How Economic Attention Deficit Disorder Infected the Corporate
Posted by Jon Lukomnik, Investor
Responsibility Research Center Institute, on Wednesday, June 22, 2016
According to one
widely reported study, three quarters of senior American corporate
officials would not make an investment that would benefit a company
over the long run if it would derail even one quarterly earnings
 Combine that with the fact
that corporate officials and institutional investors commonly
over-discount the future, meaning that they don’t fully appreciate
returns on investments that are more than a few months away. For
instance, the Bank of England has found that cash flows five years
away are actually valued in the marketplace as if they were eight
years away and cash flows 30 years in the future are not valued at
 “This is a market failure. It
would tend to result in … long-duration projects suffering
disproportionately… including infrastructure and high-tech
investments… often felt to yield the highest long-term (private and
social) returns and hence offer the biggest bang to future growth,”
explained Andrew Haldane, the Bank’s Chief Economist.
Simply put, we are
suffering from an epidemic of Economic Attention Deficit Hyperactivity
Disorder. But if short-term thinking at today’s companies is
commonplace, the implications are profound. Economic ADHD silently
robs us of wealth and decreases our standard of living.
If Economic ADHD is
the disease, and underinvestment in our economy the symptom, what is
the cause? Absent discovering how and why Economic ADHD infects the
board room, the odds of reversing it are slim.
Let’s start our
forensic search in the capital markets. In theory, at least, we invest
for the long term; for retirement, home ownership, education. Indeed,
that used to be the case. In the 1930s, when the modern regulatory
framework of our markets was established, the average holding period
of a New York Stock Exchange traded stock was 10 years. By 2010 it was
down to six months. While high-frequency traders certainly have some
effect on that number, the truth is that even traditional mutual funds
tend to turn over the value of their entire portfolios every year.
What has changed?
Almost everything, from computerization to a change in national market
regulation. But let’s focus on three underlying contextual issues: the
legal underpinning of our capital markets regulation, and the business
model and culture of the investment management industry. These three
factors often escape attention exactly because they are chronic and
omnipresent rather than acute and sporadic. As a result, we tend to
accept them as the background against which short-termism plays out,
rather than examine them as causes which contribute to Economic ADHD.
Indeed, while we may
call it “investing”, our capital markets and the investment industry
are really organized around trading, at least insofar as public
securities are concerned. Let’s begin with the legal architecture of
our capital markets, which is built on disclosure to help trading
markets, not on corporate law to help owners steward their
There is a simple
reason for this. Corporate law is largely a state matter. Indeed,
sales of securities was, until the 1930s, largely a state matter,
governed by the various states’ blue sky laws. Following the Great
Depression, a consensus for national regulation bumped up against a
constitutional issues: How can we grant Washington authority over
companies, when there are Delaware companies, Nevada Companies,
Massachusetts companies, but virtually no nationally-chartered
companies? The solution was to focus on interstate commerce. Is it any
wonder that the resultant national regulatory regime centers on
disclosure so as to facilitate a market for securities sales and
trading, not corporate stewardship.
Twenty years later,
Nobel prize-winning economist Harry Markowitz invented modern
portfolio theory (MPT).
 MPT was a great step forward
in that it popularized diversification, allowing investors/traders to
hold “riskier” individual assets. But MPT also accelerate the trend
towards trading by focusing on securities, rather than on the
companies which issued them. For example, MPT judges the relative
return and risk of an individual securities against that of the market
overall. From there it was a minor step to investment managers judging
how well they did by comparing their performance to that of the
market, rather than against the long-term liabilities (e.g. the need
for retirement income or offsetting mortgage payments). So, for
example, an investment manager with a large-capitalization US stock
portfolio will judge its performance against the S&P 500, or some
other “market” index. Since the price movements of both the market and
the managers’ portfolios can be measured continuously, they were.
Pretty soon the excess or lesser performance was being measured
quarterly or monthly or even daily (and, particularly on trading
desks, in real time). An entire industry of performance measurement
sprang up to compare investment managers’ performance month-to-month
or quarter-to-quarter. As the amount of money those managers attract
is materially affected by those short-term, market-relative returns,
and as investment managers are paid based on how much they have in
assets under management, the pressure to “beat the market” on a
quarterly basis is intense.
In fact, most active
traders trail the overall market. But that doesn’t stop them from
turning over their portfolios in rapid fire bursts. One study found
that two thirds of all institutional money managers trade more than
they anticipate doing even though they know that doing so is likely to
be disadvantageous. They advance various reasons for that, including
both market and macroeconomic conditions, but, notably, they also
mention behavioral biases such as herding and recency bias. Faced with
ever changing situations and pressed for outperformance on a real-time
basis, investment management houses have a hard time sitting still.
The combination of a
legal/regulatory structure based on disclosure for trading/price
discovery purposes, plus the domination of MPT with its focus on
securities rather than companies, has also shaped the dominant
interpretation of fiduciary duty in the United States. For decades, it
has been interpreted as encouraging investment managers, acting on
behalf of beneficial owners, to maximize short-term financial results.
Longer term sustainability issues were regarded as either irrelevant
to fiduciary obligation or even, at times, as antithetical to it.
