Our current global financial and geopolitical climate represents an episode in human history that will be studied and written about for generations to come.While sheltering in place, I’ve had the opportunity to watch movies I’d mostly forgotten, including “The Perfect Storm.” Like the explosion created by three colliding weather systems in that film, we are in the throes of a three-front crisis inflicting catastrophic damage.Society is confronting a pandemic, a crisis of racial inequality and an economic crisis on a scale not experienced since the Great Depression. This defining moment in our history reveals fundamental challenges that distill down to our health, our moral compass and our livelihoods.Unlike a hurricane, we cannot afford to wait for the storm to pass before assessing the devastation and rallying the resources needed to repair the damage. We will be living with the impacts of this trauma for years. We need to gather learnings, work on solutions and begin to put them in place starting now.When we look closely, we can see that each prong of the crisis has distinct origins. Each warrants examination, without which we will struggle to understand both how we got here and how to move forward.The discussion that follows addresses the economic crisis, which LTSE stands ready to help lead us out of together with companies, investors, policymakers and others who share a long-term vision.
How we got here: six events that transformed the capital markets
On the surface, it appears the economic crisis can be explained through simple causality. The pandemic necessitated a shutdown of our economy that led to a contraction of activity and the loss of tens of millions of jobs.But peel back a few layers, and we can see systemic issues that have contributed to the current crisis.Since joining LTSE, I am often asked about our focus on the long term, and how short-term thinking came to dominate capital markets. It’s easy to spot the symptoms of short-termism because they’re all around us. Companies in the S&P 500 Index spent more on buybacks in 2018 than they did on research and development. Fast forward to this year, when some of those companies did not have enough spare cash, leaving them ill-prepared for the downturn.But let’s step back.Let’s unearth some of the origins of short-termism and shed light on why short-term behavior is not only encouraged, but expected in the markets today.We can look to a series of events that unfolded over the past 20 years. It is ironic that the forces of capitalism made a long-term play to subtly shift the market to a short-term posture. Taken together, these events shine a bright light on the illusion companies have been skillfully convinced to accept as reality: That companies — employers, makers of things, providers of services, engines of innovation — exist largely to fuel the market by aligning their business models with the incentives that matter to traders and others whose livelihoods govern it.Short-termism is a crafty foe. Let’s unpack some of its causes.
Wall Street takes over Main Street. The Glass-Steagall Act of 1933 (GSA) separated investment banking from retail banking. By separating the two, it barred retail banks from using depositors’ funds for risky investments. It forced the Morgan family to divide its financial empire into J.P. Morgan and Morgan Stanley. But Congress repealed the GSA in 1999 in a move that largely legitimized practices banks and others had engineered to circumvent the statute. The repeal generated significant debate, especially in the wake of the 2008 financial crisis. More broadly, there is consensus that the repeal accelerated short-termism by enabling the risk-taking of Wall Street to overtake the financial sensibility of Main Street.
A settlement that falls short. The Global Settlement of 2003 mandated the separation of investment banking (which focuses on winning equity underwriting deals like initial public offerings) from equity research (which analyzes and rates public stocks). The settlement aimed to ensure the independence of research. It did so by prohibiting, among other things, banks from compensating equity research analysts based on investment-banking fees. The settlement has not worked as intended. Sell-side research sits within the equities division at investment banks that generate significant revenues from hedge funds through trading commissions and prime brokerage. The question remains whether research funded by and tailored to serve the needs of hedge funds meets the standard of independence.
Hedge funds at the center of the machine. Assets managed by hedge funds grew to $3.1 trillion in 2019 from $189 billion in 1999. The growth itself is impressive, but what matters more are the fees hedge funds pay to Wall Street. Revenue from prime brokerage is expected to top $30 billion dollars this year. “Prime brokerage is our biggest business,” Jonathan Pruzan, the chief financial officer of Morgan Stanley, told investors last fall. “It’s the center of the machine, if you will.” The machine does not include companies at its center.
Pay that rewards short-term success. Hedge funds are compensated on a monthly or quarterly basis. So they are incentivized to optimize compensation through strategies that maximize short-term returns. The rise of hedge-fund influence coincided with a surge in demand from analysts for public companies to provide quarterly earnings guidance. This trend accelerated in 2003, just as the global settlement went into effect.
Innovation that fuels speculation. Most of the innovation in financial markets over the past 20 years aims to enhance the ability for traders to profit from advantages measured in nanoseconds. High-speed trading has nothing to do with fundamental analysis or a company’s commitment to creating value over time. Major advances in trading technology first took hold in the late 1990s, which happens to be when the average holding period for public stocks started to fall below one year.
