The search for a long-term premium

Jaap van Dam, principal director of investment strategy at PGGM, one of the world’s largest asset owners that is known for its commitment to long-horizon investing, 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? Because, if we’re not, then why bother?”

A sound answer to this question, as Jaap rightly put it, will determine whether long-horizon investing will really take off among asset owners.

Supported by the work we have done in the Thinking Ahead Institute, in particular the long-horizon investing working group, I would propose a resounding yes as the answer to this question.

In our soon-to-be-published paper, “The search for a long-term premium”, we conclude that a sizeable net long-term premium of 0.5% to 1.5% per year, depending on investors’ size and governance arrangements, can be exploited by investors with the appropriate mindset and skillsets.

Hunting for evidence of long-term premia is easier said than done. In an ideal world, we would run a regression of net investment returns against investors’ time horizons. Sadly, to our knowledge, the data to run this regression does not exist due to a number of obstacles such as how to accurately measure the time horizon of investors.

As a result, an “indirect” approach was conducted, based on the belief that long-horizon investing offers investors both return opportunities and the possibility 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 required to the investment process. Together, they provide evidence of a sizeable premium from long-horizon investing.

We can split these building blocks into strategies that: 1) provide long-horizon return opportunities and 2) lead to lower long-term costs and/or mitigate losses.

Let’s start with return opportunities. A study that examined over 2000 highly-intensive engagements with over 600 US public firms between 1999 and 2009 produced some revealing conclusions. The study showed that engagements with investee companies generate, on average, positive abnormal returns of 2.3% 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.

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 suggested that long-horizon investors have the potential to earn additional returns of 1% pa at the expense of shorter-horizon investors by providing liquidity when it is most needed.

Another aspect of liquidity involves the illiquidity risk premium (IRP), which is well established as a source of return for long-horizon investors.  When investors accept illiquidity, they accept greater uncertainty about the outcome 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% – 2% pa 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% pa relative to the cap-weighted index.

Investors have long been aware of thematic investing. A belief that education, renewable energy, ageing, technology and so on, are key value drivers, is held by many investors. The lack of consistency in implementation approach means we have been unable to find empirical evidence that categorically demonstrates the success of a thematic approach. However, belief in thematic investing is certainly strong: 93% of attendees at the 2016 Thinking Ahead Institute New York roundtable believed that it was possible to enhance portfolio value by investing thematically.

A long-horizon mind-set can also usefully guide behaviours to reduce drags on investment returns.

study of over 400 US plan sponsor “round-trip” decisions (firing and replacing managers) between 1996 and 2003 compared post-hiring returns with the returns that would have been delivered by fired managers. It suggested that by replacing their investment managers, the plan sponsors on average gave up a cumulative 1.0% 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 mind-set.

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 other short-horizon shareholders. In such a structure, long-horizon shareholders effectively subsidise their short-horizon peers for their liquidity needs. One study found that liquidity-driven trading in response to flows (in particular redemptions) has reduced returns in US open-ended mutual funds by 1.5%-2.0% pa from 1985-1990.

Last but not least, significant savings in transaction costs can be made by avoiding unnecessary turnover as a long-horizon investor.

Capturing the benefits of long-horizon investing is likely to require a major shift of mind-set and significantly expanded skillsets by investors. In many cases, it entails incremental spending – eg expanding investment expertise in active ownership by hiring a specialist, or increasing the number of trustee meetings to strengthen long-horizon investing beliefs.

The potential benefits of this additional spending are in many cases return enhancements. In the paper we take 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% 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 around 1.5% a year.

In the investment world where there are very 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 costs of developing the mind-set and acquiring the skillsets to address long-horizon investing challenges are substantially outweighed by the potential return enhancements.

If such a premium exists, why are institutional investors not already exploiting it? Our next challenge is to understand the potential obstacles, and, finally, present a range of practical solutions for investors to access that premium.

Having successfully conducted the search for a long-term premium, we now embark on the journey towards building a long-term orientation.