, that prices reflect their fundamental value, that markets are selfstabilising and that competition ensures that agents do not earn excess profits. That has not been apparent for the last 20 years.
Moreover, the theory of efficient markets has informed the actions of everybody to devastating effect. It still informs the actions of investors and intermediaries, but also of the regulators. We know that markets are not efficient, but we are using all the metrics, analysis and prescriptions of a dud theory, which is only a special and limiting case. What happens is two effects of the fact is that markets are not efficient. I can explain more why they are not efficient, but that will take a bit longer, so I will skip it. The two consequences of inefficiencies are first, that assets are mispriced and we get the potential for bubbles and crashes, and, secondly, that the agents are in a position to capture excess profits. The combination of the two is devastating and has caused the size of the finance sector to balloon and to do its job, which is simply a utility function, very badly.
Q136Chair: I was going to ask you if you could explain why it is a dud market-I think those are the words you used. I am a bit nervous in view of the time you said it would take to explain it. Could you summarise it in perhaps 40 or 50 words?
Dr Woolley: The efficient market theory assumes that investors invest directly in securities, but they do not; they delegate to agents. The investor does not know if the agent is competent or diligent. That is the heart of the problem, and it is called asymmetric information. The investor does not know these two important facts, and that is the cause of all the problems. What I and my colleagues have been doing for the last several years is providing an alternative framework for analysing markets that presents a general theory rather than a special and limiting case of market efficiency. We assume everybody acts in their own self-interest and in a rational framework-they seek to maximise profits and do the best job as they see it to invest to achieve the best riskadjusted return-and that they are not stupid or do not have behavioural biases. They may do, but he point is that by assuming rationality we can provide an alternative framework that explains all the mispricing. It goes a long way to explaining all the various market failures and phenomena that have not been explained by a theory that assumes that everything is perfect to start with. It is like natural science, where in physics you continue to assume that there is a perfect vacuum or zero friction. You have to relax those assumptions, and that is what we do. We show how it is that markets go wrong. If you can show how they go wrong you can make a good stab at the solutions.
Q137Chair: I am a layperson in this. Would it be fair to say it presupposes that the investor has the level of knowledge and expertise and will act in a rational way, whereas in fact the investor delegates that role to the agent, who may be acting not in the interests of the investor but in the interests of the agent?
Dr Woolley: Who owns the capital? We all, in our private capacity, are the owners of capital. Because we are operating on the basis of a false understanding of how finance works-because theory does inform the general understanding-we have been delegating in the wrong way. That includes the pension funds that act on our behalf, because they are agents as well and have their own interests, as well as the pure agents-the fund managers, brokers and investment banks. But the key to solving the problem is to have a better understanding of how finance works and fails, which involves the simple step that I explained of introducing delegation, and seeing the implications of that. Then we can start to sort things out. We can show those who are responsible for investing the assets of the man in the street how they need to change the way they delegate and the strategies they need to embrace and those they need to ensure are avoided.
Q138Chair: Do you think that the Kay proposals meet that challenge?
Dr Woolley: No. We have been worrying about the issue of short-termism essentially for 40 years. We have never addressed the problem properly, because we have not got to the key issue. They have all been good descriptions of what goes on and good seat-of-the-pants responses, but you need a new analysis and a new framework for understanding finance. Without that, you will never get anywhere.
Simon Wong: To develop further the discussion on the agency issues and lack of knowledge, regulation equates size with sophistication, so if you manage a pension fund you are considered to be a professional investor, and as a result a certain set of assumptions goes with that. That is quite false. You see that people who are managing these large pools of money are being outmanoeuvred by their agents purely because they do not have the sophistication to understand what they have purchased and what they have been told. There is a big issue there. You see reforms in different parts of the world to try to improve the governance of pension funds and enhance the competence of the people running them, whether they are trustees or people within the pension fund vehicles. The lack of knowledge contributes to the expanding chain of intermediation. You do not know, so you get advice. You might retain other consultants to assist you in your task.
Having said that, I do believe in aggregation vehicles. I do not think we should go back to the days when retail investors made all the decisions. I do not think they are in a better position either. Around the world you see efforts in places like Canada and Australia to build scale in pension funds, whether they are defined-contribution or defined-benefit plans. With scale comes greater resources to hire staff and attract people to be governors, and greater access to alternative asset classes, which might be better aligned with the time horizon of pension funds, for example real estate or infrastructure. You might also have greater leverage vis-à-vis your asset managers, so that will bring down costs. That is just one aspect of the agency issue that it is important to stress.
One other aspect, which may not have been given sufficient attention in the debate, is conflicts of interest. There has been great effort in recent decades to disclose and manage conflicts of interest. We should also stress the importance of avoiding conflicts of interest to start with.
Catherine Howarth: To build on both those sets of remarks, delegation to investment professionals is obviously inevitable in a system of pension savings nationally. What is missing, we feel, is accountability, transparency and opportunities for those whose money is invested by others on their behalf to scrutinise what is done. What is perhaps missing from Kay’s recommendations is things that bring the whole debate right back down to the saver whose capital is at risk and who has to trust others in this system. At the moment, there are very few mechanisms for them to access information, for example about how votes have been cast on their behalf. There are very few expectations or practices for pension funds to provide succinct narrative reports about how they have exercised stewardship on behalf of savers, as is expected at the next chain down in the link. Companies are encouraged to provide to shareholders succinct narrative reports on what they do, but agents do not have to provide that kind of quality of succinct information to savers on whose behalf they act. In our system at the moment, there is a big democratic deficit and a big opportunity to begin to overcome some of these agency problems. I certainly do not disagree that we need a new theory of finance, but in practice we need to overcome those problems by making sure savers can hold their agents to account and see what they are doing on their behalf.
Q139Chair: At our previous hearing, which you may well have followed, Lord Myners commented that technology had impacted on the way the market worked and that we had a transactional-based process. Do you think that in a way that is inevitable, and that the issues you have highlighted hark back to a perceived golden age of democratic accountability and transparency and we will never go back there?
Catherine Howarth: I do not think there has ever been a golden age in this respect. One of the important transitions we are undergoing in pensions is from defined-benefit schemes, where individual savers could sit back and relax because they had a guarantee at the end of the day, to a situation now where they are fully exposed to the investment risk, and it is absolutely essential we have mechanisms to enable scrutiny to take place. Most pension savers are busy and preoccupied with their lives and do not have the time to undertake detailed scrutiny, but, just as in a parliamentary democracy you have a small number of citizens who take the trouble to scrutinise what is done by their representatives, similarly you could have a very small number of people in a workplace pension scheme who undertake that scrutiny and look for reporting from the scheme about how stewardship is being undertaken on their behalf. We do not imagine that everyone is going to get involved in this, but, unless people have rights to information about what is done on their behalf, the agents are free to act in any way, and that is a big part of the fundamentally poor health in the system currently.
Q140Chair: That is an interesting suggestion. I do not want the rest of the panel to comment at length, but broadly, would the other witnesses be in agreement with those comments? Yes, good. Professor Kay did say, "‘The market’ is simply some average of the views of market participants. ‘The market’ knows nothing except what market participants know." Do you think we have attached too much power to the market, and what has been the consequence? This is a question to the whole panel, and if comments could be kept brief I would welcome that.
Christine Berry: When you say "too much power to the market", do you mean market participants or the idea of the market as a whole?
Christine Berry: The point Kay makes that companies should concentrate on developing relationships with shareholders rather than with the market is certainly true. The idea of the share price and the market as the thing around which all the players in the team calibrate their behaviour, even if that is not in the interests of the people who the system is supposed to serve, either the companies or the savers at the end of the chain, is certainly part of the problem. In a while I suppose we will come on to our work on fiduciary duty, and there is also a problem in the way intermediaries see their duties.
Simon Wong: The belief that prices in the markets at any particular time are correct, as we have discussed, is ill founded, yet it infects regulation and contributes to short-termism and corporate pension funds worrying about liabilities expanding, and to executives being perhaps overly concerned about stock price or having share price-based remuneration schemes. Those are a few examples of how it has impacted the market.
Dr Woolley: If I were to point to one major problem about the way markets function and participants act, it is that the greater part of investment now conducted is based on current and recent price movements rather than fundamental value. There are only two basic strategies of investment: trend following-let’s call it momentum investing-and fundamental investing. That is actually the best way of looking at short-termism and long-termism-to understand that short-termism is not just a short holding period, and long-term investment is not just buy and hold. The important distinction is the choice being made between investing on the basis of recent price movements, ignoring value, and fundamental investing, which focuses on the true worth of assets. Unfortunately, because of our misunderstanding of how finance works, the contracts that pension funds are writing with their agents and the way regulators are regulating, vastly more transactions are conducted based simply on recent price movements rather than fundamental value. Very few steps are required to address that problem and rid the markets of so much momentum trading, or automatic trading if you like. The beauty of it is that to do so would be to the great advantage of pension fund returns and the ultimate beneficiaries. There is a self-interest.
Chair: That is a very lucid explanation, and we will come back to the measures before the end, but I want to bring in Paul Blomfield, who has some questions on Catherine and Christine’s evidence.
Q141Paul Blomfield: I want to focus on the three mechanisms you suggest to address the principal/agent problem. The first is that you argue for legal mechanisms to be attached to fiduciary duties. What are the minimum fiduciary standards that you think are essential for regulators to enforce?
Christine Berry: It is important to remember that Kay made two different recommendations on fiduciary duty, one of which recognised that fiduciary duties should be part of the solution to dysfunctional capital markets and that they require intermediaries to act in the best and sole interest of the people whose money they manage. The other recommendation recognised that, unfortunately, too often the fiduciary duty has been part of the problem and has been interpreted in an unhelpful and narrow way by people who do possess fiduciary duties. Your question relates to the first of those.
The key difference that Simon touched on between fiduciary standards of care and the standards currently applied by, for example, FSA rules or under MIFID, relates to the avoidance of conflicts of interest. As Simon said, we have spent far too much time worrying about the disclosure and management of conflicts of interest. In theory, the starting point for fiduciaries is that conflicts of interest should be avoided altogether and, if they can’t be, they must be resolved solely in the best interests of the beneficiary.
Professor Kay himself made a good analogy in an article he wrote for the FT drawing on the recent incident involving a ballboy who covered the ball. Kay made the point that he saw there was a clear difference between what would have been fair for him to do and supporting the home team. In the same way, FSA rules currently require that conflicts of interest are managed and resolved fairly as between the firm and the beneficiary, which is clearly different from resolving the conflict always in the best interests of the beneficiary. Those are clearly two different standards. There have been lots of attempts to conflate that in the debate and to say there is no need to talk about fiduciary duty because the regulatory rules already impose those standards. They do not; it is clearly a different standard. The real value of talking about fiduciary duty is in the context of requiring a higher standard in relation to avoiding and managing conflicts.
Chair: That must be the first time ever the activities of a ballboy at a football match have been quoted in evidence in a Select Committee.
Paul Blomfield: But it is a very good way of illustrating the point.
Chair: Yes, it is.
Paul Blomfield: Catherine, did you want to comment?
Catherine Howarth: No, I am fine with that.
Q142Paul Blomfield: The further recommendation you make is that the remuneration of fund managers should be structured to encourage long-term behaviour. Are you satisfied that Kay has addressed that? Knowing intermediaries as you do, how would you implement such incentives?
Catherine Howarth: There are huge risks in trying to be too clever with the remuneration of fund managers. We ought to be able to learn the lessons from having tried to be clever around the remuneration of company directors. Simplicity is best. Paul can perhaps speak more about remuneration of fund management. There have not been particularly complex arrangements, but they are creeping in and there is much more performance-related pay now in fund management. That brings a host of risks because, depending on the time frame involved, it will exacerbate the existing compulsion towards short-term trading in the emphasis of fund managers over long-term stewardship orientation. It is an area where pension trustees potentially are a bit naive and could be more engaged.