The rise of passive investing. It is up for debate whether the rise of passive investing is a symptom or a cause of short-termism. However, it introduced two risks, one well known and one that is rarely discussed.
Passive investing hurts or eliminates price discovery. Passive strategies, with their goal of replicating the returns of an index or exchange-traded fund, do not require analysis of individual companies that results in true price discovery. In that way, passive investment, especially at its current scale, distorts market valuation and erodes transparency. A lack of trust and transparency encourages short-term behavior.
Passive investment funds profit from short trading. The fees on passive investment products range from very low to zero, so fund complexes lend their shares into the stock-loan market, where they receive fees from short-sellers. Asset managers earned a combined $10 billion last year from securities lending. Last year, passive U.S. equity funds overtook active funds with total net assets of $4.27 trillion, compared with $4.25 trillion in active funds. With more than $4.2 trillion dedicated to passive investment, it is more than reasonable to conclude that its role in facilitating short trading helps drive short-term behavior.
Where we are today: The short term reigns
Taken together, the events outlined above have produced an environment in which certain market participants, intended to be stewards of long-term value creation by companies, have placed themselves at the center of the capital markets. Companies orbit at the periphery.
We see this when a company shortchanges investments in R&D or otherwise engineers its results to meet the expectations of Wall Street from one quarter to the next. Eighty percent of CFO’s say they would cancel or postpone long-term investments to meet quarterly estimates.
The incentives to focus on the short term comes at a cost. McKinsey & Co. has estimated that had all U.S. publicly listed firms operated like their long-term counterparts, the economy would have created more than five million additional jobs and generated an additional $1 trillion in gross domestic product in the 14 years that ended in 2015.
As it happens, many leaders and architects of today’s capital markets themselves say the focus on the short term has gotten out of hand. Together with Warren Buffett, Jamie Dimon, the CEO of JPMorgan Chase, has called for public companies to stop providing quarterly guidance, or for that matter, annual guidance. Dimon also alluded to the fact that public companies blame the sell-side for requiring them to provide quarterly guidance.
Last August, the Business Roundtable abandoned its 40-year-long stance of shareholder primacy in favor of a more modern version of capitalism centered on benefitting all stakeholders. One-hundred-eighty-one CEOs signed the announcement, which commits them to lead their companies for the benefit of customers, employees, suppliers, communities and shareholders.
Eliminating quarterly guidance and signing a statement with no enforceability will not cure the preoccupation with the short term that plagues public markets. Shifting focus to the long term will require a holistic approach, within a new system of support that aligns executives and managers, directors, shareholders, workers and other stakeholders. LTSE has developed a financial ecosystem designed to restore the original promise of capitalism.
Where we go from here: Capitalism 2.0
Refocusing our capital markets on the long term starts with a partnership between companies and investors who share a long-term focus. Companies can envision their roles as participants at the heart of capital markets and not as the raw material feeding a short-term machine. Investors who are long term can lock arms with one another in the knowledge that their success lies with companies that create value over time.
The refocusing can start right away.
And it doesn’t have to dismantle incentives or nudge aside any group of investors for whom the status quo works just fine.
What we need is for companies that are long term and investors who are long term to work together for mutual benefit.
LTSE has built an SEC-registered stock exchange designed to offer long-term companies and investors a genuinely new approach to governance that aligns with long-term thinking. The Long-Term Stock Exchange offers a public-market option for companies and investors who recognize that stakeholders are key to success and that resilience matters more than financial engineering.
The exchange offers the same access to liquidity as every other U.S. exchange and welcomes investors whatever their horizon. But its principles-based listing standards align with those companies and investors who believe that business is about creating value for customers and sharing the benefits of that growth with shareholders, stakeholders and society.
We are building our business accordingly, with the goal of restoring the focus of a public market on the companies and long-term investors that the market is built to serve. The Long-Term Stock Exchange will not aim to maximize fees from trading — and, in fact, plans to share revenue it receives from its membership in the national market system with the broker-dealers who use the exchange.
Software from the LTSE helps companies operationalize long-term strategies by, among other things, enabling them to distinguish investors who are truly long term from those who hold shares for shorter periods. We offer tools and services for company-building together with insights on governance and resilience from a team of founders, builders and experts. We operate the world’s largest corporate governance platform for startups, to help the founders of today build the long-term focused public companies of tomorrow.
We can return companies and their long-term stakeholders to the center of the capital markets and, by doing so, deliver on the promise of business and capital to help solve the world’s biggest problems and to produce positive change.