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The Long and Short of Institutional Investment
You may be growing tired of the debate surrounding long-term investing, but some pretty smart folks have identified it as one of their key competitive advantages in the marketplace. And that means, at least to me, that we should keep focused on it...
Yes, I know. Youre getting tired of hearing the same story about the pervasive short-termism in finance and the potential benefits of being a long-term investor. There are so many groups working on this topic its becoming a challenge even for me to keep track of it all. There are clubs, forums, initiatives, policy groups, nerdy academics, do-gooders, and even some borderline vigilantes pushing for more long-term investing and offering ideas on how to get there. Its a lot to take in and process! But...alas...I tend to agree that its a necessary and indeed required discussion. Why?
Long. Term. Risk. Adjusted. Returns.
Thats kinda the point of all this, right? Creating value? And all the groups listed above believe that long-term investing offers economic opportunities not available to short-term players. Perhaps its because these funds can sidestep the short-term imperatives typically driven by funding commitments, liabilities or redemptions. And this allows the funds to invest in a broad array of liquid and illiquid assets, which offers better diversification (free lunch) as well as a higher Sharpe ratio. In addition, long-term investors tend to have lower portfolio turnover, which is linked to higher returns. All this results in better and more sustainable asset management that creates lasting economic value...as opposed to positioning for a profitable exit.
Lets take the Canadian pension funds, which are consistently the best performers. Shall we ask them how they do it?
- CPPIB: Any comments? We can exercise the patience required for the true long-term investor to reap the associated rewards. Oh, OK. Interesting.
- OTTP: What say you? Taking a longer view, we have earned an average return of 8.0% over the last 10 years and 10.0% since 1990. Wow. Solid.
- AIMCo: Whats your biggest challenge? Convincing everyone to retain a long-term focus and not be myopic about quarterly or even annual results. Right. Fascinating.
In short, you may be growing nauseated with this topic and debate, but some pretty smart folks have identified it as one of their key competitive advantages in the marketplace. And that means, at least to me, that we should keep it on the radar for senior executives of pensions, endowments, foundations, and sovereign funds.
So lets talk about long-term investing, shall we! Or, rather, lets talk about why long-term investing isnt happening. Heres the OECD Observer today with some of the reasons:
Institutional investors increasingly rely on passive investing or indexing on the one hand and alternative investments (such as hedge funds) on the other. The former can discourage them from being active shareowners while the latter may involve shorter term, higher turnover investment strategies.
Agency problems are another barrier to long-term investment. Pension funds in particular rely increasingly on external asset managers and consultants for much of their investment activity. However, they often fail to direct and oversee external managers effectivelyhanding out mandates and monitoring performance over short time periods which introduces misaligned incentives into the investment chain.
Institutional investors also contribute indirectly to short-termism via some common investment activities, such as securities lending or increasing investment in Exchange Trade Funds (ETFs). Investors may, therefore, be inadvertently contributing to speculative trading activities in the very securities that they own.
Government regulation can also exacerbate the focus on short-term performance, especially when assets and liabilities are valued referencing market prices. For example, the use of market prices for calculating pension assets and liabilities (especially the application of spot discount rates) and the implementation of quantitative, risk-based funding requirements appear to have aggravated pro-cyclicality in pension fund investments during the 2008 financial crisis in some countries.
A lack of long-term investment opportunities, such as infrastructure projects, also acts as a barrier. This can be due to poor planning on the part of government, which leads to a dearth of projects in the pipeline as well as of financing vehicles that do not give institutional investors the risk/return tradeoffs that they need. Insufficient investor capability could also be a reason. This is particularly true of smaller pension funds, which do not have the knowledge or scale to become involved in such projects.
Finally, conditions for investment may simply be inappropriate due to a need for improved data collection and benchmarking for such projects.
I think thats a thoughtful list of constraints. But Id like to add three more factors to it:
1) Governance: The people with oversight responsibility for these funds have to understand and indeed endorse the longer-term view. They have to be prepared to ride out short-term volatility in public markets and help their funds develop the capabilities to access the illiquid asset classes in a cost-effective and aligned way.
2) Resourcing: Because the asset management industry tends to be focused on shorter-term time horizons, the Boards of long-term investors will have to provide them with the necessary human capital and systems to be effective players in long-term markets or strategies. In other words, if youre implementing an investment strategy that isnt offered by external funds (e.g., buying and holding a toll road for 40 years), you need to design and build the capability yourself (either through in-house teams or seeded vehicles).
3) Transparency: As I wrote in a recent paper, one of the potential consequences of the international communitys focus on transparency and commercial orientation when it comes to sovereign wealth funds has been to shorten the latters investment time horizons. As a result, these theoretically long-term investors are pressured into behaving like the many short-term investors in the marketplace today, pushed by structural conditions that demand short-term performance in order to secure legitimacy. And this means rethinking and reconceptualizing the various forms of transparency that we demand.