The persistency of the long-term premium

In a previous post, I introduced a research piece (The search for a long-term premium) produced by the Thinking Ahead Institute long-horizon investing working group. The paper attempted to quantify the potential return uplift to asset owners of having a long-horizon orientation. We provided evidence of a sizeable net long-term premium of 0.5% to 1.5% pa, depending on investors’ size and governance arrangements. The eight building blocks of the long-term premium laid a solid foundation for the practical framework of capturing the value-add.

The result is unlikely to be shocking to investors given my belief that most investors intuitively get the benefit of long-horizon investing. 100% of attendees at the 2016 Thinking Ahead Institute New York roundtable expressed a belief in a positive long-term premium (94% of them believed it was higher than 0.5% pa).

In this post I am going to try to address the next logical question that begs to be asked: if everyone believes in the existence of a long-term premium, why aren’t they already doing something to capture it, and as a result very quickly arbitraging the premium away?

In investment, it is generally the case that a consensus expectation would lead price to very quickly reflect that consensus, causing any potential profits from trading on that expectation to evaporate. However there can be important anomalies that persist over long periods of time.  Consider the value premium. Despite it being the oldest and most studied anomaly in investment, it continues to persist. Why? One theory is that investors’ tendency to buy high and sell low not only ruins their chance of capturing the premium, it arguably makes them become a source of “funding” the premium. The money-weighted return investors achieved in value strategies trailed the value index by 1.3% pa over the period from January 1991 to June 2013 (Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies”, Hsu et al, Journal of Portfolio Management, 2016).

Back to long-horizon investing: while evidence suggests the existence of a net positive long-term premium, practically harvesting this premium poses enormous implementation challenges. I would argue the long-horizon premium exists and persists precisely because it is so hard to capture. In fact, 80 years ago, Keynes wrote a whole chapter on the challenges of long-term investing. Clearly nothing much has changed since then.

“Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. … It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; human nature desires quick results, there is a particular zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. … Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate … with borrowed money … Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism”

The 1997 “The limits of arbitrage” paper written by Shleifer and Vishy made a similar argument to support the persistence of a long-term premium. They argued that trading on long-term mispricing is generally more expensive and difficult (eg an asset manager may be fired for short-term under-performance before their long-term strategy has had paid off).  This barrier to entry makes trading on long-term mispricing particularly rewarding for those who can successfully overcome the skill and implementation hurdles.

The long-term premium comes partially from exploiting mistakes caused by short-term behaviours (eg buying under-priced assets from investors who are forced to sell). The logic is if we all behave in line with a long-horizon mind-set (eg never put ourselves in the position of being forced sellers), soon there won’t be any forced sellers to exploit.

However, most investors face considerable constraints that prevent them from being truly long-term focused in their entire portfolios. The nature of liabilities and liquidity requirements are significant obstacles, along with investment beliefs, risk appetite and decision-making structures. A 2011 World Economic Forum study (The Future of Long-term Investing) concluded that only 10% of the entire institutional investment capital can be employed in long-term investing strategies. Additionally, the WEF predicted a further decline in long-term investment capital at the aggregate level.  We believe that given the constraints faced by investors, we are far from reaching the point where the long-term premium is in danger of being arbitraged away.

Consequently, addressing the implementation challenge for long-horizon investing (the focus of the working group’s future outputs) will be difficult and, for those that have the necessary orientation and capability to invest for the long term, very rewarding. For those of us committed to unlocking the long-horizon premium, we can take inspiration from the words of John F. Kennedy: “We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard…”