Institutionalizing countercyclical investment

The IMF has published a working paper, Institutionalizing Countercyclical Investment: A Framework for Long-term Asset Owners that I think is a really good paper and worth reading.

The paper explores two questions: (1) whether the world’s largest asset owners respond procyclically to past returns, or countercyclically to valuations? And (2) if countercyclical investment is a public and private good (is both market-stabilising and return-generating), how might we encourage more of it?

The bad news is that the analysis concludes that asset owners tend to behave procyclically – they engage in ‘multi-year return chasing’, or allocate more to asset classes that have been performing well. The good news is that the paper also suggests a number of ways to raise long-term returns and enhance financial stability, including:

  1. enhance governance: we couldn’t agree more with the starting point. The paper makes three specific recommendations. First, introduce minimum accreditation standards. This very much jibes with the Institute work on best practice investment committees where we argued for the primacy of investment expertise over representation, but we stopped short of pushing for accreditation. Second, change communication to stakeholders to emphasise long-term objectives and manage expectations about short-term mark-to-market losses. Third, greater accountability over the implementation of the investment policy statement. The paper doesn’t unpack this last point so, if we agree on its importance, it will be up to us to fill in the detail.

  2. rebalance to benchmarks with factor exposures best suited to long-term investors: this section doesn’t strike me as the strongest section of the paper. Its main point is that cap-weighted benchmarks are inherently procyclical and there are now non-price-weighted alternatives available which are inherently counter-cyclical. It then holds up NZ Super as a best practice exemplar. More could, and arguably should, be made of counter-cyclical rebalancing at the asset class level, or of valuation-sensitive allocation.

  3. shift the emphasis of risk management to minimise long-term shortfall risk (not short-term price volatility): no argument here – this is very much in line with TAG’s ‘wrong type of snow’/risk is permanent impairment to mission philosophy. Where the paper differs from my personal belief system is its argument that long-term investors should have a symmetrical stance (need to harvest upside) rather than asymmetrical (protect the downside). For long-term compounding I err more towards the asymmetrical camp, but this may be a nuance.

  4. minimise principal-agent frictions: this section takes two angles – the expected procyclical hiring and firing of managers on relative returns (and the role of consultants is, rightly, included in the discussion), and the less-expected discussion on fee structures that also amplify procyclicality where they reward on the upside but don’t punish on the downside. The solutions offered include closed-end vehicles (protecting the asset manager), changing to counter-cyclical benchmarks (as above), and changing fee structures.

  5. ensure regulatory conventions do not amplify procyclicality at the worst possible times: the final discussion is very good, and argues that transparency (mark-to-market) and stability (not being forced to act on mark-to-market valuations) can co-exist.