It is now widely acknowledged that the UK stock market is suffering an existential crisis. UK equity funds have seen 36 months of consecutive outflows that show no sign of slowing. A record £2.7 billion fled the funds in October, according to data from funds network Calastone. Given the market’s recent performance, that can be no surprise. Since the peak of the internet bubble, the S&P 500 has quadrupled, while the FTSE 100 is up by just a fifth.
Some of this decline reflects a shift from domestic investing towards global benchmarks, as well the success of large US fund managers such as BlackRock, which has $11.5 trillion of assets under management (AUM). At the turn of the century, UK pension funds held 40% of their assets in UK equities. This has now fallen to less than 5%, as the pension funds have shifted their allocation towards global equities, as well as unlisted private-equity vehicles and fixed-income instruments such as government bonds. In this world, it is tempting to conclude that where a company is listed doesn’t matter: if we can readily buy US-listed stocks, the steady decline of London is largely irrelevant.
This conclusion is wrong. A modern economy needs a vibrant stock market that can provide equity financing to fund productivity growth. Few of the world’s most innovative companies have funded their growth with bank debt. That’s because bankers prefer to lend money secured on collateral: a piece of machinery, a vehicle or, more often, physical buildings and land. If a borrower defaults, the bank knows that it can take possession of the collateral asset and sell it to recover the value.
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Most start-ups and high-potential companies are not merely physical assets – instead, they are the future cash flows generated from the know-how of their employees, the brand, the customer relationships and technology. The nature of these intangible assets is often contested, with “winner takes almost all” network effects and negligible recovery value for the also-rans.
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For an example, take the early clash of social-media networks: MySpace versus Facebook. Two decades ago it was clear to some that investing in social media could generate outsized returns. In 2004, Peter Thiel invested half a million dollars for 10% of Facebook, valuing the entire company at less than $5 million. Rupert Murdoch bet 1,000 times more but backed the wrong horse when he invested $580 million in MySpace in 2005.
This is an extreme example, but an equity investor with a 1:2 chance of investing in a company worth $1.5 trillion 20 years later (as Facebook – now called Meta Platforms – has become) would be keen to take the risk if the upside is 300,000 times the initial investment. Bankers would not benefit from this potential and instead would worry about the value of the collateral if the company were unable to repay its debt.
Why is the UK stock market failing?
We need equity markets to fund these kinds of businesses and we need to ask why London’s market has failed to create them. We may also want to understand why the share price of the London Stock Exchange (LSE) has risen 35-fold over the past two decades, despite the deterioration of the UK’s main stock market on which it was built. One culprit often blamed for London’s problems is the burden of regulation. Take the Markets in Financial Instruments Directive 2014 (known as MiFID II) that was introduced across European financial markets in 2018. Its rule book is more than 1,500 pages long. The increased cost and complexity for banks and brokers, plus the requirement for fund managers to pay separately for investment research from brokers, rather than having it bundled into commissions, has probably reduced liquidity in smaller companies.
That said, broker research may help with liquidity, but few investors rely on it. Where “research” is paid for by corporates, it is effectively marketing – often uncritically supportive of the investment case, rather than sceptically trying to balance the potential returns while highlighting risks. Broker research has an audience among corporate executives who feel the need to pay other people to say nice things about them.
One alternative might be creating a free research platform to enhance the attractiveness of London’s equity markets (and coverage of smaller companies), as suggested in a review of equity research by Rachel Kent of law firm Hogan Lovells last year. This could be financed through a levy on issuers, by Aim or the LSE, a contribution from the government or a stamp duty type tax, but none of these options sound appealing.
A more equitable source of funding to pay for research on smaller companies could be a levy on large global banks, which operate in London and compete with each other for mandates on large deals such as Saudi Arabia’s Aramco initial public offering (IPO), which raised $29.4 billion and valued the company at $1.7 trillion. This generated large fees for the 27 banks working on the deal, but the investment case was uninteresting for a typical retail investor.
On the other hand, global banks steer clear of helping smaller companies raise equity capital because the fees that they can charge are too small to pay the bonuses of their big hitters. A charge on global banks to fund research on smaller companies could help redress this. That said, most self-directed investors are sceptical of the value of free research. “If the product is free, you are the product,” as the old saying goes. And so an excessive focus on research risks blinds us to the other, broader issues that have gone wrong in public markets.
Who should markets serve?
The concerns of bankers and fund managers reflect the benefits of scale to them. These professional intermediaries benefit from charging fees based on the size of the transaction or AUM, and this colours their perspective. As an example, a recent report on the future of listed smaller companies from New Financial, a think tank, was sponsored by fund manager Abrdn, and Winterflood, a market-making business. Hence it comes up with recommendations that are good for fund managers and market makers, but little thought has been given to what benefits the end consumers of financial services: you and me.
An unexamined assumption of “Big Bang” reforms in the 1980s was that financial markets needed to professionalise to suit the interests of large institutions with capital. This meant consolidation, and the creation of “universal banks” that mixed retail deposit-taking with financial-markets divisions. The Big Bang can be judged a success if viewed through the lens of whether London has maintained its role as a financial centre and an attractive place to do business for global banks and international law firms. It has also provided employment for an army of compliance professionals within banks, plus the various regulators overseeing the banks, who were required to monitor everything. The extra costs of hiring all these people has far outweighed the benefits of consolidating the activities under one roof. It would have been far simpler to keep banking and equity market activity separate.
