INCENTIVES AND REGULATION OF LONG-TERM INVESTMENTS Sébastien POUGET Toulouse School of Economics EIF Scientific Morning Conference
Based on the paper: “ Fund managers ’ contracts and financial markets ’ short-termism ” Catherine CASAMATTA and Sébastien POUGET Toulouse School of Economics EIF Scientific Morning Conference
MOTIVATION Asset owners typically have a long horizon Pension funds, insurance companies, sovereign wealth funds… Liabilities have a pretty high average maturity DNB indicates an average maturity of 17 years for Dutch pension funds Firms ’ operations also typically pay off in the long run “ For a representative company with a price earnings ratio of 15, for example, around two thirds of the current fundamental value of the company would be derived from earnings which would arise more than five years ahead ” , Kay Review (2012) 3 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION However, asset managers tend to Report to their clients on a quarterly basis Be compensated on a yearly basis Facing short-term incentives makes it harder for asset managers to implement long-term investment strategies “ The big difficulty is that a lot of the reputational and environmental issues play out over a very long period of time [...] and if the market isn ’ t looking at it, you can sit there for a very long time on your high horse saying ‘ this company is a disaster, it shouldn ’ t be trusted ’ and you can lose your investors an awful lot of money... ” (dixit an SRI asset manager quoted in Guyatt, 2006) 4 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION There are signs of financial markets ’ short-termism According to an IRCC-Mercer report (2010), average turnover rate of long-only equity funds is 72% Stock price incentives make CEOs invest less in R&D (Edmans, Fang, and Lewellen, 2014) This is striking because many people have advocated the need to lengthen the horizon of asset managers: This is what I will call “ the long fight against short sight ” 5 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION The long fight against short sight (1/2): CFA (2006) ‘ Breaking the Short-Term Cycle ’ report: “ align asset manager compensation with long-term performance and with long-term client interests ” Aspen Institute (2009) ‘ Overcoming Short-termism ’ report: “ base the compensation of long-term oriented fund managers on the fund ’ s long-term performance ” Kay Review (2012) on ‘ UK Equity Markets and Long-Term Decision Making ’ : “ align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm ” 6 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION The long fight against short sight (2/2): Rogerson (1985) Biais, Mariotti, Rochet, and Plantin (2007) Biais, Mariotti, Rochet, and Villeneuve (2010) Edmans, Gabaix, Sadzik, Sannikov (2012) Numerous papers on principal-agent theory show that deferred compensation is good for incentives 7 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION QUESTION: Why don ’ t we see longer-horizon mandates in the asset management industry? ASSET OWNERS ’ ONE-LINE ANSWER: We don ’ t want to keep incompetent managers for too long! ASSET MANAGERS ’ ONE-LINE ANSWER: We have to eat on a quite regular basis! 8 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION Asset owners face two major issues when designing long- term incentive schemes First, there is a tradeoff between Promising to keep asset managers long enough (so that they are accountable for portfolios ’ long-term performance) and Firing them after bad performances (so that owners have a chance to hire better managers) Tradeoff studied by Guembel (2004) 9 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
MOTIVATION Second, asset owners face a tradeoff between Compensating asset managers in the long run (once investment outcomes are known) and Offering bonuses based on short run performance (so that asset managers do not have to wait too long) We study this tradeoff 10 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
ANALYSIS Principal-agent model of delegated asset management Central assumptions: Asset owners have a long-term horizon Asset managers would like to smooth consumption over time Asset owners cannot perfectly monitor asset managers Consequences for the design of long-term incentive schemes and for the efficiency of financial markets? Preview of the conclusions Short-term incentives can be desirable and feasible The future level of market efficiency is crucial Short-termism may arise due to a negative feedback loop between long-term investors and subsequent investors 11 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
ANALYSIS Timing of the model Date 1 Date 3 Date 2 • Investor 1 offers contract • Investor 2 offers contract • Dividend is realized Delegation: Long run: Short run: • • • to manager M1 to manager M2 Asset owner Prices may reflect Assets pay off cash- • Transfers R 1 3 and R 2 3 delegates to asset the long-run flows • Effort decision of M1 • Effort decision of M2 • manager Incentive payment information • Signal s 1 is received • Signal s 2 is received • Investment: Incentive payment • Demands are submitted • Demands are submitted • Asset manager (if any) collects or not long- • Price P 1 • Price P 2 term information • Transfer R 1 • Transfers R 1 2 and R 2 • Asset manager 1 2 selects assets 12 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
ANALYSIS Results: the bright side of short-term incentives Rewarding managers only in the long-term may be detrimental both for asset owners and market efficiency Impatience or income smoothing motivation would make it very costly to provide incentives Absent short-term incentives, asset managers may refrain from collecting long-term information (=short-termism) A mix of short- and long-term compensation may thus be optimal If financial markets are perfectly efficient, prices reflect long- term information and short-term incentives are effective 13 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
ANALYSIS Results: the dark side of short-term incentives When long-term information is private, it can be reflected into prices only if investors in the future (at date 2 in the model) decide to acquire it and invest accordingly A negative feedback effect may create short-termism: Asset owners design a proper ST-LT incentive scheme mix Asset managers collect long-term information Asset prices reflect this information at date 1 No subsequent investor acquires the information at date 2 Prices at date 2 cannot be efficient and used for incentives 14 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
LITERATURE Other sources of short-termism in financial markets Shleifer and Vishny (1990): arbitrage being more costly in the LT than in the ST, mispricing in LT assets is higher and firm invest more in ST projects Froot, Scharfstein, and Stein (1992): ST traders herd on the same (potentially useless) information Dow and Gorton (1994): LT information might not be incorporated into prices because ST traders are not sure that future prices will reveal this information Bolton, Scheinkman, and Xiong (2006): speculative bubbles may induce managers to focus on ST information 15 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
CONCLUSION Short-term incentives are effective to promote long-term goals: when the market is liquid enough (e.g., for large-caps and mature industries) When there is a good coordination between long-term investors and subsequent speculators Short-termism is more prevalent when long- term information acquisition is more costly… … and more difficult to monitor (intangible items, Environmental Social and Governance issues…) 16 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
IMPLICATIONS For asset owners Use short-term incentives for some asset classes (liquid) but not others (emerging)? Design appropriate performance benchmarks: Overweight assets sensitive to long-term issues (R&D intensive assets, ESG)? Smooth-out short-term asset price movements? For regulators Favoring the production and dissemination of information on long- term issues to facilitate market efficiency? Favor in-house research by asset owners to better monitor managers? 17 fund managers ’ contracts and financial markets ’ short-termism C. Casamatta and S. Pouget
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