Berkshire Hathaway Chairman Warren Buffett and Vanguard Group founder John Bogle have joined with 26 other prominent individuals to call for action to reduce “short-termism” in business and investment management. In an Aspen Institute statement released today and summarized in a Wall Street Journal article, the group called for more robust action to encourage longer term thinking among investors, boards, and executives.
Systemic Problems Call for Broad Based Action
The statement asserts that the focus on short term results among shareholders is now widespread and driven by large institutions rather than individual investors. One clear result of this short term mentality is that portfolios experience higher turnover which harms the overall returns shareholders will realize. However, a more insidious consequence of short term thinking among investors involves the pressure this creates for boards and executives to ignore longer term considerations and simply focus on matters such as hitting Wall Street earnings expectations for the next quarter.
The Aspen statement strongly calls for broad based changes due to the system-wide nature of the problem:
… Short-termism is not limited to the behavior of a few investors or intermediaries; it is system-wide, with contributions by and interdependency among corporate managers, boards, investment advisers, providers of capital, and government. Thus, effective change will result from a comprehensive rather than piecemeal approach.
The statement goes on to describe changes in three areas: Market Incentives, Fiduciary Duty, and Transparency.
The statement calls for changes to market incentives meant to encourage providers of capital to be more patient in their outlooks. First, capital gains taxes could be restructured in a manner that provides for lower tax rates for longer holding periods. Of course, we already have the distinction between short and long term capital gains, but the statement suggests that more differentiation could be put in place for much longer holding periods.
The statement also calls for a removal of the limitation on capital loss deductibility against ordinary income for “very long-term holdings” which are now capped at $3,000 per year. In a footnote to the statement, a suggestion is made to remove the deduction limit entirely for losses that have been held for ten years or longer.
The statement calls for imposing the same “fiduciary” test on brokers that has long been in place for investment advisers. Under a fiduciary standard, an adviser is required to act solely in the interests of the client without regard to the financial interests of the individual providing the advice. Brokers have often operated under a less strict standard in which they may recommend securities based on the “suitability” of the investment even if the choice is not the best one for the investor (possibly due to higher fees that might benefit the adviser).
The Administration’s proposal in the “Investor Protection Act of 2009” would enable the SEC to define “the standards of conduct for all brokers, dealers, and investment advisers, in providing investment advice about securities to retail customers or clients (and such other customers or clients as the Commission may by rule provide), shall be to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” The SEC would also be required to “examine and, where appropriate, promulgate rules prohibiting sales practices, conflicts of interest, and compensation schemes for financial intermediaries (including brokers, dealers, and investment advisers) that it deems contrary to the public interest and the interests of investors.”
The statement also suggests changes to improve transparency related to investor disclosures:
The final leverage point, greater transparency in investor disclosures, can also play an important role in helping corporations maintain a long-term orientation. The advent of increasingly complex non-traditional structured and derivative arrangements has enabled some investors to influence corporate decision-making without being subject to duties to disclose the existence or nature of their positions or their plans. This lack of transparency undermines the efficacy of the disclosure regime and creates opportunities for investors to use their influence to achieve short-term gains at the expense of long-term value creation.
The proposals related to improvements in transparency and strengthening the fiduciary standards for advisers are long overdue. Most individuals who rely on brokers for advice probably never realized that they were receiving advice under the “suitability” standard rather than a stronger “fiduciary” standard. While there are no doubt many brokers who elected to operate under a higher fiduciary standard all along, this standard should have been formalized as part of the code of ethics for the profession long ago.
One area of potential concern involves adding complexity to the tax code in an attempt to encourage longer term holding periods. The extremely complex United States federal tax code already differentiates between short and long term capital gains by imposing a much lower 15% rate on capital gains realized from securities held for over one year while gains on assets held for shorter periods are taxed as ordinary income at much higher rates. Adding a third tier into the mix would complicate the tax code to some extent. However, the attraction of a very low rate (maybe 5 to 10%) on “super long term” capital gains has obvious appeal for “buy and hold” investors.