I also think that fiddling around and trying to bring in sets of remuneration consultants to advise about the ideal theoretical arrangements for pay in the fund management industry could lead us down the same alley where we try to structure corporate pay in a way that is aligned with shareholders to great detriment. It is undoubtedly important, but I do not think it is the main area for recommendation in trying to achieve structural change in the fund management industry. It is far more important to make sure that pension fund trustees as the clients of fund managers are asking smart questions about the stewardship approach that is taken; the engagement that takes place with company directors about the strategy of the company; the long-term risks facing the company, including environmental, social and governance risks. It is important that reporting by fund managers about their stewardship is available down the chain to those savers whose capital is ultimately at risk, who depend upon the trustees to do a good job and who ought to be in a position to keep an eye on the oversight by the trustees of the fund manager stewardship of the underlying companies. Part of the challenge here is that there are lots of links in the chain. That is somewhat inevitable, but bringing it back down to the saver is the critical thing.
Q143Paul Blomfield: Notwithstanding that caveat, in your evidence you did suggest that a different approach to remuneration could encourage more long-term behaviour. Beyond simplicity, what would you recommend?
Catherine Howarth: There is perhaps a case for ensuring that in the way fund managers are remunerated, there could be some emphasis on putting stewardship, oversight and engagement with companies centre-stage. At the moment, many fund managers regard stewardship activity and engagement with companies, which is a labour-intensive process, as just a cost centre for them, whereas that can in fact be some of the most value-adding process undertaken by fund managers. Trying to make sure that it is very explicit that part of the contract for payment for fund management includes resources being devoted to that by fund management firms makes a lot of sense for pension fund clients.
Christine Berry: In terms of our taxonomy of ways in which you can address the problem, we talked about remuneration as one of those. On reflection, I would broaden that to call that category "incentives". Remuneration is one incentive that fund managers are faced with, but it is not the only one. There has been talk in the oral evidence already about the other ways in which pension funds incentivise their asset managers. We gave the example in our written evidence of fund managers who were sacked during the dotcom bubble because they did not invest in tech stocks, so they were underperforming in the short term even though that was clearly a prudent decision in the long term. That is an incentive. Government also provides incentives through the tax system and regulatory regime, so in looking at how we can align incentives better in the chain we should not just fixate on remuneration. There are a range of other relevant tools as well.
Simon Wong: I would certainly second that. I have been speaking to large pension funds around the world as part of research I am conducting. The largest pension funds are looking to streamline their asset manager relationships. They want fewer external asset managers but deeper relationships, so they want to get to know them better and establish a strong basis of trust.
Certain remuneration practices would be helpful, one of which is to have fund managers invest in their own funds so they have skin in the game, so to speak, or to pay fees looking at multiple-year performance. I also would like to warn against certain ones. I have seen in passive mandates that the fund manager is rewarded only through the securities lending revenues that they generate. Imagine the misalignment that creates, because that fund manager has much less interest in the value of the fund going up: rather, that person will be more interested in how much securities lending revenue he can generate through that relationship. There are certain things that I would advise against strongly.
Dr Woolley: The key is for the right contracts to be written in terms of the guidelines, benchmarks and risk parameters. Then the remuneration side of it will take care of itself. Once you make sure that fund managers are focusing on fundamental value and are given the appropriate benchmarks, not market-capped weighted benchmarks, and all the risk parameters are sorted, you eliminate most of the momentum trading and the trouble we have with ridiculously high rewards.
Q144Paul Blomfield: Can I return to Catherine and Christine on the question of consumer pressure? That is another area you focus on, and you say it should have a greater role. You recently wrote in "The Missing Link" about the disconnect between savers and those who manage their money, which is obviously what we are talking about today. How specifically do you think policy makers should address that?
Catherine Howarth: There are a number of different mechanisms. At a very simple level something we have been advocating for a long time is mandatory disclosure to savers of voting by fund managers who have been delegated those powers by pension funds. I emphasise that most savers are not going to be leafing through the voting disclosure record of their pension fund, but having that information available in the market will allow very valuable opportunities for comparison between funds. It will ensure that fund managers casting those votes know there is a potential to be scrutinised and that interesting controversial votes will be picked up, and that does happen. Some disclosure is going on; it is best practice and is in the stewardship code, but it is very far from the level that would really raise standards across the market as a whole. That is one simple mechanism.
Coming down to the pension fund level, as part of our work at FairPensions we engage a lot with individual pension fund members who are interested in getting answers from their schemes about what is going on and how their money has been invested. They have virtually no rights to information. Some funds do disclose what holdings are held on behalf of the saver and how votes have been cast, but they do not have to. Similarly, although funds are required to disclose whether or not they give account to environmental, social and ethical factors, they do not have to give any account about how that was undertaken, so the opportunity for a fund member to take a view on whether these stewardship functions have been exercised on their behalf diligently and intelligently is extremely limited. Quite small regulatory interventions could be introduced to ensure that information in the market exists and the scrutiny function can be undertaken, which should improve behaviours right through the market.
Q145Chair: You referred to fairly small regulatory interventions. In a few words could you just summarise what should be done to realise this?
Catherine Howarth: We have long advocated improvements to the disclosure regime for pension funds so they have to give an account of how they exercise stewardship and voting and engagement activity on behalf of scheme members. In the same way that there are calls for company directors to provide succinct narrative reports on forward-looking risks, that is absolutely what pension funds should also be doing for their members. I am a pension trustee and I sit on the board of a scheme that works hard in this regard. Nevertheless, it would focus our minds, and those of pension trustees all over the country, if we knew we had to provide a succinct narrative report detailing the forward-looking risks to the investment portfolios, how they have been managed and what fund managers are doing effectively to manage those risks for the long term. That is where long-termism can start to be hard-wired into the system in a helpful way.
Q146Paul Blomfield: Can I move on to the stewardship deficit that you have talked about and Simon has written about? Can you describe the problem as you see it and whether Kay has addressed it?
Simon Wong: I alluded to it in my earlier remarks. It starts at the top of the investment chain. I disagree with the Kay report in the sense that it places excessive reliance on asset managers to drive things forward. The asset owners need to step up in terms of how they monitor the asset managers and the type of investment management agreements they reach with their asset managers. It really starts from that.
There are issues, which I have written about, of whether as an asset manager you have the capacity to monitor properly. If you have a portfolio of hundreds of stocks, can you properly understand each one? My argument would be: no. There is scope to reduce portfolio size in terms of the number of holdings. For example, why would a pension fund need to be invested in 700 companies in the UK alone to feel properly diversified? Academic evidence says that the benefit of diversification tapers off at 20 to 50 stocks, provided they are not all in the same industry, of course. There are issues in terms of being able to monitor companies properly and become a stronger steward.
There is also the issue of skill set. Two weeks ago Lord Myners alluded to the fact that fund managers might not have such a deep understanding of how companies are run. If you are going to engage, do you have the right people with that sort of corporate-type background?
Last, how will they be rewarded for it, or how will the costs be borne? I have written previously that in some funds the costs of engagement will be shared with the asset manager in terms of the fees he receives as well as the assets of the fund. Those are different aspects that need to be addressed in order to improve stewardship.
Q147Paul Blomfield: Is there also a question of resources in terms of companies not being prepared to commit sufficiently?
Simon Wong: Exactly. There is the issue of whether you have the right skill set. Do you have the right people who can engage with companies with credibility? Are they sufficiently senior? Do they have a deep enough understanding in terms of what is going on and the complexities of running a business? Presently, people would probably argue that on the institutional investor side you may not have the right personnel in all cases to undertake this type of engagement.
Paul Blomfield: That is helpful. Thank you.
Q148Mr Walker: One of the Kay recommendations supported by the Government, which was also very strongly supported by Lord Myners in his evidence to us, was the idea of creating an investor forum. FairPensions has been a bit more sceptical about that, saying it is unclear how this initiative will differ from previous and existing investor bodies. Some of the evidence we have just heard suggests that might even entrench some of the problems, with the focus on asset managers talking to themselves rather than necessarily to their shareholders. Would you care to comment on that idea and whether you think that could make a difference? Is there a way of setting up an investor forum which could improve the situation?
Christine Berry: There are a few points to make about the investor forum. The first is what it would have to look like in order to be effective. It would need to include representation from asset owners as well as asset managers; it would need to be not just another vehicle dominated and run by the trade associations, which would be very similar to the vehicles we already have. To be fair, that is a view shared by many people who are involved in trying to set up the investor forum. It is not completely clear at this point whether it will ever get off the ground, and that is something worth bearing in mind when making a wider judgment about the extent to which some of the more voluntaristic elements of the Kay package are likely to be successful in the medium term.
It is also important to be clear about the limitations of what an investor forum would and would not resolve. My understanding of the reasoning behind the investor forum and its creation is that it was intended to deal with some of the collective action problems particularly created by the dispersion of ownership, excessive diversification and the fact that any individual shareholder would own only a very small proportion of a company. Clearly, enabling investors to act collectively would be very helpful for that specific problem, but that does not mean it is the silver bullet that will solve some of the underlying structural problems we have talked about in terms of the relationships between asset owners and asset managers, the way those players are incentivised, the excessive diversification that itself leads to this problem in the first place and so on. I hope that is helpful. The investor forum would useful if it happened in the right way. It will not be the silver bullet that fixes all the problems in the market.
Q149Mr Walker: Dr Woolley, you talked about the dysfunctionality in the markets. Do you think this would help with that at all?
Dr Woolley: Yes, absolutely. We have to learn the new code of behaviour that needs to be followed. You need a forum to help promulgate this new approach. It is very significant that in the last couple of weeks the G30 has come up with a proposal in its report on long-term finance and economic growth. The first of the five proposals is for a new code of best practice for large funds. That is a huge step. We have never had anything like that proposed. The implication is that currently there is malpractice. It is saying that there should be a new understanding and a new instruction manual. Everybody is using an instruction manual based on this efficient market hypothesis, and we need one that recognises the best benchmarks, risk parameters and contracts with agents. It has to be a complete revolution in the way delegation is handled, and a forum would play a valuable role in educating the asset caretakers. It is not just a UK problem but a global one, and it should be handled globally.
Q150Mr Walker: Is it not rather optimistic to assume that a forum that is likely to be dominated by the asset caretakers or their trade bodies, as has been suggested, will come up with a revolution? Is it not more likely to try to entrench the status quo?
Dr Woolley: No. If one rewrites the understanding of finance, one points to the way that funds can in their own self-interest, irrespective of what any other fund does, adopt these strategies and policies. There will be a very significant early mover advantage to funds. If you get the G30 coming up with a code of best practice and some of the sovereign wealth funds and big public funds start adopting this, members of pension schemes in the UK could say to their trustees after a year or two, "Look at the returns you are getting and the returns that the sovereign wealth funds are getting. Why is there a difference?" They can challenge trustees. It replaces a silly herd with a sensible herd.
Q151Mr Walker: If the forum is structured in the right way. I am interested in the point you make about having asset owners represented in the forum. How do you think that could be achieved?
Catherine Howarth: It is already partly the case that a number of the very largest UK pension funds have staff dedicated to working on stewardship issues-corporate governance experts and so on-so there are resources that they can contribute in terms of personnel or helping to fund the activities of an investor forum. Making sure that asset owners contribute to that would be a very good thing. The point has already been made that to take on a company over a sustained period about a problem you have identified as a shareholder is quite resource-intensive. Given that you own only a very tiny fraction, everyone who owns those shares in that company will benefit in the market if you secure an outcome through your engagement and dialogue. It is very sensible to look for a way that asset owners of shares in a given company can share the costs arising from an intensive engagement with a company on a long-term risk. All of that makes sense. It would be really good if we had contributions from individual pension schemes to the costs of running the investor forum. They would then take quite a close interest in what it got up to, and that would be a good thing.
