Long-Term Investment, Motherhood and Apple-pie
Exhortations to invest for the long-term have come thick and fast these past few years. It is, perhaps, surprising that the expression ‘long-term’ passes largely undefined, though the idea of “patient, engaged and productive capital” has gained some authoritative adherents. Long-term investment is presented as virtuous, to be regarded in much the same way that the Victorians regarded thrift. It is also surprising that we should need encouragement to invest for the long-term when that theoretically holds the prospect of superior returns over sequences of short-term operations. In this article, we will consider what the long-term might mean, drawing out some inferences and differences from current practice.
Though closely related to the holding period, this is not the sole determinant of the long-term; savings purpose also enters the frame. Joining the Christmas club is saving and long-term investment in just the same way that buying a stripped gilt and holding it to maturity may be long-term investment. Savings purpose is important. There is a missing analysis here, which clearly should be the subject of future research. We should be concerned not just by the volume of savings and investment, but also by the term structure of savings purpose and the term structure of investment demand, and the extent to which financial intermediation mitigates mismatches between these. This is the real measure of the efficiency of a financial system. Largely this is a question of markets competing with and complementing the banking system in maturity transformation and a key issue in financial stability.
With this in mind, we will distinguish the short from the long-term by the source of liquidity. We shall define the long-term in terms of dependence upon this security-specific source of income and the short-term as dependence upon the market for liquidity, or income through sale. Long-term investment is dependence upon the performance of the contract. By contrast, speculation relies upon realisation in a market for its performance. Clearly, there is a time dimension present in this distinction. The longer we hold an equity security then typically the greater the importance of the dividend income received in the total return. Of course, this has been known for rather a long time.
The work of Beebower, Brinson and Hood (Determinants of Portfolio Performance, FAJ July/August 1986) showed that most of a portfolio’s return volatility could be explained by asset allocation – subsequent empirical studies vary but most attribute 80% or more to asset allocation. At a daily or intra-day level, almost all performance will be causally due to changes in price. All that this is really telling us is that price performance dominates returns in the short-term. To this day, most performance attribution analysis is conducted in this framework. It is perhaps not surprising that these attribution methods run into difficulty when moving to multiple periods or the long-term.
The long-term, however, is a rather different story. The classic study of long-term performance is Dimson, Marsh and Staunton’s work, published as “Triumph of the Optimists”, but also reproduced by many others. In this study of returns since 1900, the real return of 5.5% p.a. achieved by UK equities consists of 4.8% dividend yield, 0.6% growth in dividend yield and just 0.1% change in price. This is as intuitively obvious as the earlier observation that the short-term is dominated by price performance. It also applies to bonds – a bond held to maturity will return the face coupon and principal, and variation will only arise from differences in the achieved reinvestment rates of coupons, which are small convexity effects.
It is clear that investment managers should be using fundamentally different techniques and resource dedication when managing for the short-term than when managing for the long-term. The short-term is predominantly a game against others in markets; it is endogenous to the market. The long-term, by contrast, is driven by the fundamentals of the company, its earnings and dividends. This is exogenous to the market. Dedicating 90% of your analytic resources to price performance, and the game against others, may be justified when that accounts for 90% or more of the total, but clearly, it isn’t when it accounts for less than 2%.
The distinction by liquidity source goes beyond contract versus market, or income versus price; it is production versus valuation. Reliance upon the contract is “patient” investment; it is long-term. It is also “productive capital”. We might equally describe this distinction as the difference between investment and speculation, without any pejorative overtone.
Another important distinction arises here. The empirically observed lowering of volatility with holding period is a reflection of the growing importance of income in total returns with holding horizon rather than some inchoate reversion to the mean in asset prices. This also raises issues with market prices for valuation.
