John Kay has released his final report on the UK financial services sector, calling for investors to rethink their approach to portfolio construction and risk management.

The author of the government-backed Kay Review recommended asset managers run more concentrated funds, judged on their long-term absolute performance, which will allow them to engage more with the companies they hold.

Kay (pictured) also said investors should not rely on tracking error against a benchmark as a measure of risk.

“Risk in the equity investment chain is the failure of companies to meet the reasonable expectations of their stakeholders or the failure of investments to meet the reasonable expectations of savers. Risk is not short-term volatility of return, or tracking error relative to an index benchmark, and the use of measures and models which rely on such metrics should be discouraged,” the report said.

Kay, a professor at the London School of Economics, said regulatory pressures have forced groups to create risk management systems which have no relevance to their investment team’s approach to risk.

“Respondents told us that the greater obligations on trustees to seek professional advice, and the general extension of transparency requirements, has led to much more extensive benchmarking, performance monitoring, and use of consultants.

“We were told that the result of all these pressures was frequent resort to ‘closet indexation’. Although those who appointed asset managers were seeking – and paying for – active management, the portfolios that were constructed for them tended closely to follow the index.”

He argued risk models used in the regulation of the investment process should focus on risk as perceived by savers, not risk as experienced by market participants, and there should be less emphasis on short-term relative performance of funds.

“The appointment and monitoring of active asset managers is too often based on short-term relative performance. The shorter the timescale for judging asset manager performance, and the slower market prices are to respond to changes in the fundamental value of the company’s securities, the greater the incentive for the asset manager to focus on the behaviour of other market participants rather than on understanding the underlying value of the business.

“Competition between asset managers on the basis of relative performance is inherently a zero sum game.”

The report also said short-termism in markets is unhealthy for the economy, while a “misalignment of incentives” throughout the equity investment chain has led to a breakdown of trust within financial intermediation.