In a way, a trick was missed in the Kay report in not emphasising enough the role of asset owners in taking the initiative on this. There is very strong emphasis on asset managers. The asset managers are critically important agents, and we do need to think about their behaviours, but they are not the ones with the incentives to move this situation along; asset owners are. Asset owners themselves would focus more on the problem if they had to give an account to the underlying members of how they were resolving these issues.
Simon Wong: I completely agree that asset owners need to play a central role. A broader point is that we have a lot of small pension funds in the UK. What do we do? Ontario, for example, has issued a proposal to try to consolidate asset management to build scale among smaller pension funds. There are steps in that direction that could be extremely helpful. I know this is beyond your remit here.
In terms of the investor forum, it is important for it to have dedicated resources and to come to an agreement with existing bodies that they would perhaps adjust or reduce their activities to avoid unnecessary duplication. That might mean they should be represented in some form in this new forum.
One of the key objectives is to attract the involvement of foreign investors. That is a laudable objective, but we should temper our expectations because of the following. For foreign investors, the UK may be a small market relative to their other holdings, or they may see the UK as relatively well governed and as a result they want to allocate their limited resources to other markets. We should also think about the practices they bring with them. In continental Europe there is probably greater sensitivity to environmental issues and human rights. In the US there is a more permissive stance on executive remuneration, so it is also about the standards that investors bring when they come to this forum.
Q152Mr Walker: That is very important, and I think colleagues will all want to touch on the issue of foreign investors. I want to touch on one other Kay recommendation around executive incentives. We have talked a lot about the incentives for asset managers and intermediaries. One of the recommendations of Kay was that executive incentives should be provided only in the form of company shares to be held until at least after the executive has retired from the business. There are some concerns about the practicality of that. Do any of you have any views on that idea and suggestion? Is that something on which there could be legislation?
Dr Woolley: No. That is a rather long horizon for an individual. If we have a code of best practice for longterm investors, corporates will start to act in ways that reflect that. They will start to recognise that dividends are the only way the investor gets his money back from investing in shares; they will start to recognise that buying back shares when the price is high is not a sensible thing; they will start to invest for the future and take a longterm view. Just as there should be a code of best practice for investors, similarly there should be a code to show managers what best practice is, not just on research and longterm projects but also on the financial structure and retention ratios to wean them off the short-term focus.
Catherine Howarth: It makes a lot of sense to let the new regime on executive pay that is now going through Parliament bed in. Much more important than further tinkering with executive pay is all the stuff I talked about earlier on which we focused in our report "The Missing Link", which is enabling those at the bottom of the chain who invest in capital, take the risk and delegate to other people to oversee executive pay to have some kind of scrutiny and accountability of what is done in their name. In that area where there has been very little focus, there are real opportunities to advance the debate. If fund managers know that they are being watched in the way they cast their votes, they will pay more attention, and if they are being explicitly mandated by their pension funds to have conversations and cast votes with an eye to the longterm value of the underlying corporate entity when they are thinking about remuneration, all those are positive things. Further tinkering in terms of regulation is probably not going to take us forward.
Q153Rebecca Harris: I want to go back to the governance of pension funds. Mr Wong, you wrote an article saying that it was the missing link in the Kay review. Lord Myners told us of the possibility of resourcing and equipping pension funds as well. What would we need to do, from your experience, to make that happen?
Simon Wong: At present Canada has an interesting proposal, which is to mandate the transfer of assets from smaller pension funds to a new vehicle as a way to build scale. These are defined-benefit plans, so asset allocation decisions will still be made at the pension fund level, for example, but at least you have a collective vehicle that hopefully will give you better scale and so reduce costs. Where you decided to retain external managers, it would give you greater leverage. These are steps in terms of how we bring together smaller funds.
A big part of it in different countries with large funds is who should sit at the top of these organisations. Increasingly, people are coming to the view that the well meaning person on the street is perhaps less and less suitable for this role, and you need senior people with either business or investment expertise because investment has become that much more complicated. Without addressing the top in terms of who governs the quality of the people, both in terms of the trustees but also those in management, you will continue to have problems with an extended chain of ownership, meaning excessive reliance on investment consultants or the use of multiple layers of fund managers either because you do not have access to certain products or you just need advice.
Another benefit of scale is that, instead of just buying products off the shelf, you are in a better position to say, "Can you please design something that would fit my particular needs?" I hope that answers your question.
Q154Nadhim Zahawi: I have been listening very carefully to the very useful contributions. Dr Woolley talked about eliminating momentum trading and looking at fundamental investing. That is a good point, but, to get rid of the short-termism, on the side of the corporate you go before your investment community at prelims, interims and so on during different periods, and you are judged on that short-term performance. Therefore, that is the driver of human behaviour. Pension fund managers themselves are judged on short-term performance because of their league table. Is not the problem a cultural one in the sense that my parents and their parents have got used to pension returns that are just unachievable? The problem lies there rather than with all the issues around governance. They are all good things, but is there a cultural problem in that we have got used to unrealistic returns on our pensions?
Dr Woolley: Not at all. We enjoyed lush pensions in the 1980s and 1990s for special reasons, mainly because equity and bond markets were so cheap at the beginning of the period, but we can expect a little more than the 1% per annum real that we have had for the last 12 years. It should be possible to earn on diversified assets in pension funds more of the order of 3% or 4% per annum real. Part of the reason it is not 3% or 4% real is the cost of the finance sector, which probably amounts to between 1% and 2% per annum real taken off your pension for having it managed-the hedge fund costs, brokers and the whole caboodle. It is also the fact that the way the finance sector is currently structured and its size means it is prone to crisis, and that imposes a huge cost on the economy. As we have seen, in the UK 15% has been knocked off GDP in the last four years. In a steady state, if we get back to global growth of more like 3%, we should look for a return similar to 3% real, but beyond that you should be able to add 1% or 2% on top of that as an expectation. The target that pension funds should aim at is a benchmark of something like real growth of global GDP plus local inflation.
Q155Nadhim Zahawi: But do the rules of the game allow the pension fund manager the time and the room to say, "I am going to stick with this management team because they are investing for the long term; they may not deliver the returns in this or the next quarter, but I will stick with them"? I do not think the rules of the game allow the pension fund manager that leeway.
Dr Woolley: I agree, given the way the game is played. The point is that, as I said at the outset, we do not understand how finance works, and we have a discredited theory delivering an instruction manual for funds and regulators that causes them to engage in short-termism and all the bad things that are so costly to the ultimate beneficiary.
Chair: What it comes down to is that the purpose of this inquiry is to see where we can change the rules of the game to realise long-termism. Catherine, did you want to respond? If you could keep your remarks brief that would be helpful.
Catherine Howarth: At the moment about 11 million people in the UK are saving through workplace pension schemes. That is about to grow by about 8 million more people through pensions auto-enrolment. We need to get this right, because a very large number of UK citizens are going to be committed through auto-enrolment, often without making a very active choice in that direction, to this system where their hard-earned money will be committed to agents in the hope they will look after them well. While returns in the future-who knows-may not be as juicy as they have been in the past, that is all the more reason to try to get these conflicts of interest in the system ironed out and ensure the beneficiaries get the maximum possible benefit from the system. Good governance, oversight and scrutiny-all the things we have been talking about-are essential components to getting that right. This may lead back to the conversation about fiduciary duty, which is really about trying to make sure that the saver is absolutely at the heart of the system.
Simon Wong: There is a cultural issue. Part of the reason asset managers are obsessed with short-term relative return is that their clients focus on that, but do the clients really understand what they are buying? A UK pension fund trustee admitted to me last year, "We look at benchmarks because that is the easiest way to measure performance." It is much harder to understand the capability of the asset manager and the strategy being pursued. That is where governance needs to change. If you look at the Australian Future Fund, they explicitly stress that they do not look at pure risk and how their asset managers perform over the short term. They look at 10-year rolling returns or three-year rolling downside outcomes, so it is a very different way. Some of the larger pension schemes are looking for fewer but deeper relationships so they can understand them.
Q156Rebecca Harris: How do pension funds differ in their structure and governance from other players in the equity market?
Catherine Howarth: There are important differences between trust-based pension schemes, where they are defined-contribution or defined-benefit, and the insurance side of the pensions market, which has grown rapidly, where individuals have a contract with the firm. One of the issues about which we have concerns is that the standards of protection and the focus on the sole interests of the saver are a bit weaker on the insurance side than the contract-based side of the market. That is one important difference. There are real variations among pension schemes. Some are very big and do their own asset management in-house; they have their own fund managers and hold shares and trade them directly themselves, and most delegate to asset managers so they have various mandates and contracts for equity investing and bond investing and so on. There are some important differences. The evidence is that where pension funds take some of that stuff back in-house and manage it themselves, they produce excellent returns and save a lot of costs. One of the reasons they produce good returns is that the costs are lower and high costs eat into returns in a very damaging way. That is a point well made by Kay in his report.
Christine Berry: One of the important differences between trust-based pension schemes and most other players in the chain is that they are generally non-commercial and not-for-profit entities that exist purely to serve the interests of the saver. One thing often forgotten, whether it is in the debate on executive pay or on Kay, is the fact that a lot of the entities we are talking about, whether it be asset management firms, insurance companies or whatever, are themselves listed companies that are subject to all the same pressures we are talking about in relation to listed companies generally. That is why asset owners, particularly large not-for-profit trust-based asset owners with good governance, are the players in the chain who really should get a lot more focus than maybe they have in the debate on the Kay review previously and are the ones with the potential to shift the system. They have more of an incentive and less of a disincentive to shift the system.
Q157Rebecca Harris: Dr Woolley, to go back to short-termism, clearly we need to extend the period of time over which the performance and the portfolio of individual traders are measured and compensated. You said at the outset that this was an issue that we have failed to get to grips with for over 40 years. As the Chairman said earlier, this Committee is trying to get solutions, so can you help me with practical solutions about how we align those incentives as policy makers to make it happen?
Dr Woolley: In a written submission yesterday, I set out seven steps that needed to be taken. To summarise those, it is to educate the asset caretakers. One uses the term "asset owners of the pension fund". They are not the owners; we are. They are the asset caretakers. We have to educate the asset caretakers to show them that they are pursuing strategies that are causing the returns to be severely reduced. We need to show them the steps they need to take to change to a stable long-term cash flow-based benchmark with risk metrics, and we need to write contracts that focus on longterm performance and, accordingly, fees based only on longterm performance. From the regulator’s point of view, they should recognise that they should not impose these short-term mark-to-market valuations that are coming in. They are trumping every attempt investors might make to be more long-term. If you are focusing just on what the value is in a year’s time you will be forced back into a shortterm strategy, so the regulators need to be educated as well.
Q158Ann McKechin: Professor Kay was quite passionate about the need to abolish quarterly reporting obligations. Dr Woolley, you have mentioned looking at a three to four-year period as the average time over which people should be looking at investments. Do you think that one measure would be of real help, or would people find another way to get back to the same culture we have at the moment?
Dr Woolley: I understood that John Kay was talking about the quarterly reporting of companies. I see no merit in reducing the information flow. The quarterly reporting of pension fund returns should still go on. My concern is that there should be much more focus on longterm cash flows for the investing funds. The point is that, if you focus on doing the best you can each year in terms of the market value of the fund, it will not give you the best outcome in the long run. The long run is not the same as the sum of the intervening short terms. The way of achieving the best longterm results is to invest on a long-term basis, focusing mostly on dividends and interest payments. The whole strategy should shift. Funnily enough, what are called value managers have been doing very well for their clients, and that is a similar sort of approach, which should be adopted.
