Eight paths to long-term premia
Jaap van Dam, principal director of investment strategy at PGGM, one of the world’s largest asset owners known for its commitment to long-horizon investing, was once asked what he called “the million-dollar question”: Can we be reasonably certain that we will be rewarded for being a long-horizon investor?
As van Dam rightly put it, the answer to this question will determine whether long-horizon investing will take off among asset owners. Because, if there’s no reward, then why bother?
I would propose that the answer is a resounding yes. And that response is supported by the work we have done at the Thinking Ahead Institute, in particular within the long-horizon investing working group.
In our paper, The search for a long term premium, we conclude that a sizeable net long-term premium of 0.5 per cent to 1.5 per cent a year – depending on investors’ size and governance arrangements – can be exploited by investors with the appropriate mindset and skillsets. (See Long-horizon premium: up to 1.5%).
Hunting for evidence of long-term premia is easier said than done. In an ideal world, we would run a regression of net returns against time horizons. Sadly, to our knowledge the data to run such a regression does not exist due to a number of obstacles, such as the difficulty in accurately measuring investors’ the time horizons.
As a result, we used an indirect approach, based on the belief that long-horizon investing offers both return opportunities and the chance to reduce drag on returns. This led to the identification of eight building blocks of long-horizon value. Each is practical to implement, albeit with changes to the investment process. Together, they provide evidence of a sizeable premium from long-horizon investing. Some provide return opportunities and others create chances to lower costs.
Liquidity provision and other opportunities
Let’s start with return opportunities. The first relates to a study that examined more than 2000 highly intensive engagements with over 600 US public firms between 1999 and 2009. The study showed that engagements with investee companies generate, on average, positive abnormal returns of 2.3 per cent over the year following the initial engagement – clear evidence of the benefits of being active owners to encourage investee companies to take long-term approaches.
The next two return opportunities relate to liquidity. When investors are willing to pay for liquidity – in other words, sell assets below fair value – someone on the other side of the trade gets paid. One study suggests that long-horizon investors have the potential to earn additional returns of 1 per cent a year at the expense of shorter-horizon investors by providing liquidity when it is needed most.
Another aspect of liquidity involves the illiquidity risk premium, which is well established as a source of return for long-horizon investors. When investors accept illiquidity, they accept greater uncertainty because they are less able to liquidate the asset. The longer the capital is tied up, the more return investors expect by way of compensation. Academic studies point to a range of 0.5 per cent to 2 per cent a year for this particular premium – and even higher returns might be available to very long-horizon investors.
A fourth return opportunity for long-horizon investors comes from exploiting various mispricing effects via smart betas. Decades of data suggest that this can add more than 1.5 per cent a year, relative to the cap-weighted index.
Finally, understanding the long horizon can help funds take advantage of thematic investing. Many hold a belief that education, renewable energy, ageing, technology and other themes are key value drivers for investors. However, lack of consistency in implementation has prevented researchers from finding empirical evidence that a thematic approach works. Even so, belief in thematic investing is strong: 93 per cent of attendees at the 2016 Thinking Ahead Institute New York roundtable believed that it was possible to enhance portfolio value by investing thematically.
Lower turnover and other potential savings
Now let’s examine how a long horizon can help reduce drags on returns.
A study of more than 400 US plan sponsor ‘round-trip’ decisions (the firing and replacement of managers) between 1996 and 2003 compared post-hiring returns with those the fired managers probably would have delivered. It suggested that by replacing their investment managers, the plan sponsors gave up a cumulative 1.0 per cent, on average, in the three years following the change – a dear cost they paid for buying high and selling low that can be mitigated by a long-horizon mindset.
Open-ended fund structures, despite the flexibility they provide, might not be fit-for-purpose for long-horizon investors, who do not require nearly as much liquidity as short-horizon shareholders and can, therefore, take advantage of closed-ended opportunities. In open-ended structures, long-horizon shareholders essentially subsidise their short-horizon peers’ liquidity needs. One study found that liquidity-driven trading in response to flows (in particular redemptions) reduced returns in US open-ended mutual funds by 1.5 per cent to 2.0 per cent a year from 1985-90.
Last but not least, long-horizon investors can save on transaction costs by avoiding unnecessary turnover.
An advantage for larger funds
Capturing the benefits of a long horizon will probably require investors to expand their skillset and make a major shift in mindset. In many cases, it will entail incremental spending; for example, expanding investment expertise in active ownership by hiring a specialist or increasing the number of trustee meetings to strengthen belief in long-horizon investing.
The potential benefits of this additional spending are in many cases enhanced returns. In The Search for a Long-Term Premium, we examine two hypothetical pension schemes to develop a reasonable estimate of the potential long-term premium in practice.
The smaller fund focuses its long-horizon efforts on avoiding costs and mistakes. It reduces manager turnover, avoids chasing performance and forced sales, and moves part of its passive exposure into smart beta strategies. The rationale is: If you don’t have the resources to win big, at least don’t lose. The net benefit of these efforts is potentially an increase in investment returns of about 0.5 per cent a year.
The larger fund has the governance and financial resources to consider all available options for capturing premia. It introduces long-horizon return-seeking strategies while reducing its exposure to mistakes and costs. The net uplift to returns is potentially about 1.5 per cent a year.
In the investment world, where there are few universal truths, it would be hubristic to conclude that we have proven the existence of the long-term premium. We are, however, reasonably certain that the potential return enhancements of long-horizon investing substantially outweigh the cost of addressing its challenges.
If such a premium exists, however, why are institutional investors not exploiting it already? Our next challenge is to understand the potential obstacles and, finally, present a range of practical solutions to allow investors to build a long-term orientation and access that premium.