To that you can add a
dominant investing culture that focuses on short-term trading. We may
say we admire Warren Buffet, whose “favorite holding period is
 but more people watch those
hyperactive television shows promoting trades for that day than read
his annual letters. Do a Google search for “buy and hold is dead” and
you will get more than 4 million hits.
 You can buy videos, download
podcasts, or enroll in training sessions all designed to get you to
trade securities, rather than to own companies.
So the capital markets
have become more short term. That begs a key question: How did
Economic ADHD jump from the trading floor to the board room? Via the
transmission mechanism of executive compensation. In trying to tie
executive compensation to performance, we accepted that performance
meant short-term stock market (price) performance, rather than
anything more fundamental to the company. So, for instance, we cheered
when the President Bill Clinton signed into law a tax law which made
executive compensation of more than $1 million deductible only if it
were performance related
, and then said stock options
and other types of compensation payable in currencies linked to the
equity market’s price-setting mechanism—a mechanism designed to
establish trading prices, not to run companies—would automatically
qualify as performance related and therefore deductible.
 As former Merck CEO Ray
Gilmartin notes, how can you not expect short-termism when you pay
senior management in a currency that fluctuates with every with every
market up and down?
Some might say, so
what? Long-term performance is just a compilation of shorter periods.
But it’s not quite that simple. By reducing the incentive to invest in
NPV positive projects so as to reduce market price volatility, we have
unintentionally contributed to the hollowing out of American
So how do we solve the
problem. Solutions abound, from the Aspen Institute’s suggestion that
companies end quarterly guidance
 to changing the measurement
period for executive compensation to be at least five years and
changing the performance measures to better focus on drivers of a
company’s future growth rather than stock market price.
Those are all logical
suggestions, in that they seek to divorce motivations in the boardroom
from the short-term pressures of the capital markets. But perhaps
instead of accepting the trading-oriented, short-termist legal,
business and cultural underpinnings of the capital markets as givens,
we should focus on changing them. There are innumerable efforts to do
James Hawley, Keith Johnson and Ed Waitzer have
written a succession of articles arguing that fiduciary duty is, and
should evolve to consider longer-term sustainability issues.
Generation Management and others claim the mantle of
long-term investors, and Generation even published a white paper
seeking to change how investment managers are paid. “Most
compensation schemes emphasize short-term actions disproportionately
…. Instead financial rewards should be paid out over the period
during which these rewards are realized,” they wrote.
Even international investor organizations are taking
notice and trying to change the culture of the investment management
industry. The United States is one of the few developed markets in
the world which does not have a stewardship code for investors. But
that gap may be plugged, at least partially, when the International
Corporate Governance Network, representing asset owners and asset
managers in 47 countries with $26 trillion under management, unveils
its stewardship principles late this month at its annual general
meeting in San Francisco.
There are dozens of
other initiatives focused on re-orienting public capital markets to
investing and long-termism, rather than short-term trading. They are
gaining traction—the number of signatories to the Principles for
Responsible Investment (PRI) has grown to more than 1500 in its ten
years of existence, but it seems to be a race against time, as an
increasing amount of capital simply flees markets which the investors
regard as short-term and goes to where a long-term focus is expected.
The number of private equity firms in North America has more than
doubled, growing from 936 in 2004 to 1956 in 2014.
It’s time to recognize
that Economic ADHD is an epidemic that is draining our economic
future. Yes, the symptoms manifest themselves in corporate board
rooms. And we have to combat them there. But we also must minimize the
factors which gave birth to it: the legal, business and cultural
short-termism which infest the capital markets.
John R. Graham, Campbell R. Harvey and Shiva Rajgopal, “The Economic
Implications of Corporate Financial Reporting,” Journal of
Accounting and Economics 40, nos 1-3 (December 2005); 3-73.
Andrew Haldane, “The Short Long,” speech, May 2011.
James Saft, “The Wisdom of Exercising Patience in Investing” (Reuters,
March 2, 2012).
Harry Markowitz “Portfolio Selection,” Journal of Finance 7,
(March 1952): 77-91.
Danyelle Guyatt and Jon Lukomnik “Does Portfolio Turnover Exceed
Expectation?”, Rotman International Journal of Pension Management
3, no 3 (Fall 2010): 40
James Hawley, Keith Johnson and Ed Waitzer, “Reclaiming Fiduciary
Balance,” Rotman International Journal of Pension Management 4,
no 2 (Fall 2011): 4-16
Warren Buffet, 1988 Annual Report of Berkshire Hathaway.
Google search performed May 27, 2016
Section 162(m) of the United States tax code.
Christopher Cox, “Testimony Concerning Backdating,” US Senate
Committee on Banking, Housing and Urban Affairs, September 6, 2006.
Raymond Gilmartin, Comments to the 2013 Board Leadership Conference of
the National Association of Corporate Directors, National Landing, Md.
See, for instance, The Aspen Institute, “In Focus: Earnings Guidance.”
November 2007. Accessed May 29, 2016.
IRRC Institute and Organizational Capital Partners, “The Alignment Gap
between Creating Value, Performance Measurement and Long-term
Incentive Design,” 2014.
for example, Hawley, Johnson and Waitzer, above, as well as articles
in the Cambridge Handbook of Institutional Investment and Fiduciary
Generation Investment Management, “Sustainable Capitalism,” February
www.icgn.org. Accessed May 30,
Accessed May 30, 2016.
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on Corporate Governance and Financial Regulation
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