The Kay Review and The ‘Chain of Fools’

Yesterday, the UK’s Department for Business Innovation and Skills published the “Kay Review of UK Equity Markets and Long-Term Decision Making”. As you might expect, I persevered through each and every one of the 113 pages. My take? Solid. In fact, I was surprised at how refreshing and innovative the report is; governments aren't normally so direct  (and provocative). 

I’ve spent a lot of time (probably too much time) over the past decade gnashing teeth and chin rubbing over the endemic short-termism in financial markets. I’ve also spent a lot of time mumbling to myself and staring out windows thinking about how investors might organize themselves to overcome the short-term pressures that seem to be institutionalized in today’s financial markets. In both of these respects, the Kay Review offers a very good diagnosis of the problems and some quite reasonable suggestions as to how these problems can be overcome.

Here are some of the sections I liked best:

“...there has been an explosion of intermediation in equity investment, driven both by a desire for greater professionalism and efficiency and by a decline in trust and confidence in the investment chain. The growth of intermediation has led to increased costs for investors, an increased potential for misaligned incentives and a tendency to view market effectiveness through the eyes of intermediaries rather than companies or end investors.”

“Whether the reasons for the proliferation of intermediation and intermediaries are good or bad, such proliferation adds to the costs of the investment chain, and creates potential for misalignment of incentives at each link of the chain. The imperatives of the business model of the agent do not necessarily coincide with the interests of the ultimate principals – the companies which use equity markets and the savers who provide funds to them.

And so what does the Kay Review suggest doing?

“The chain of intermediation should be shortened... in an environment in which trust and confidence are lacking, the process of hiring advisers to review the work of other advisers can multiply indefinitely, creating a self reinforcing cycle of mistrust and complexity. The addition of successive layers of oversight and accountability not only adds to cost but also dilutes trust and judgment, and creates additional possibilities of misalignment of incentives.”

“At each stage of intermediation, relationships should be fewer and deeper. Diversification of a portfolio can be achieved with a relatively small number of stocks if these stocks are substantially uncorrelated: conversely the diversification seemingly provided by a portfolio which contains a very large number of stocks is illusory if movements in the individual stocks are strongly correlated with each other. This principle applies not just to portfolio management, but to commercial relationships more generally.

“In the equity investment chain the development and maintenance of relationships based on trust, respect and the confident and open exchange of information is possible only to the extent that these objectives of fewer, deeper relationships and a short chain of intermediation are achieved.”

What to do about all of this? The report uses a bit of inductive reasoning and draws inspiration from the structure of Warren Buffet’s Berkshire:

"Because the fund is a listed closed ended security, where savers hold shares in the fund company rather than units in the fund, there is liquidity for savers even although there is little or no liquidity in many of the holdings within the fund. The closed-ended investment company model also means that fund managers can take a long-term view: they are not obliged to buy or sell shares in companies they hold in unfavourable market conditions in response to savers buying or selling the fund.”

“There is near complete alignment of the interests of savers and fund manager, since Buffett is rewarded almost entirely by the increasing value of his own holding in the fund."

I couldn’t agree more.