Q159Ann McKechin: Does anyone else on the panel have a different view about the issue of quarterly reporting?
Christine Berry: My understanding of your question was whether, if we abolished the regulatory requirement, people would continue to do it anyway. There is an extent to which quarterly reporting and all the dynamics that go with that are driven not just by regulatory requirements but by shareholder expectations. That dynamic is part of the reason we have argued quite strongly-it is something we have not really touched on today-for clarification of investors’ fiduciary duties. There has been a lot of hand-wringing over the fact that we introduced these duties for directors under section 172 of the Companies Act, which were based on the idea of enlightened shareholder value and that directors should look to the long-term success of their company and should consider wider social and environmental factors. That does not seem to have had a lot of impact, and all the evidence suggests that that is because you cannot have enlightened shareholder value without enlightened shareholders.
Q160Ann McKechin: Some people say that part of the problem is that it was so vaguely set out in legislation that the ability to enforce it was practically nil. People just felt they could ignore it anyway. We can prepare legislation, but if it is not sufficiently well defined you do not have the ability to enforce it.
Christine Berry: There is an argument around that and I am sure there are respects in which the legislation could have been improved, but the more fundamental problem is that the way the legislation was explicitly formulated was to go not for a stakeholder approach but enlightened shareholder value whereby, because it is ultimately in the interests of the members of the company, to whom directors still owe their fundamental duty, they should take an enlightened approach.
Q161Ann McKechin: My final question, which all of you can answer, is: do you think that currently we have the right balance between voluntary compliance and statutory legislation? You seem to be suggesting that we need more of the latter. Does the panel think we have the right balance in terms of making these changes?
Christine Berry: On the specific point of fiduciary duty, we have argued that statutory clarification will be needed. That is not to say we need to impose by regulatory fiat good behaviour, but we need to clarify an area of the law where currently it is thought that the law prohibits good behaviour, which is a real problem. That has gone to the Law Commission. We are supportive of that process. We should not assume that at the end of the process it will be sufficient just for the Law Commission to pronounce, "This is what we think the law is", and it will change behaviour. That would be hugely helpful, but I am sceptical whether it will be enough. There will be a need for express clarification.
More generally, there is certainly a case to say that there is too much focus on voluntarism at the moment. Kay makes the point, which I think is correct, that you cannot impose regulation to make all these cultural changes, but that does not mean there is nothing Government can do. One of the things Kay says Government can do is set the tone, and one of the ways of doing that is by articulating a willingness to regulate where voluntarism does not work.
Simon Wong: On your last question, I am going to sound like a broken record, but the Government can facilitate the consolidation of pension funds either by establishing vehicles compelling transfer or by providing protection in terms of liability, which is being proposed in Canada. There might be scope for regulatory intervention in terms of avoiding conflicts of interest. The last thing is the tax regime. People have talked about perhaps lowering capital gains tax if you hold shares for the longer term, but maybe you also want to take away their ability to write off losses in certain respects for short-term trading and so on. There is scope there.
Chair: That concludes our questions. I realise that we have had to hurry you to a certain extent; indeed, we have had to hurry ourselves. If there is further evidence you would like to give to the questions you have been asked, or questions that have not been asked but you feel should have been, please feel free to write to the Committee to submit that. Similarly, if we feel that there is a question we should have asked arising out of the evidence you have given us we will write to you and will be grateful for your courtesy in replying. Thanks very much indeed. I am sorry we have had to hurry you a bit.
Examination of Witnesses
Witnesses: Dominic Rossi, Global Chief Investment Officer, Fidelity Worldwide, Anne Richards, Global Chief Investment Officer, Aberdeen Asset Management, Harlan Zimmerman, Senior Partner, Cevian Capital, and Roger Gray, Chief Investment Officer, Universities Superannuation Scheme, gave evidence.
Q134Chair: Good morning and welcome to the inquiry. Thank you for agreeing to give evidence to us. I do understand, Harlan, that you have a problem with your throat. We appreciate your fortitude in coming before a Select Committee and trying to speak to us, but if it does become a problem, feel free to back out of this session and we will rearrange for you to address the Committee at a future date. I would stress that we do want to get full value from your contribution today and if you have physical impediments to giving us that then it will be better to leave it to another day.
Can I just ask you to introduce yourselves and the organisations that you represent, just for voice transcription purposes?
Roger Gray: I am Roger Gray. I am the Chief Investment Officer for USS. My title actually goes Chief Executive Officer of USS Investment Management Limited.
Chair: That is the Universities Superannuation Scheme.
Roger Gray: Correct, which is the pension fund for the university sector for primarily the academic staff. There are about 300,000 members and about £36 billion; it is the second largest pension fund. Relative to the previous discussion, we are in that rare category in the UK of being large enough to have a large inhouse investment team and therefore a significantly reduced proportion of intermediation.
Anne Richards: I am Anne Richards, the Global Chief Investment Officer of Aberdeen Asset Management. We are a listed company on the London Stock Exchange. We manage around about just shy of £200 billion for external clients, which will be a mixture of pension funds, institutions and private retail investors, both in the UK and a considerable proportion of our clients are overseas.
Dominic Rossi: I am Dominic Rossi, the Global Chief Investment Officer of Fidelity Worldwide Investments. We manage approximately $300 billion, of which about $175 billion is invested in equity markets around the world.
Harlan Zimmerman: I am Harlan. This may not work, because of my throat-it sounds a bit like garbage collection testimony in New York. It sounds much worse than it feels. I will leave it to you whether we should continue. I am Harlan Zimmerman, Senior Partner, Cevian Capital, which is the largest dedicated active ownership investor in Europe. We have only approximately 10 to 12 companies at a time. The average holding period is four to five years. We manage about €7 billion.
Q135Chair: Thanks very much. I would reiterate if you do feel that you cannot speak anymore, feel free to back out and we will arrange for you to come again. I have a couple of opening questions. This is to Roger Gray. You included a copy of the letter that you sent to Professor Kay during his review. Why was that and did you feel that you had not had adequate consultation with him? Do you feel that the concerns that you expressed have been addressed by Professor Kay?
Roger Gray: That is quite a wide open question. Ours is one voice. We believe that, as an end investor, that voice probably had some standing and indeed is generally heard in the market. It is not universally held, so no umbrage if not all of our views are incorporated in his conclusions, but I would say that the letter is there as much to show that we are actively engaged, as an end investor, with any consultations to do with the workings of the financial system and how it plays to the interests of longterm investors.
Q136Chair: Do you feel that organisations were sufficiently consulted by Professor Kay?
Roger Gray: It was a tough ask, and one of the reflections on the nature of the pensions industry in the UK is that there are not very many of us who have the dedicated resource to respond to inquiries such as this. We have a team of five professionals in responsible investment. There are a handful of other funds that have one or two individuals so dedicated, and then it runs out. So if the voice of pension funds has not been heard through us or through the trade organisation, then that is as much a reflection of the structure of our industry as it is on the endeavour that he undertook.
Q137Chair: That is an interesting observation because, from my perspective as, obviously, a contributor to pension funds, it is a bit worrying that there are, shall we say, inadequate resources in the industry to respond constructively and positively to the inquiry. Is that a fair reflection of what you said?
Roger Gray: That is a fair reflection, yes. There is a high degree of fragmentation in the UK. There are certain markets in Holland, Canada or Australia where there is more concentration and you have a stronger representation of that pension fund group in the ownership of domestic stocks and somewhat different governance arrangements arising from that.
Q138Chair: You also said to Professor Kay that "there are likely to be different solutions to the agreed problems." Now, given the fact that we are trying to hold an inquiry to come to an agreed solution to agreed problems, what exactly did you mean by that? In effect, what would your solution be to what I think are generally agreed as the problems?
Roger Gray: I do not think there is a magic bullet and I do not think there is one clear regulatory or legislative solution to this. It is going to be built up from a number of contributions. This inquiry, the Kay inquiry, the Stewardship Code, the increased attention to corporate governance and the responsible investment more generally that has built up post the financial crisis are all good stuff pushing in the right direction. The question is: will it actually help, or will there be unintended consequences if one pursues with too much emphasis any one of these tracks? I would encourage a broader front rather than a single silver bullet, which I do not believe exists.
Chair: I am now going to hand over to Julie Elliott to ask some questions of the whole panel. I would emphasise that there is no need for every member of the panel to contribute an answer if it does not add significantly to, or indeed subtract from, what a previous speaker has said.
Q139Julie Elliott: I think that means keep it short. Ten years ago, 15.3% of UK shares were held by individuals. In 2010, that figure had fallen to 11.5%. In your opinion, what are the reasons for this continued rise in institutional investment?
Dominic Rossi: The first point is obviously that equity markets have not performed very well, and in any market that has disappointed with its returns the activity of the individual investor is likely to fall. Subsequently, I do think that if equity markets were going to recover you would see an increase in that participation. But obviously is it likely to be just that factor? I suspect not. I suspect that the intermediation structure that we have and that has grown over the course of the last 10 years or so is part of the reason as well.
Anne Richards: I would add that people have been working in an environment where they have been saving less and borrowing more, and it is a net effect from that. If you are borrowing a mortgage to buy a house, you have choices. You do not just have the option of putting your money into the equity market. You can put it into property and other sorts of assets. In a world where people have been tending to direct more of their savings towards building property, one of the consequences of that is that they put less into equity markets. That is also a factor.
Harlan Zimmerman: The other factor is there has been an obvious breach of trust. It would be difficult to pick up a Financial Times today and not find an article about an august British listed company for which the man on the street would think, "What are these people doing with my money? Paying themselves too much, playing with LIBOR, buying companies here and there, paying billions of dollars of fines in America for all sorts of institutionalised schemes that have been found to be corrupt." If you are the average man or woman on the street, it is quite obvious that you would begin to consider whether these sorts of institutions can be trusted with your money.
Q140Julie Elliott: With the increasing presence and responsibility in the equity market, have you perceived any strengthening in the regulation of institutional investors?
Anne Richards: If you look at regulation and how it has evolved over the last 10 years or so, there have been some things that have worked well and some things that have not worked well. The things that have worked well have been around principlebased regulation. It came under some pressure for failing to prevent some of the flaws in 2008 in the financial sector, so it is not a solution to everything. But look at some of the things that I think have worked very well-I would draw your attention, for example, to the treating customers fairly regime. It is not prescriptive in the detailed implementation of rules and regulations around treating customers fairly, but the concept is easily understood. It has forced all of us in the investment management world to take a step back; for every action and step along the way, whether we are dealing in the institutional or in the retail space, which is quasiinstitutional, it has given us a very good and timely reminder to consider the effect of any action we are contemplating on continuing, exiting and new customers. I speak for our own business, and that is probably true generally across the industry. That is now a very well embedded concept and it has worked well.
Where regulation has not worked well is when it has drilled down into detailed complexity and attempted to, in a sense, micromanage some aspects of the market. In fact, increasing that complexity has made the market-and I use "the market" in its broadest sense-more difficult to gain transparency on and more difficult to manage. As an example of that, I would say the increasing requirement upon many of the agents in the food chain themselves to seek external advice has dramatically increased the number of agents in the chain and has not ended up with us having a better and more effective chain. For example, for the individual who is now required to take advice from an independent financial adviser on their pension fund, the pension fund takes advice from actuarial consultants and investment consultants. They have their asset managers who then manage the money on their behalf. We invest in companies who, in order to get the remuneration reports right, use remuneration consultants and so on and so on and so on. That is an example of where an attempt to micromanage has not ended up with a more robust regulatory regime, even though the rules are many times more prescriptive.