The market consistency justification for their use, even when it is clear that that they introduce the volatility of the short-term into valuation, is weak. Markets are not consistent among themselves; if they were, diversification would not be feasible. The contracts written by long-term insurers and pension schemes are not negotiable; they lack the option on market liquidity of traded negotiable instruments. It should be realised that liquidity is costly; if it were not, all assets would be liquid. The question is not which market should we require these institutions to be consistent with, but rather: why should we shoehorn these institutions into a framework where they are not naturally members at all?
Engagement is currently a popular concern, usually rooted in the principal-agent problem between investors and managers. Since Hirschman, this is often expressed as the difference between ‘exit’ and ‘voice’. For many investors, notably short-term players, it may be more efficient to ‘exit’, by sale in a market, rather than to engage, since engagement is costly. For the long-term investor here, the effect of management rents is directly visible and engagement to rectify these issues more probable as the trade-off can often then be measured; though quite how one would measure and evaluate management ‘shirking’ is difficult to see. One of the issues for the short-term investor is that the purpose of this engagement is to affect prices, from which all benefit, though most have not incurred engagement expense; this may place them at a competence disadvantage to other short-term players. This is the ‘free-rider’ problem. However, the long-term investor is unconcerned with market price performance; engagement is matter of self-interest. Engagement, per se, though is a healthy symptom rather than a defining characteristic of the long-term.
This question of the differences between the short-term endogenous game against others and the long-term exogenous game against nature is itself important in terms of investment management incentives. In the former, players are concerned with their position relative to others and price performance matters only to the extent to which it attracts further savers to the market. There is no incentive for such short-term players to want prices to reflect fundamental value, and often many to prefer distortions of this relation. By contrast, the long-term investor should want to see improvements to the fundamental productive output, and be unconcerned by market price behaviour.
The form of distribution preferred also varies as we move from the short to the long-term. The long-term investor will typically prefer special dividends to share ‘buy-backs’.
Perhaps, the greatest paradox of the short and the long-term lies in the incentives for research and innovation, which is intrinsically a speculative activity. The short-term player will discourage these in pursuit of the immediate, while the long-term investor will encourage them. Ultimately, of course, the benefits of innovations will accrue to consumers, but in the short-term, they are a source of supra-normal profits to investors. The far more important point, though, is that it is research and innovation that are responsible for growth in productivity and productive output – something we have seen precious little of in recent years.
Risk Management and Regulation The question of incentives also applies in the realm of risk management. Both insurance companies and pension funds are subject to regimes of risk-based solvency tests. These are immediate, with asset valuation based on market prices, discouraging consideration of the long-term.
One of the few things we know about risk is that it means that more things can happen than will. Holding current provisions against all that might occur introduces significant redundancies, which are costly. The assumption is that the portfolio will visit all future possible states, but the reality, when investing for the long-term, is that few of these will be visited at times when they are relevant.
It is clear that recent regulation has had significant effects upon the asset allocation strategies of both pension funds and investors. Hedging has grown greatly in popularity. It should be realised that the only perfect hedge of an asset is the sale of that asset. This leaves the institution holding only cash, which is hardly consistent with any concept of investment.
The problems of long-term investment have become the focus of much official interest recently. In large part this is a result of their recognition that the need for infrastructure and sustainable green investment is huge almost everywhere. Some appear even to have noticed the effects of regulation in limiting this.
Conclusion The forthcoming consultation from the UK Department of Work and Pensions on the smoothing of assets and liabilities for pension schemes and the much-heralded EC Green Paper on long-term investment hopefully will provide the opportunity to discuss all of the issues extensively.
The clamour from the authorities for higher long-term investment is to be expected, but such talk is cheap; actions and commitments are better signals of intention. The best signal that could be provided in the UK would be the reinstatement of advanced corporation tax credit for long-term investors.
We should also not forget that fund managers are the agents of pension fund investors; the terms on which mandates are awarded and the ways in which performance is measured by them may continue to frustrate the best intentions of fund managers and the authorities, in the absence of some substantial evidence of the superiority of long-term investment. For the financial analyst, this is motherhood and apple-pie, where fundamental and cash-flow analysis are all-important.