With collaboration from the Future Fund, the Centre for International Finance and Regulation has produced a body of research which amounts to an investor’s guide for capturing the advantages of long-term investing and avoiding some of the traps along the way.
Geoff Warren, academic and former asset consultant, who is CIFR’s research director, told the annual Paul Woolley Centre conference at the University of Technology Sydney last week that “agency problems” were heightened when investing for the long run.
But there was no “clean and tidy” definition of long-term investing and no underlying theory to support it. The two main characteristics were: a lot of discretion over when the investors could trade and an approach which was focused on long-term outcomes rather than shorter-term benchmarks.
“Long-term investing is an investing mentality rather than a trading mentality,” he said. “It focuses on cash flows and value creation. The holding period is really not relevant… A long-term investor can do everything a short-term investor can do and then some.” Examples of what long-term investors could do included:
> They can adopt and hold positions with uncertain pay-off periods
> They can exploit opportunities created by short-term investors, and
> They have greater latitude to invest in unlisted and less-liquid asset classes (although Warren believes that the benefits of this are usually overstated).
He listed eight strategies for long-term investors, drawing also from a paper co-authored by David Neal, the Future Fund’s chief executive. These were: risk premia; liquidity provision; value investing; pricing discrepancies in segmented markets; thematic investing; control and engagement; complex assets; and, dynamic strategies, including holding cash.
Two elements made long-term investing difficult, he said. One was difficulty of making long-term forecasts and the other was the chain of delegations through a series of principal/agency relationships. With agents, there was often a misalignment of interests, at least initially, and extra difficulty over monitoring in the long term.
“The hold or fold decision is often tortured,” Warren said. “If there’s initial underperformance, the uncertainty creates doubt in the investor’s mind. Sometimes, the line ‘we are in it for the long term’ can be used as an excuse to do nothing.” His work pointed to four building blocks:
> Orient the organisation towards an alignment of interests of agents (including internal management). Have guiding principles, mission statements, and so on. Promote the appropriate culture, governance structure and people. “David Neal calls it ‘immersed monitoring,” Warren said, where the asset owner got involved in a partnership with the manager to understand the basis of investment decisions.
> Set the right incentives. This should include a subjective bonus component, rewarding behaviour, and a calculated bonus with regular rewards along the way. De-emphasise relative performance, measure progress, attribute discounted cash flows and look at direct and co-investments.
> Establish a long-term investment approach. Value and growth styles can be used. Risk needs to be defined differently – not volatility but, rather, the permanent loss of value.
> Harbour discretion over trading. Increase the stickiness of funds, for example, by using closed-end funds and actions to lock-up funding. Abstain from giving managers discretion to trade.
On the same theme, Catherine Casamatta, from the Toulouse School of Economics in France, said that asset owners should use a mix of long-term and short-term incentives for their asset managers. Short-term incentives were better suited to managing liquid asset classes but not others, such as emerging markets.