Dominic Rossi: The question offers the opportunity to endorse one of the comments on regulation that Professor Kay makes in his report. This is that, with the question of stewardship and the desire to encourage asset managers like Fidelity to engage with companies on board appointments, major investments, acquisitions and so on, that engagement comes head to head against a regulator and a market abuse regime that insists upon uniform information. Within Kay we have an agenda that is entirely different from the one that the FCA is currently pursuing around market abuse. At some stage, we are going to have to triangulate this conversation and include the FSA, because they are trying to sterilise the dialogue between professional asset managers and the companies in which we invest.
Q141Julie Elliott: How do you-and, indeed, do you-think the UK benefits from the growth of institutional investors?
Dominic Rossi: In the UK alone, we employ 40 analysts and 30 fund managers to scrutinise companies, their management and their corporate strategies before we make an investment. I do not think that would have been possible without the institutionalisation of our industry. Not all asset managers will do this, but we have a very effective corporate governance team that genuinely works with the companies in which we invest to improve their performance and to monitor and, if necessary, redirect their own management incentives. If you consider that asset management has a dual mission-which we do, and I think that is one of the most important conclusions that Kay comes to-first the fiduciary duties to our clients to maximise their returns, but also the stewardship responsibility of improving corporate performance, without the resources of an institutional organisation you would not be able to perform those two. That is not to say that all institutions do perform those two missions, but if you did not have an institutional framework I do not think it would be possible.
Anne Richards: It comes back to the point that was raised in the first session about the information asymmetry. It is not just an information asymmetry but a skill asymmetry between somebody whose day job is quite different, trying to decide, as an individual, whether they think that is an appropriate individual investment or an appropriately riskadjusted portfolio in which to invest, and the economies of scale, as Dominic has said, that you can gain from a lot of heads who are effectively looking at a particular issue, company or group of companies day in, day out. They can glean much more information from the mass and morass of information that is out there. There are benefits to it in helping bridge that information and skill asymmetry gap.
Roger Gray: I do not know if I should drop this point in, but of course one of the big changes is that the pension fund industry, the insurance industry, in the UK is no longer such a prominent investor in UK equities as it once was. That has to do with the derisking that has taken place and is partly to do with demographics; obviously in the pension fund industry a lot of defined-benefit pension funds have closed and have matured, which means that they have to take lowrisk portfolios. So it is rather stark: where else do you look? We can play a significant role still as investors, but just speaking about my own fund, in the mid2000s about 40% of the fund would have been in UK equities. That is now about 16% of the fund. Part of that is that we have globalised and diversified our fund, but the institutions that are investing in the UK equity market are now far more diverse in terms of their origin than they were. So the UK-held portion of the UK equity market is much reduced, not just in the retail space, which you alluded to at the beginning of this question, but also in the UK institutional space. If I just choose an asset manager, BlackRock has $3 billion under management [Interruption.] Yes, sorry, $3 trillion-it’s like Austin Powers, isn’t it? That is more than the entire UK pension fund industry, of which only a portion and now a much reduced portion is in UK equities.
Q142Chair: A couple of questions have arisen out of the answers to that one. First of all, Anne, earlier you mentioned that Government are trying to introduce regulation to the detail rather than the broad principle, and you gave an example. What could the Government have done to realise the objectives of their regulation but without having to regulate to the detail that they did? Have you any observations on that?
Anne Richards: The first thing to point out is that it is not all Governmentinduced. Part of it is regulatoryinduced. In part, it is to do with perhaps not joining the dots. It is a fragmented approach rather than perhaps starting from a unifying vision and then working out how that can be taken down. When I talk about a fragmented approach, the sorts of things that I would put into that category are perhaps along the lines of taxation for different types of instruments, which has an effect on behaviour in the markets, and how that taxation is dealt with alongside the pensions regime or the broader savings regime.
One of the things that Government can do to bring about a greater effective change is, for example, by adopting a crossparty and longer-term approach to the overarching operation of the savings and pension regime right across the spectrum. You take away the annual tinkering, for example, that goes on around the rules and regulations of individual savings and pension products. We still have a very fragmented approach in that regard. At a very practical level, moving the savings regime out of the political football to the greatest extent possible, and bringing about a more broadly based and a longer-term vision as to how we might then tackle some of the individual problems that have arisen underneath that, would be a very good starting point.
Q143Chair: Perhaps this Committee will make a contribution to that process. Roger, there is a particular question I wanted to ask you. You talked about the steps taken to derisk pension funds and take them out of equities into gilts, bonds, etc. Do you feel that, if there had been a better regulatory environment that concentrated on longtermism, the need for doing that and the consequential reduction in returns that we had arising from that move would have been avoided?
Roger Gray: Yes. Paul Woolley was referring to some ways in which one could assess whether a longterm investor was indeed doing all right relative to their longterm liabilities. He was saying to look at their income generation capacity, for example, not just the mark-to-market movement in price, and that is an important consideration. Movements in the direction of allowing pension funds to look very carefully at "these are our assets, these are our liabilities; we believe that we are doing all right against them, although the markets do not necessarily agree with that on a snapshot basis" seem to me to be an important dimension of flexibility to get into the system.
All that having been said, the world is a very complicated place and there is real risk out there. The reason why pension funds are suffering at the moment is because there was indeed a financial crisis, and five years have passed and we are still suffering from that in terms of economic progress. Changing cannot get rid of the fact that the pension fund must look after paying its liabilities. Indeed, as I say, there are lots of good reasons why pension funds have derisked; they are not just regulatory ones, but probably at the margin some of the regulatory practices have conduced, or would in future conduce, to behaviours that are not optimal for the long term.
Q144Julie Elliott: Professor Kay told us that companies tend to finance investment through debt and retained earnings rather than from equity markets. Do you agree with that?
Dominic Rossi: Obviously, over the course of the last 15 years the cost of debt has fallen significantly relative to the cost of equity, which has risen. So if you are a company and you are looking to finance an expansion or an acquisition, debt is going to look like a much cheaper option than equity. On top of that, one has to recognise that the tax code acts as a subsidy through the P and L statement from equity owners to debt. So you have a tax system that incentivises the accumulation and creation of debt as opposed to the creation and accumulation of equity, and then you end up with a financial crisis.
Julie Elliott: That sounded so simple.
Anne Richards: When I started looking at UK equity markets a little over 20 years ago when I started running money, there were close to 1,000 companies in the FTSE AllShare Index and now there are just over 600; the number of companies listed in the AllShare Index has fallen markedly. As asset managers, a lot of us would have sympathy with the view that Professor Kay talked about in his report, which is that the primary function of equity markets is evolving. They are no longer the sources of primary capital. They have become largely the transaction of secondary holdings, and that is their primary purpose. That is quite interesting.
I think the taxation point is an excellent one and I completely agree with that. There is an unequal treatment.
Q145Julie Elliott: You have really answered this, but does anyone else have any comments? What do you regard as being your primary role in the market?
Dominic Rossi: Also governance. Some companies are publicly quoted in order to protect themselves from regulators, because it gives that check and balance to regulatory involvement. It is not a common answer to the question, but certainly if you ask companies-defence contractors, for example-one of the reasons they are publicly quoted is because they think that the public market gives them some protection.
Roger Gray: Before this Committee, it would be important to say the equity market does some good things. Amidst the noise of the pricing of stocks it does identify winners and losers, and while not always getting it right-who does, particularly when it concerns the future?-that is one of its purposes. Of course, in this context it also gives an avenue for the influence of the owners of that business in terms of the longterm strategy, remuneration and other policies where we think it is important to get the right balance between the end owners and the executive and board.
Anne Richards: We are allocators of capital. In our business that is how we view ourselves. In the UK, our typical portfolio will have between 40 and 50 names in it and our average holding period will be upwards of five years; it is usually seven, eight or nine years. So we regard ourselves as allocators of capital. What we are looking at is where we can allocate capital on behalf of our clients to get the best and most robust long-run return out of that. It incorporates what Dominic talks about in terms of governance. That is a very important part. We do not, for example, have a separate corporate governance team or stewardship team that sits on the side. Our fund managers are responsible for all engagement with the companies in which we are investing, because if we are going to allocate capital to an industry, to a business for a long period of time we want to make sure that we trust the management team to look after that capital appropriately. There is very much that broad allocator of capital view in our role, and Aberdeen is not unique in that. There are other companies that will very much articulate in a similar way.
Q146Julie Elliott: Lord Myners recently described his report from 10 years ago as a call for action, and Professor Kay closes his report by saying that the task will be long and difficult, but it is time to begin. What will success look like and how do you see the equity market in 10 years from now?
Dominic Rossi: Shall I try to answer that?
Chair: If you can keep it fairly succinct.
Dominic Rossi: Professor Kay’s report was one of the best that I have read on our industry in 25 years. It has been criticised because the recommendations seem relatively light compared to the analysis, but if you ask an academic to produce a report it is going to be an academic report. The analysis that he has put into the industry from a nonpractitioner is undoubtedly sound. Where we will hopefully make progress over the course of the next 10 years-and we do need to make progress- is on the three key issues that he raises. The first is stewardship. Too many asset managers, as I have said already, view their responsibility solely to be that of investment performance rather than also improving the performance of the companies in which they invest. The industry could make huge progress in that role and one way of strengthening that dual mission is to get the regulator to recognise that we, as asset managers, have a dual mission. In all my conversations with the FSA over many, many years they have never asked me once what I am doing to improve the performance of the companies in which I invest. That is the first thing I would suggest.
The second thing is around the whole issue of shorttermism. Everything that you have read around the culture of shorttermism is indeed correct. One of the challenges that we, as asset managers, face with respect to shorttermism is the persistency of our clients. It is an industrywide problem, but I think the proliferation of intermediation has shortened the persistency of clients in our industry. This means that fund managers are under pressure to perform within a two or threeyear time period.
Asset managers used to market directly to the end client 30 years ago, but tend not to today; we have lost contact with the client. By asset managers getting closer to the end client and strengthening our direct relationships with the end client we will improve persistency of assets, and that will have a spin-off in terms of the investment time period.
The third key area is the one of remuneration. I am on record as saying many times that corporate remuneration is too complex and too shortterm. That is also true of the asset management industry. The asset management industry will not be treated seriously in boardrooms until it extends the duration of its own compensation schemes, and we fully endorse the recommendations of Professor Kay on that particular issue.
If we pursue those three issues, I think we will be in a far better place in 10 years’ time than we are today.
Anne Richards: It is about trust restored. Success will be that the person in the street has regained trust in the savings and investment industries in general. That trust has been lost to a large degree. I agree with what Dominic has said. I would also add that a focus on outcome rather than process is an important part of rebuilding that trust.
Q147Julie Elliott: Dominic, you have alluded to the supplementary on this question but I will ask it in case anyone else wants to add. It has been reported that the European Securities and Markets Authority has laid out reform to fund managers’ pay. They said that deferred bonuses should be paid out over a three to fiveyear period, with firms encouraged to consider even longer delays for members of management. The FSA will be consulting on this. How should such a reform be implemented to ensure maximum effect?
Dominic Rossi: Our own view on this is very clear: we should strengthen equity ownership, and the vesting period and the holding period of that equity ownership should be a minimum of five years. Our own scheme is career shares. We own shares in our company that we cannot sell until we retire. That might be too much of a mouthful for some in our industry, but I genuinely think that longterm equity accumulation really does lend itself to longerterm thinking. I think Kay is absolutely right on that matter.
Q148Julie Elliott: Would everybody else agree with that?