Reforms need to focus on encouraging individual investors back to the London stock market, since they are the foundation of an investment culture. The most vibrant, innovative, entrepreneurial economies encourage everybody to participate in building wealth. Yet UK regulators and lawyers struggle to deal with the idea of letting individuals make their own investment decisions, due to the asymmetric pay-offs investing in equities, particularly growth companies.
Anyone who has held a diversified portfolio over a few years tends to find that most investments trundle along, a few lose money and a handful are big winners that generate outsized gains. This is true for the FTSE Aim All-Share index as a whole, which in aggregate has a shocking record: it is down by a quarter since the start of 2020, 40% since mid-2007 and 75% since the dotcom peak. However, it has still played host to successes such as Judges Scientific, FD Technologies or Jet2, all up well over 20-fold in the last 20 years.
Is the IPO market really broken?
Another common refrain overheard in City pubs is that the IPO process – which is how, in theory, new companies raise money from investors – is broken. There is some evidence for this: of the 60 companies that listed on Aim in 2021, just six are now in positive territory. The performance of the bottom two-fifths is even worse: 23 of the 60 are down more than 80%. For the FTSE All Share, three of the 17 are in positive territory, while there have been high-profile losers such as Dr Martens, down almost 90%.
The underlying problem is that speculative early-stage investing has shifted away from public markets to private markets, such as venture capital. The most successful companies, such as Stripe in the US, Revolut in the UK and Klarna in Europe, have no reason to seek further capital from investors in public markets. Their sole reason to list – when they do – will be to provide an exit for their early investors and employees. One should keep this in mind when deciding whether to buy at IPO.
It’s not obvious how to fix this, except to notice that professional fund managers seem to be even worse at judging the quality of IPOs than retail investors, as demonstrated by their regular participation in IPOs, such as Dr Martens. The phenomenon is not new, and not limited to private equity IPOs – we can look back to many IPOs in the energy and mining boom. These deals were certainly profitable for some – in 2011 Glencore published a 1,637-page prospectus, with at least eight banks advising on the deal. That didn’t prevent the shares from falling 85% in the following years. The fund managers who bought into these IPOs badly let down their investors. The professionals have done a worse job as stewards of capital than the informed amateur, who are at least putting their own money at risk.
Where did the online revolution go wrong?
The early promise of the internet was that technology could cut out the middleman and reduce the spread between the wholesale and retail price of goods. Wholesale customers who deal in large sizes for any goods normally receive a better price than individuals – if you want to buy 10,000 barrels of oil, you’ll be quoted a tighter price than if you want to fill up your car at a petrol station. However, technology made it feasible to narrow the gap between the wholesale and retail prices. For instance, Amazon started life as a warehouse and logistics system that allowed retail customers to pay closer to the wholesale price for books and CDs, as their overheads didn’t include high-street bookshops.
In the late 1990s, people believed that abundant information online would eliminate estate agents, used-car salesmen, travel agents and stockbrokers, giving customers the ability to compare prices and make informed decisions. Some of these industries have been disrupted, while some have changed less than expected, but, certainly, the internet enabled us to buy shares far more cheaply than before. Yet oddly, the opportunity that this unleashed was a short-term phenomenon in the UK. Over the past 20 years, the share of households directly owning stocks has halved from 22% to 11%. Retail investors now hold less than 14% of shares listed on the LSE’s main market; for Aim the figure is 25%.
The decline in the role of individual shareholders has been accompanied by an explosion of fund managers, funds of funds, analysts, advisers, compliance officers, trustees, brokers and investment consultants. The explanation for the curious fact that the LSE has boomed while its exchange has shrunk is that it now makes far more from supplying data and analytics to all these intermediaries than it does from the exchange.
Technology was supposed to level the playing field and reduce friction – direct online dealing, rather than having to pick up the phone and speak to a broker, who would then ask a market maker to quote a two-way price. Instead, we have seen many more intermediaries, all taking their cut, adding to costs for the end investor. This has been encouraged by regulators, with their belief that everybody must be sheltered from risk.
The Covid pandemic brought a return to the frenzy of the late 1990s. Many people sought both returns and entertainment in investing, encouraged by investing apps that “gamified” the process. However, those apps only offer trading in the most liquid markets, such as Nasdaq or FTSE stocks. The idiosyncrasies of the SETSqx market-making system – on top of a lacklustre pipeline of IPOs stretching back years – meant that Aim was poorly placed to capitalise from the arrival of new investors. Most of these new, younger investors headed to US markets instead. More than 40% of Tesla’s shares are held by retail investors.
To bring London’s equity markets back to life, we need to ignore the professional middlemen – global banks, lawyers, brokers and fund managers. Instead, there’s an urgent need to attract individual investors to equity markets. We need shareholders with a risk appetite, taking responsibility for their own gains and losses. The amount of gambling adverts on TV between football matches – as well as the success of bitcoin – suggest that people enjoy taking risks with their money.
A stock market should be a mechanism for harnessing these animal spirits into productive activity. We would all be better off if the speculation on sports betting and crypto had instead been seeking the next ARM.
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