Top stocks to invest in
“We have met the enemy and he is us.” — Walt Kelly
We blame capitalism for most of our modern ills, from climate change to iPhones that die every two years. Yet we rarely bother to read the sales pitch our accountant, banker, or adviser gives us for the mutual funds to invest our hard-earned money in. I believe these two activities are related. Fund research may well be one of the weakest links in the investment management chain.
Big call, I know. But let me explain how, before proposing what we can do about it.
Companies manage for shareholders rather than stakeholders.
Most economies have adopted capitalism in varying degrees, encouraging private ownership of trade and industry. Individuals pool their skills and money to form companies and appoint professional managers to run them, directing them to maximize profits and shareholder returns.
Unfortunately, most owners neglect to directly specify the time horizon for such profit maximization. Indirectly, shareholders incentivize managers in line with their short-term results. So, it’s not unreasonable for managers to focus on the short term and ignore broader stakeholders who could help produce better long-term results.
Some companies and owners then turn to philanthropy and corporate social responsibility to give back to society, often as a superfluous nod to some of those broader stakeholders.
We don’t trust employers or governments to manage our retirement. We trust mutual funds.
Whatever our views on benevolent companies, the changes in our social structure give away our desires.
We no longer work for the same employer all our lives like our grandparents did. We don’t even want to work in the same profession throughout our careers like our parents did. It’s a gig economy now. We want to work at the intersection of two to three fields, from our laptops, in cafes, while traveling the world. We have replaced the physical villages where our families and neighbors could help in times of need to a global online village where everyone is a so-called friend.
Employers no longer provide defined-benefit health coverage during our working lives or a defined-benefit pension for when we retire. Instead, they transfer a defined contribution into a pension fund and let us worry about whether the accumulated amount is enough.
Of course, we grumble about our retirement savings being locked until retirement age. We complain about the low returns if the deducted amount is put into safe government bonds and returns are smoothed. But we also demand security if it’s put into shares. We certainly don’t trust the government to fund a comprehensive pay-as-you-go social security system — it can’t even provide decent roads.
So while we won’t trust employers or governments, we will trust financial institutions to help manage our cash flows.
We borrow from banks, we buy insurance policies, and we pool our money with other investors in mutual funds. Of these financial service firms, mutual funds stand out because our money does not make it to the balance sheet of the asset management company (AMC). It sits in a pooled trust account and we essentially outsource the investment management to the AMC. Other financial institutions — banks, insurance companies, and pension funds — have also begun to outsource their investment management function to AMCs.
We are the shareholders, funds are our agents.
Over the past two decades, the mutual fund/asset management industry has expanded at an explosive rate. The number of funds now exceeds the number of stocks in some markets. Assets under management (AUM) has grown so much that some regulators are wondering if large names like BlackRock, Vanguard, and Fidelity pose systemic risks to the global financial system.
Is the industry becoming a victim of its own success? As professional fund managers with similar qualifications and analytical tools manage more assets, they essentially compete against each other and are less able to consistently outperform. This has led to the rise of passive investing.
Whether through active or passive funds, mutual funds and pension accounts, or banks and insurance companies, AMCs invest our money. We are the shareholders. The funds are our agents. And this is where the story intersects with those of the companies that manage mostly for the short term.
AMCs act as though they don’t need to hold companies accountable for anything other than shareholder returns. Indeed, research highlights the anti-competitive and adverse implications of concentrated company ownership through lax incentive structures. In India, while regulatory pressures have increased voting on company resolutions, most institutional investors still vote as the company wants them to, without any opposition or engagement.
Global organizations such as CFA Institute and Principles for Responsible Investment (PRI) are appealing to mutual fund companies and other institutional investors to take a more proactive approach to voting and corporate behavior in general. But a powerful way to force mutual funds to hold investee corporations more accountable is for investors to first hold mutual funds more accountable.
- By insisting any investment recommendations, fiduciary or otherwise, be accompanied by competent, independent, and transparent fund research.
- By requiring fund research to disclose whether the fund in question has a long-term focus by explaining its investment process and proving it with evidence, like turnover and average holding periods, for example.
- By asking how the mutual fund incorporates such non-financial factors as environmental, social, and governance (ESG) issues into its investment process.
Only when we as investors demand good mutual fund research will the intermediaries produce it.
We can ask for simpler communications, but we also need to commit to learning the basics. Of course, we have to invest for the long term ourselves if we expect mutual funds and companies to manage for the long term.We can’t invest in an equity fund when we intend to use that money in the next two to three years. This is why we have to plan our finances carefully and match our goals to the investment horizons of the funds we choose.
The future of capitalism depends on how well we invest.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/Spark Studio
Top stocks to invest in