Roger Gray: It is clearly a balance. Paul Woolley mentioned this previously and I will just repeat it. Someone who is working may have a mortgage and a family and may therefore want to reap some of the reward from what they are doing, and it is about what is the weight that you put on the longterm incentive.
A comment on the industry. First, internally we focus on fiveyear rolling average returns and then we defer some of the bonuses that arise out of that for a further three years. I would call that relatively long term. We do not have shares in our own company; we are not set up for that. One of my comments about the industry at large is that we have sought to engage managers with longterm incentive arrangements, and we have been relatively unsuccessful in achieving that. Particularly in the hedge fund domain, where we thought some humble pie would have been consumed sufficiently to shift that dial, it has been an almost hopeless exercise.
Anne Richards: In the spirit of longer-term compensation I think the direction is absolutely right. One of the things that we are somewhat resistant to is the idea that compensation should be linked in a formulaic way to individual investment performance. I have seen this many times over the years and there is no doubt that behaviour follows incentives, so you have to be absolutely crystal clear what incentives you are putting in place. The approach that we have taken in our business is that the primary incentives we are putting in place are the behaviours that we want. We focus on certain things that are important to us and stewardship plays a part in that and longer-term investment performance is also a part of that, but we are resistant to the idea of making it very formulaically driven because then you start to get investment decisions being driven by the compensation rather than as a reward for it. It is important to make sure that it is a balanced scorecard approach, not just a simple numerical formulaic approach to delivering compensation.
Q149Ann McKechin: I will turn to the impact of foreign investors and to you, Dominic. Professor Kay’s report mentioned the fact that foreign investors, in his opinion, were reluctant to involve themselves in the governance and strategy of UK companies. He did list Fidelity as among the American firms to which he was referring. Has he understood the structure and global nature of you and other international businesses?
Dominic Rossi: I certainly read Professor Kay’s comments. I also note that Paul Myners mentioned Fidelity in a completely different light, I am glad to say. I agree with Kay on the issue of stewardship. I also agree with him that the asset management industry is committed to stewardship to varying levels of degree and that this creates a free-rider problem, but I completely distance myself from Professor Kay when he wraps the stewardship issue up in a Union Jack. I do not think it is a matter of nationality. I think it is a matter of attitude. The question that all asset managers need to face is: do they believe that part of their role is to improve the performance of the companies in which they invest? We certainly do and we are resourced in order that we can fulfil those obligations.
Q150Ann McKechin: Can I just clarify one point with you? Are the shares managed by Fidelity classed as UK-owned or foreign-owned?
Dominic Rossi: I remember that question. They will be classified as UK-owned.
Q151Ann McKechin: That is very helpful. Can I ask all the panel now, in your experience, are Professor Kay’s comments and his analysis of the issue of foreign investors in general correct? Obviously, I take Dominic’s point about Fidelity, but do you think that there is a growing issue about foreign investment?
Harlan Zimmerman: There is a general issue that proper stewardship and engagement is a cost centre for most investors. There are some exceptions sitting on the panel here, but for most investors that is the case. You do the minimum that you can to protect your investments, which is much less costly than getting involved in 6,000 companies. You focus only on the greatest transgressions and react in a defensive way, and you do the minimum that society imposes upon you. For many foreign investors who do not have the societal pressure here, it is much easier just to vote and do no more. I have been in the asset management industry here in the UK for 20 years or so, back when even the UK institutions often did not vote. Then it became voting with management, if you wanted-you had to vote but you really should vote with management. If you did not want to do that, it had to go all the way up to the top of the organisation. Then it became voting in an educated way, which meant using proxy advisers. We are slightly evolving beyond that, but too many institutions are able to hide behind that and say that because they are voting that is stewardship; because they are writing letters to 14,000 companies around the world that is stewardship. In fact, that is the least costly way of doing something that will protect you from the societal pressures etc.
Q152Ann McKechin: So it is really more to do with the fact that these companies are global conglomerates rather than being just simply foreign owned, because the vast scale of their business is such that they are not interested in a more direct approach with a company’s investors.
Harlan Zimmerman: Do you mean the asset managers?
Ann McKechin: Yes.
Harlan Zimmerman: It is just a numbers game. I would say USS is about the best that exists in the UK, from our perspective, of an engaged owner. If you look even at the numbers there-and it is just five people, I think Roger said-the people there are very good, but how many companies do they have to look after? There is only a certain amount that can be done, which is why there is all this discussion of trying to outsource this work to the investor forum or something of that nature. Then, as most of you know, and we may come back to this, our point of view is that we are already paying 1,000 people or so in the FTSE 100 to whom we are outsourcing stewardship on our behalf, and those are the nonexecutive directors of the companies. It is they who often do not seem to be doing the job on our behalf.
Ann McKechin: I wonder whether Roger or Anne have any comments on this issue.
Roger Gray: I would like to pick up on that flattering accolade in the air and also accept the point that it is the art of the possible. There are limited resources, and in fact a definition of hell would probably involve all fund managers being hyperactive with all company boards and management, because there are other things to do than dealing with that. Clearly, we all must look to be effective rather than encumbering the companies we invest in or, indeed, snarling up all our resources doing something, so there is a judgment to be made. We vote 97% of the shares that we own, and 100% in the UK. We engage in some close engagements with companies, but I would say the UK will be a larger proportion of those. Our holdings are bigger in the UK and therefore there is more money behind it. We do participate, where it is available to us, with services or groupings such as Eumedion in Holland, which reflect our institutional-
Q153Ann McKechin: Do you think it is sensible that when a UK company gets beyond a certain critical mass of shareholders who are foreign shareholders there is an impact on the degree of engagement? There has obviously been an increasing shareholding in UK companies held by foreign companies. Has that had an adverse or neutral impact, in your opinion?
Roger Gray: There are forces moving in different directions. The passive industry has grown and it is definitely debatable to what extent they have interest in deploying a lot of resource in terms of active engagement. The concentration of the asset managers, the active ones, does mean that even while the shares of companies are owned by the foreigners, the share register is not getting less concentrated if you look at the asset manager status. I am afraid I do not have a perspective on whether there is a big tectonic shift. We do know that the UK institutional investor voice, the end owner such as ourselves, is somewhat less strong in terms of its ownership stakes than it was.
Anne Richards: I would just add onto that, I see this from both sides of the table because I am an Executive Director of Aberdeen and I do spend time with our shareholders as well. We have quite a significant overseas shareholder base in our own share register and it is difficult to generalise. There are some overseas investors who are extremely engaged, so it is quite variable. What I would say, as it was a very good point that Harlan made, is that we do, to a degree, outsource part of this to nonexecutive directors. They are there to guard stakeholder interests, and shareholder interests most particularly within that. One of the more encouraging things that has come up in the last three to four years is that we are definitely seeing much more proactive engagement from chairmen, in particular, chairmen of remuneration committees, coming to us in advance of renegotiating executive pay, appointments of new executive directors, and so on and so forth, having that dialogue in advance of something becoming a controversial issue, and saying, "What do you consider are the key things that we should be looking at and building in?" That is an encouraging trend and we should do more to encourage even more of those nonexecutive directors to step up to the plate and do that. That is not just necessarily with UKbased investors; that can also be overseas investors, so that is a really important mechanism in this.
Q154Nadhim Zahawi: Roger has told us about the percentage of his business that is UKbased, but Professor Kay reports that owners of more than 40% of UK shares are based outside of the UK now. What proportion of your clients is based in the UK?
Anne Richards: Just over a quarter of our clients are UKbased clients. I think the number is about 27%, give or take. The rest will be overseas.
Dominic Rossi: I think we would be slightly less in terms of our UK client base, given the fact that we have large businesses in Asia and particularly in Japan.
Harlan Zimmerman: In our case, almost none. So that we can make longterm investments, we require a threeyear lock-up from our investors. Most institutional investors in the UK are not comfortable with that, investing in listed equities.
Q155Nadhim Zahawi: What proportion of your funds is made up of UK companies, and what proportion is foreign companies?
Anne Richards: For us, a little less than 10% of our total assets under management will be invested in the UK stock market.
Dominic Rossi: Coincidentally, ours is about the same level.
Harlan Zimmerman: We have 12 investments in total; four of them are UK companies in which we own between roughly 7% and 20%. These are FTSE 100 and 250 companies.
Q156Nadhim Zahawi: I do not know whether you can help me with this question, but in terms of voting, do you tend to take more or less interest in your UK companies versus your foreign-owned companies? Dominic, I think you addressed that by saying it is a cultural thing inside the business.
Anne Richards: For us it is right across the board. We have the same level, the same aim to attend AGMs where we think it is particularly important to do it. We aim to vote all of our shares unless there is a shareblocking mechanism. So it is absolutely the same. We have a unified process.
Dominic Rossi: The issues you face are very, very different. In the UK, much of our engagement with companies revolves around nonexecutive appointments to boards and management incentives. In Indonesia, you do not get asked about management incentives, curiously; it is more about just trying to assert your rights as minorities. So you have to alter the agenda depending upon the environment you are working in, obviously.
Q157Nadhim Zahawi: How are the roles of the fund management and corporate governance management administered within your institutions? How is it split?
Dominic Rossi: We have a separate corporate governance team, although I should add that they work very closely with the fund managers. We have a separate corporate governance team for two reasons. First of all, particularly in the area of management incentive and remuneration, it is quite a complex issue and we think it requires a specialist expertise. Secondly-and this is particularly important-it is around pricesensitive information. By having a corporate governance team we can be brought over the wall by a company much, much earlier on than we otherwise would be if that information went directly to our fund managers. Therefore, we can split the two off when we need to create a Chinese wall. It enables our fund managers to continue managing their portfolios, yet we can get involved in the appointment of an executive chairman or nonexecutive chairman and so on. So the separation fulfils two particular issues.
Anne Richards: We have the completely contrasting approach, which, as I have already mentioned, is very much to embed corporate governance within the fund management team. Perhaps for us that is more manageable given that we have the single unified investment process, our active holdings in the UK are a relatively short list and we expect our fund managers to be able to drill down deeply into it, and because we do not trade them very frequently. It is a different model.
Roger Gray: We have separate responsible investment and fund management teams-separate by five yards. The expectation is that fund managers who are taking the final decision to invest in a company will have incorporated the environmental, social and governance considerations into their decisions.
Harlan Zimmerman: Our strategy is specifically to invest in companies and try to make them better listed companies. Therefore, all of us are focused on the governance as well as the investment. The route to making them better normally is, in part, improving the governance, because that filters down into the areas of operational underperformance, bad strategic decisions, bad capital allocation decisions and so on. So, for us, it must be integrated.
Q158Nadhim Zahawi: We have integrated, five yards and total separation. My supplementary to you is: what happens when a corporate governance manager votes in a way that will be detrimental to the shortterm share price? Where is the separation? Where is the wall? Take, for example, voting down the remuneration of the chief executive.
Dominic Rossi: We have a set of remuneration policies. The voting team will vote in accordance with those policies. To be honest, that covers 90odd per cent. of situations, but you are right. There are instances where it is not possible. A classic will be where we have a takeover situation and we own both sets of shares. How do you marry that problem up? Those issues will often come to me to resolve one way or another.
Nadhim Zahawi: Presumably, if it is totally integrated-
Anne Richards: You would not get a situation where there was a disagreement, because we would come to-
Nadhim Zahawi: You would sell the shares, presumably, if you are voting down something that you do not like.
Anne Richards: We will tolerate shortterm underperformance if we think that the longer-term goal is worth that price. If we think it is something where we have engaged with the company, they still do something that we dislike and we have to mark their card on this year, but we feel that the direction of travel notwithstanding that blip is right, then we probably would not sell the shares. There might be other instances in which we would. We are trying to focus on building the longterm value chain.
