Long-term investment premium quantified

LONDON, Wednesday 21 June, 2017 – There is a net premium of up to 1.5% pa available to long-horizon investors according to new research from the Thinking Ahead Institute. In the research – entitled The search for a long-term premium – the Institute quantifies, and provides evidence for, the size of the long-term investment premium that can be exploited by investors. The research is based on the premise that long-horizon investing offers investors both return opportunities and the potential to reduce the drag on returns.

Tim Hodgson, head of the Thinking Ahead Institute, said: “In the investment world, where there are very few universal truths, it would be hubristic to claim that we and our members have proven the existence of the long-term premium. However, we are more certain than ever that the costs of developing the mind set and acquiring the skillsets to address long-horizon investing challenges are substantially outweighed by the return enhancements. As such we believe this is ground-breaking research because it provides sufficient evidence to answer – with a confident yes – this perennial, billion-dollar investment question.”

The research, released today, identifies eight building blocks of long-horizon investment value, each practical to implement, with the expected size of the net premium (between 0.5% and 1.5% pa) dependent on investors’ governance, asset size, mind set and investment processes.

Liang Yin, senior investment consultant at Willis Towers Watson and lead author of the report, said: “It is well documented that direct evidence to support the long-term investment premium has been elusive. Ideally we would run a regression of net investment returns against investors’ time horizons to prove it, but data on time horizons doesn’t exist. Instead our Institute working group chose an indirectapproach, incorporating both return opportunities available only to long-horizon investors and reducing the drag on their returns, which led to the identification of the building blocks of long-horizon investment value.”

In the research the eight building blocks are split into strategies that provide long-horizon return opportunities and those that lead to lower long-term costs and/or mitigate losses. The return-opportunity building blocks are:

  • Active ownership and investing in long-term oriented companies  – engagements with investee companies on average generate positive abnormal returns of 2.3% in the year following the initial engagement
  • Liquidity provision has the potential to earn 1% pa additional returns at the expense of shorter-horizon investors by providing liquidity when it is most needed
  • Mispricing effects captured via smart betas or factors can add more than 1.5% pa relative to the cap-weighted index
  • Illiquidity risk premium – by forgoing access to liquidity, long-horizon investors can earn a return in a range of 0.5% to 2% pa depending on market conditions
  • Thematic investing – the most challenging to evidence but a growing belief among investors that it is possible to enhance portfolio value by investing thematically.

The return-drag building blocks are:

  • Round-trip decisions (firing and replacing managers) – on average investors cumulatively give up 1.0% in the three years following a manager change
  • Forced selling can reduce returns by 1.5% to 2.0% pa
  • Transaction costs – significant savings can be made by avoiding unnecessary turnover as a long-horizon investor.

Not all of these building blocks are independent, and some (e.g. providing liquidity and harvesting an illiquidity risk premium) are even contradictory. Consequently the components cannot simply be added together to derive the long-term premium. Instead the research quantifies the long-term premium through a case study of two hypothetical pension funds using these building blocks to determine a reasonable estimate of the 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 as well as forced sales and moves part of its passive exposure into smart beta strategies. The net benefit of these efforts is shown to potentially increase investment returns by around 0.5% pa. 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 also reducing its exposure to mistakes and costs resulting in a net uplift to returns of around 1.5% pa. In the research, significant penalties were applied to the historic evidence to produce these realistic forward-looking expectations.

Liang Yin said: “On the basis of this research, produced with our members, it is the Institute’s clear view that the search for a long-term premium has been successful. However, capturing the benefits of long-horizon investing is likely to require a major shift of mind set and significantly expanded skill-sets by investors. It is reasonable to assume the long-horizon premium exists precisely because it is so hard to capture. In fact, 80 years ago, Keynes wrote a whole chapter on how hard long-term investing was and clearly nothing much has changed since then.

“Therefore the Institute has now started work on the next phase – the journey of discovering how to successfully implement a long-term investment orientation across the industry. When we consider that investment returns are set to remain low for the foreseeable future, these findings are, and will be, all the more compelling.”

About the Thinking Ahead Institute

The Thinking Ahead Institute is a global not-for-profit group whose aim is to influence change in the investment world for the better by improving the provision of savings. The Institute’s members comprise asset owners, investment managers and other groups that are motivated to influence the industry for the good of savers worldwide. It has 40 members with combined responsibility for over US$13 trillion and is an outgrowth of Willis Towers Watson Investments’ Thinking Ahead Group.

About Willis Towers Watson

Willis Towers Watson (NASDAQ: WLTW ) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson 40,000 employees serving more than 140 countries. We design and deliver solutions that manage risk, optimize benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential.