Kay Review backs concentrated portfolios to boost stewardship

Major report from respected economist

A wide-ranging UK government-sponsored report from economist John Kay and his team has called for asset managers to have more concentrated portfolios as a way of helping to boost both stewardship and investment returns.

The Kay Review also calls on asset owners and managers – as well as companies themselves – to adopt ‘Good Practice Statements’ that promote stewardship and long-term decision-making.

Kay’s proposals aim to increase engagement by encouraging fund managers to hold portfolios “judged on the basis of long-term absolute performance”.

“Active asset managers should typically have more concentrated portfolios which are more differentiated from each other and from benchmark indices, and regulatory discouragements to such behaviour should be reduced or removed,” the 113-page report states.

The idea is to encourage asset managers to act as “long-term stewards” of less liquid equity portfolios, meaning fund managers can contribute more to UK business – and to their to savers – “through greater involvement with the companies in which they invest”.

Kay is clear: “Good practice in asset management involves substantial ‘active share’, since indexation to a benchmark is a commodity that can be purchased extremely cheaply. Good practice in asset management therefore leads naturally to stewardship activity.”

Concentrated portfolios is an idea that has already taken off at Dutch pension management giants like PGGM and ABP. PGGM runs a €3bn+ responsible equity portfolio, which has a portfolio of 15-20 long-term holdings based on sustainability. And ABP is also putting together an internal ESG oriented €2bn investment portfolio of around 30 stocks called the European Focus Fund Strategy.

Kay says the appointment and monitoring of active asset managers is too often based on short-term relative performance. With this in mind, fund firms should structure managers’ remuneration to align the interests of asset managers with the interests – and timescales – of their clients. The review notes that misalignment of the interests of beneficiaries (who need long-term absolute performance) and managers (concerned about, and monitored on, short-term relative performance) “creates many problems”.As a corollary, Kay suggests that asset owners should also set mandates which focus managers on achieving absolute returns in line with their beneficiaries’ long-term investment objectives.

Among other recommendations is the setting up of an Investor Forum to foster collective engagement by investors with UK companies. This could become the place where companies consult their main shareholders over board appointments.

“Good practice in asset management leads naturally to stewardship”

Kay recommends also that the now two-year old Stewardship Code should be developed to incorporate a more “expansive form” of stewardship, focusing on strategic issues as well as questions of corporate governance.

The review aims to change the culture of market participants. Kay said: “A lack of trust and poorly aligned incentives have helped create a culture of short-termism in our financial markets.
“We must create cultures where business and finance can work together to create high performing companies and earn returns for investors on a sustainable basis.
“This means moving away from a focus on short-term transactions and trading to an environment based on long-term trust relationships.”

UK equity markets and long-term decision making was commissioned by Business Secretary Vince Cable in 2011 and its advisors included Chris Hitchen of Railpen Investments. Among other key recommendations is that companies should cease managing short-term earnings expectations and announcements.
Companies’ quarterly reporting obligations should be removed and “high quality, succinct” narrative reporting should be strongly encouraged.

Another recommendation, building on work done by campaign group Fair Pensions, is for the Law Commission to review the concept of fiduciary duty as applied to investment.

In general, Kay says the “chain of intermediation” in investment should be shortened. Instead, at each stage, relationships should be fewer and deeper.

The government also has a role, in creating a culture of “trust and respect” by making clear the behaviour expected.