Q159Nadhim Zahawi: Just in terms of human nature being what it is, you have a human being, the corporate governance manager. He does not like a particular decision and wants to vote it down. It is very hard when he is integrated inside the fund management side. How does that work, at a personal level?
Anne Richards: It is not a separate individual. The team have collectively decided that this is a share that they want to have in the portfolio. Then there is a controversial issue around a particular event that is coming up. They will sit down and thrash it out around the table and then will decide, taking everything into consideration, what the right way to go on that issue is. They will decide it collectively as a team, so it is not two discrete, separate buckets. It is very much collectively round the table. That is how we operate all around the world.
Harlan Zimmerman: It might be interesting also to ask some of the panellists about their observations of other players in the market, because I believe there are very few institutions in the UK where the corporate governance manager will be able to overrule a fund manager on something. There are exceptions, of course.
Q160Nadhim Zahawi: That is what I was heading towards: you may be forced to do something that you do not want to do if you are a corporate governance person.
Dominic Rossi: If you accept that asset managers have a dual mission, which is my starting point, we have to recognise that there are moments when those two goals are diametrically opposed to one another. When we get to those situations in our organisations, that is when my office steps in.
Q161Nadhim Zahawi: So there is a sort of umpire above the decision. Do you do the same thing, Roger?
Roger Gray: I have never seen one of these animals, which is half in favour and half agin, but if one walked into our office, yes, I would presumably have to resolve it. I think a lot is down to the culture of the institution. Our fund managers and our governance people do not speak a different language, hence we have not had that problem in practice.
Chair: Could we call it an asset managers code adjudicator?
Anne Richards: If it is a really controversial one, it will come up to me before we put it in the vote, just for a common-sense check. That is unquestionably the case.
The other situation that Dominic described was owning both sides of the shares in a transaction, where there is a clear conflict or the possibility of a conflict on that. We have a dedicated conflicts of interest committee who will meet and thrash around all sides to make sure that there is an objective view brought to bear on the situation. That is part of the broader managing of conflicts of interest that can arise unwittingly from time to time.
Q162Rebecca Harris: How often do you exercise your voting rights? How often do you vote on company matters? What proportion of your rights do you use?
Anne Richards: We aim to vote all our holdings.
Dominic Rossi: The same.
Harlan Zimmerman: Always.
Q163Rebecca Harris: My next question is void, in that case. When would you decide to consult your shareholders before exercising your vote?
Harlan Zimmerman: Clients, perhaps.
Dominic Rossi: Typically, we do not, because we have a very clear set of policies around what we are voting for and what we would vote against, and that policy is available to clients. To be honest with you, if you are voting thousands of times a year, it is not practical to approach shareholders on every single vote. But you will have institutional clients, particularly in the defined-benefit area, where the client will retain the voting rights and it is up to them.
Anne Richards: I would say that it is broadly the same. When we are awarded a mandate, part of that investment management agreement will typically cover the situations and the way in which we would expect to exercise the votes on behalf of the client, if it has been delegated to us, or will exclude it if it has not. We have a defined set of principles that clients receive ahead of time on which we will typically do our voting. So we would not normally consult clients before voting on their behalf, because it is a delegated function.
Harlan Zimmerman: For us, although we vote, it is very unimportant to what we do, because you do not use votes to make a company better. Voting is essentially, as it is being used in the UK, either a mechanism to stop bad things from happening-when the defence mechanism works and the governance people at USS and Fidelity, who are also good, by the way, get together and circle the wagons, so to speak, and vote something down-or the threat of that. That is a bad compensation plan, a bad takeover, something of that nature. But that is not activity that is really making the companies better. That is a form of engagement that is very measurable, but it is not necessarily very meaningful if the objective is to steward the companies and improve them, as opposed to stopping them from doing bad things.
Q164Rebecca Harris: Lord Myners talked to us about the concept of tracking error and how it might distort the behaviour of fund managers. I wonder if you can explain how this works and also what one would change in the practice to have a positive effect on behaviour.
Dominic Rossi: Tracking error is a statistically based measure of the likely deviation of returns of the portfolio versus the specified benchmark. It has some success, in my judgment, over time, in predicting what that potential deviation of return might be. But I do not think there is anybody in our industry, who has managed money for a long period of time-certainly no senior PM or CIO-who would rely exclusively on a tracking error measure of risk to predict in any way what his potential deviations of returns may be. The industry is full of such measures and tracking error is but one. The only thing I would say about tracking error and why it has a greater relevance than maybe others, which is possibly why Lord Myners referred to it, is that when clients approach us about specific mandates, they invariably are advised by their consultants to feel obliged to set a tracking error target for that mandate. Is it particularly reliable? It has some success, but I would not say it has much more than that.
Anne Richards: As a measure of risk it tends to focus on shortterm volatility of prices as opposed to the real longterm risk, which is that you get back less than you paid for an investment. It is the risk of capital loss that is the long-run risk you should focus on. A lot of shortterm volatility in markets is driven by potentially extraneous shortterm factors. For example, the Italian election result causes a fluctuation in the prices of UK equity stocks, the majority of which are not going to be affected one way or another by what has just happened in Italy, but it is affecting the prices in the short term. It affects their volatility, which then is captured in this tracking error number, because it looks at volatility. That sounds a bit technical, but one of the problems with tracking error is that it does focus on shortterm volatility as opposed to thinking about the longer-term risks that you really run with an investment.
The other criticism that one might make of tracking error as a measure is that it presupposes that the starting point to determine the riskiness of your portfolio is the index, because it is a measure against an index. Our starting point when we build a portfolio is to think about the economic drivers of the businesses that we are investing in-what is going to drive Unilever’s profits over the long term? What is going to drive Persimmon’s profits over the long term?-and think about those cash flows. The fact that they may be 0.5%, 1%, 5% or whatever the number might be in an index is, to a degree, irrelevant in the starting point for building a portfolio. So there are different styles of how you manage money in the market and tracking error does presuppose that you are benchmarkdriven in how you build your portfolio.
Harlan Zimmerman: I will try to put a couple of things together. Roughly, a tracking error is the extent to which you can deviate from a benchmark, say a FTSE 100. We are not indexoriented, but for a client of Fidelity, who comes and says, "Our consultant has said you should have a tracking error of no more than this", that would basically imply that they really must be invested in 90 out of 100 FTSE 100 companies. I do not know what the number is. What would the number be?
Dominic Rossi: It could be very different, but the point is still valid.
Harlan Zimmerman: The point is valid in that it means that they are forced to hold a widely diversified portfolio. If you look at, say, the largest company in the FTSE 100, which is HSBC at about 8%, or you take the top 10, because of this tracking error institutional investors will be forced to hold virtually all of them. HSBC they may think is a horrible bank and a bad investment for all the reasons that Anne was mentioning, but to have a zero weight in something that is 8% of your benchmark is virtually impossible. So you have to hold it at 2% or 3% or 4%, even though, by definition, you are saying you think it is a bad investment.
This is a root of many evils. It forces the portfolios to be much, much greater than they need to be. Simon Wong was talking about this in the earlier panel. It means that five very good, hardworking governance people at USS have to cover hundreds of companies, and it is just not possible. Many problems of the investment industry are encapsulated by the very phrase "tracking error"-it is the word "error." If you are not in line with the benchmark, that is an "error". That is a root of many problems, as I say, because it causes overdiversification of portfolios and an inability to pay for resources necessary to work with them in a good way. It comes from going up to the top, which Roger could tell us about, sitting on the top of a pension fund. This is how the assets are allocated from the top: a certain percentage in UK equities where you have an expected return of X advised by the consultants and, as a proxy for that, you use the FTSE 100 or the FTSE AllShare. Then, to measure how closely you comply with that, you use tracking error. Those bands are then set and instructions are given to Dominic and Anne and they do the best they can within those constraints.
Roger Gray: We are all fund managers, and talking about risk measures is something we could do for the rest of the day. The Kay report talked against tracking error and in favour of an absolute risk measure. The piece that probably all of us would agree on is that no single measure serves all purposes. I will not give a big defence of tracking error, but it has its place in the pantheon of things that you use to understand your portfolio. There are different ways to do this, but it also has its place in how you choose to say, "This is what we want you to do; this is your mission" and that mission could be a wideranging, absolute riskoriented, concentrated equity portfolio with a lot of activism, or it might not be. Typically, a passive investment is going to own the index and tracking error is going to be kept very tight. I am not saying that there is no purpose for a passive, but it will be within context.
This would be an area, by the way, in which it is dangerous for this Committee or indeed any Government or regulator to step in and say "You cannot use tracking error." It is like saying, "You cannot use part of basic statistics in your job", which would be a nonsense, but has it been overused? Yes.
My last comment on this is that it is much more important how a manager goes about selecting what they invest in than specifically how you define the length of the rope that they are allowed. I agree that "error" is unfortunate. You could call this "active risk"; that is a more statistically neutral way of defining it. I see tracking error or active risk as something that says, "How much rope are you playing with?", but I should also, in empowering a manager to do that, know how they are going to go about selecting their investments and be supportive that that is something that is in the longterm interest of the fund.
Q165Chair: Can I just intervene at this point? We are behind time. We have something like another 13 questions to ask. Please do not feel obliged to answer every question, but if there is one that you feel you can contribute to, feel free to write in with a written response to it. That might just cut down on the amount of time we take.
Q166Mr Walker: Aberdeen’s marketing and website makes quite a virtue of the fact that you visit companies before investing in them. Given the global nature of your business-and you explained you are very global indeed-what is the resource that needs to go into that? How much of a commitment is that?
Anne Richards: It is a big commitment. We have three regional centres-the UK, the US and Singapore; we then have local offices that feed into those hubs and we have fund managers on the ground in all those places, so it is a big commitment.
Q167Mr Walker: Is it typical among all investors that they are trying to do physical visits?
Anne Richards: It is variable. Active managers will not, as a general rule. Some feel they can do it by fly in, fly out. Some feel they do not need to visit companies. There are many different models.
Mr Walker: Are there comments from the other members of the panel on that?
Roger Gray: We have all our investment team located in London. Co-location has plenty of advantages as well. Lines of communication are short. It does mean that they are spending a bit more time in airports than they might otherwise do.
Dominic Rossi: In my area, there are 600 people globally. Most of them are investment professionals, analysts and fund managers all over China, Japan, Asia, Europe. It is very much a local branch structure when visiting companies.
Q168Mr Walker: That does mean that you will get out visiting companies on the ground rather than just head office.
Dominic Rossi: Absolutely. Indeed, we have always placed an emphasis, as a company, on proprietary fundamental research, so our analysts are building their own financial models of the companies. But it is not simply the companies in which we invest; it is across the whole market. It is pretty much waterfront coverage.
Harlan Zimmerman: We are different, because we have only 10 to 12 investments at a time. We have 22 investment professionals, two professionals per investment, so we would normally meet the companies dozens of times, literally, before we invest; that is very different. But I would say the vast majority of these sorts of visits that most institutional investors would conduct, even the best of them like Fidelity and Aberdeen, will be focused on understanding the company. This is not necessarily a feedback session where they are trying to improve the company. They are trying to use the information to make good investment decisions.
Q169Mr Walker: A quick question to Roger: in terms of balancing fund management and corporate governance, do you feel that the pension industry has a different approach to the investment management market or is it very much the same?
Roger Gray: If you look at the industry as a whole, it is a highly intermediated arrangement, so most funds rely on external managers for the vast bulk of what they do. Therefore, it is rather important that they select those managers well and incorporate what they are expecting in terms of corporate governance behaviours within those mandates.
Q170Mr Walker: Can I just ask two quick questions? One is about activist investors. A lot of the evidence we have heard in our earlier sessions, from Kay as well as from Lord Myners, has been very much that we want to see more activist investors. You described yourself, Harlan, as an activist investor. Could you differentiate what you feel makes an activist investor?
Harlan Zimmerman: Yes. The primary distinction is investing with a plan to do something. Governance, as I mentioned before, is often at the root of that. It is investing in a company that you might think is good but could be doing better. It is a full integration of the governance and the investment, as opposed to making an investment in a company that you think is good and then, if something is not going according to plan, mobilising your limited resources to stop that from happening. That is the single biggest distinction.
Q171Mr Walker: I also see what you do is based very much on a concentrated portfolio.
Harlan Zimmerman: Yes. You cannot do it when you have 100 companies in the portfolio. Arguably you should, but it is just not practical.
Q172Mr Walker: Looking at the brief CVs that we have, I think you are the only person on the panel who has spent time in the hedge fund side of the investment industry. I do not know if anyone else on the panel has done. Some of the evidence that we have heard has been very critical of the role of hedge funds, in particular in driving a transactionbased focus and using their power as activists to drive through deals to make shortterm gains against the interests of longterm value. Do you recognise that criticism?
Harlan Zimmerman: Yes, I do, absolutely. I do not think it applies to us, it will not surprise you to hear, because we do not use leverage. We do not short; we do not hedge. All we do is buy the equities and, as I say, we have an average holding period of about four or five years. But definitely, when markets are buoyant there are certain types of hedge funds that can easily get capital, the main provider of which, by the way, is pension funds. They can easily get leverage. They are shortterm focused, and they then hunt in packs and seek to put companies in play or extract jumbo dividends or things of that nature. It was a strategy that was thoroughly discredited after the financial downturn, but I fear there will be more of it over the coming years.
Q173Caroline Dinenage: On the basis that your voice is okay, can I just ask you this? Professor Kay recommended that companies should consult their major longterm investors over major board appointments. I just wondered what voice they have in terms of appointments and how that is connected to the role of nonexecutive directors.
Harlan Zimmerman: I will definitely make it through this question if you can. I have pointed to the importance of nonexecutive directors, and I think Kay does an excellent job of focusing on the agency problems in different parts of the investment world, but this one has been overlooked, I believe. It is the single biggest problem, arguably, in that, as I mentioned before, the investors are given the vote on who should be not just the nonexecutives but all the directors, but particularly the nonexecutive directors, so that they can act as stewards for our companies. Fidelity, even with the best will in the world, cannot look after the day-to-day operations of thousands of companies, so we have nonexecutive directors who are there, who are supposed to be doing that job for us.
Now, the companies will say they do consult with their major shareholders on nonexecs, and the asset managers will say that they do consult as well, but the reality is that when that happens it is a very superficial consultation in most cases. It very often takes the form of a Sunday night call before an announcement on Monday. If you look at one single damning fact, director elections here in the UK for nonexecutives are a rubberstamping exercise. Between the 2009 financial crisis and the 2012 shareholder spring, in the FTSE 100 there were 3,042 director proposals that came to a vote. 3,040 of them were elected. The average yes vote was 97.5%. The statistics are no different in the 2012 shareholder spring from what they were over that time period.
Now, some people will say "Yes, but there was behind-the-scenes activity" and, yes, that is true. There were also 10 directors who were proposed and then, for various reasons, stood down before the election. These are not our figures; these are figures from PIRC. The numbers are just as bad when you go to the FTSE 250. So what do you have here? You have, to borrow from Lord Myners, a North Korean voting system where the effect in reality is that the chairmen of the companies, who head the nomination committees, are effectively choosing their own boards. They are choosing the people who will act as our stewards, who will sit in the boardrooms, who we are asking to challenge the management team for us, to challenge the chair when a decision is not good. We are creating a dynamic that is totally wrong.
Of course there are excellent NEDs, and there may be some chairmen who say, "I want a bunch of really tough people in my boardroom, who are really going to challenge me". But human nature probably leads to them picking people who do not necessarily have that attitude. Secondly, the people going into the room know that they are beholden to the people who put them there, the very people who are asking to be challenged by them. So a very big question is why we are not doing a better job of involving ourselves in not just the rubberstamping but the actual nomination of nonexecutive directors, which is being done very successfully in some other markets such as Sweden and Norway, where they manage to avoid many of the problems that we had with lack of challenge, for instance, during the financial crisis.
Dominic Rossi: Could I add a little colour on that? Some of those comments I completely agree with, but our experience is somewhat different at the same time. First of all, the call on the Sunday night about a major acquisition, etc, is absolutely true and there are good regulatory reasons for that. Also, the voting patterns are a matter of fact. However, our own experience is that we, particularly in the United Kingdom, are quite actively involved in the nomination of nonexecutives, whether it be the chairman, the SID or the nonexecutives. In many cases, not only are we asked our views on individuals and whether they are suitable to sit on a board before the nomination is made, but quite frequently we are asked whether or not there is anybody that we might wish to suggest. We are asked to put forward a name. So I do not think that the dialogue that currently exists between boards and major shareholders like our own is so sterile that we have no influence over nominations, because there are clear instances where we have been very influential in who is on the board and who is the nonexecutive chairman.
Q174Caroline Dinenage: With that in mind then-this is for all the panel-are there any instances in the last 12 months when voting decisions went against the recommendations of company directors or chairmen?
Dominic Rossi: I have just gone through the voting report. We have voted against with 20% of our votes, usually on management incentives.
Anne Richards: I do not have the number to hand, but we certainly are on record as having-
Chair: Could I suggest that this might be a question that readily lends itself to a written response afterwards, so I think we can move on.
Q175Caroline Dinenage: I just wonder if any of the panellists practise high-frequency trading in their institution.
Harlan Zimmerman: No.
Dominic Rossi: No.
Roger Gray: Not in our institution. We have some hedge fund managers who engage in trading practices different from what we could possibly do and would possibly do and it tends to be not in individual shares, but in futures or currencies.
Q176Caroline Dinenage: It has been reported recently that the German Government intends to introduce a clampdown on high-frequency trading because it creates excessive market turbulence. I just wondered whether you thought the UK should follow suit.
Anne Richards: We have talked a lot about agency problems in markets, in the generic longterm investment food chain and the implications of that. There is another subset of market behaviours that have become technologically possible in a way that they were not before and I do not necessarily think that the market processes around the control of that or the taxation rules have kept up with the changes that technology has allowed. It is certainly an area that would benefit from much closer examination into what the genuine impact is. That is not a small thing in terms of studying and enabling it to be done, but it should be done, because there are some unintended consequences of permitting it. There are potential benefits from increased liquidity, so it is not a oneway street, but in terms of looking at the balance of the pros and cons, it would merit much closer observation than has hitherto been the case.
Harlan Zimmerman: I do not see that it brings any benefit to society whatsoever, personally.
Q177Caroline Dinenage: The next question has largely been answered, in that case. Do you make use of derivatives or short-selling in your institutions?
Harlan Zimmerman: We do not short-sell, and we normally do not make use of any derivatives other than for short periods of time when we can buy exposure to a company indirectly.
Dominic Rossi: Our philosophy is that we like to find companies, buy them and own them. Shorting as a concept does not fit particularly easily with that overriding view of why we exist, but in some strategies for protection we do use principally indexbased futures. Our involvement in single-stock shorting is extremely limited.
Anne Richards: The vast majority of our business is what you would call plain vanilla, long-only investment. As Dominic has mentioned, we use derivatives to provide market protection in certain instances or to effect a market view through futures or forwards on occasions. And there are occasions on which rather than buying an equity share by buying the physical stock, we will choose to get access through buying or, indeed, in some cases, writing an option on a stock. It is a very small part of our business and we just use it as another tool to get the economic exposure that we want.
Roger Gray: We do not engage directly in short-selling individual shares, but we do use derivatives for either hedging purposes or efficient portfolio management, which is the most effective way promptly to execute a particular exposure that we wish to achieve.
Q178Caroline Dinenage: Professor Kay recommended that income from stock lending should be disclosed and rebated to investors. Could those who feel they would like to contribute explain their interpretation of that recommendation and how it would affect the market and address the public distrust of short-selling and stock lending, please?
Dominic Rossi: On the stock lending, first of all, it should be very, very clear that the income derived from stock lending belongs to the client. That should be absolutely clear. The only subtraction from that would be administrative fees related to the stock lending programme, but the income belongs to the client.
With respect to the practice of stock lending, again, my board is extraordinarily conservative about this. The idea that we would lend the stock that we obviously like, otherwise we would not own it, to someone who is then going to short it does not really make much sense. It is not in the interests of our clients to have to foster that short-selling, nor is it in the interests of the company in which we invest. We do a very limited amount related to dividends and I suspect even that practice will stop shortly.
Anne Richards: We do not do stock lending in the majority of our portfolios. We have a number of funds where the board of directors have taken the view that stock lending is a valuable additional income and they wish to exercise it. Aberdeen did a review of this area last year and from the start of this year we took the view that in the interest of full transparency we did not even want to keep an administrative fee for Aberdeen. So we now take no direct income from stock lending whatsoever for any of our portfolios, but again it is a relatively small number of our portfolios that were in any case using stock lending.
Roger Gray: We do engage in stock lending. There is an administrative fee taken by the custodian who provides the service. We recall our stock for voting, which rather materially reduces the amount of lending we undertake.
Harlan Zimmerman: We do not do it at all.
Q179Caroline Dinenage: Finally, Professor Kay told us that he thought a financial transactions tax could be a positive way of discouraging shorttermism. How could such a tax be implemented so that it had a positive rather than a negative impact?
Roger Gray: We have one already in the UK-stamp tax-and it is quite high, so I am not sure that it is germane to this particular discussion of the UK equity market.
Anne Richards: I would just add to that. It is true we do, but it is not equally applied to all instruments, therefore there are ways of getting economic exposure that could get around it. So again, on the point that I have made a couple of times, looking at the tax regime and making it more economically consistent across a range of instruments would perhaps get around some of these behaviours. But it is quite a difficult area to see how you would implement a financial transactions tax in a really beneficial way to the end customer.
Dominic Rossi: The point is, if the purpose of a financial transactions tax is to prohibit superhectic trading on the London Stock Exchange, it is not going to work. If it is to raise revenue, I think it will work spectacularly well.
Harlan Zimmerman: I personally support looking more seriously at fiscal and other measures that compel people to be more longterm. That makes it more costly for them to be shortterm, and I believe that is why it is in the report.
Q180Chair: There is just one thing that arose from the response to that question. Roger, you said we have an FTT and it is stamp duty. Yet everybody else says a financial transaction tax cannot work. If we have one, and presumably it is working, why can’t any other form of financial transaction tax work? Is there anybody who could respond to that?
Dominic Rossi: I was agreeing with Roger. The fact is, here we are with a Kay report troubled about shorttermism in the stock market, despite the fact that we have a transaction tax called stamp duty. If stamp duty or a financial transaction tax was a cure for shorttermism, we would not need the Kay report, because we would have solved it through stamp duty.
Anne Richards: I know time is limited, but I would just add to that. It seems to me that if you want to stop high frequency trading, if you choose that as your route, the most obvious route to take is to prevent people buying and selling within a certain time period. A tax is an indirect way of trying to influence the behaviour. If it is the behaviour you want to stop, stop the behaviour.
Chair: So you are talking about the German approach.
Can I thank you? It has been a marathon. I do appreciate your contribution. As I said, there are some areas that perhaps we would have wanted to explore further but have not. If you could respond in writing to the one question that we did not take, I would be grateful. Similarly, if you want to submit any further evidence to us, feel free to do so. If necessary, we will write to you with any questions that we feel retrospectively we should have asked but have not, and we will be grateful for your reply. Thank you very much.