This article appeared in the Financial Times on 15 October 2020
Many of the problems of present-day finance have their origins in the horizons set along the investment chain.
The key players in this chain are the giant pension, sovereign wealth and endowment funds who appoint external asset managers, who in turn invest in companies. If these funds invest with their eyes set partially or largely on the short term, it sends a clear message down the line and embeds similar standards throughout the capitalist system.
Short-termism has been a recurring concern of policymakers and commentators for decades, but little or nothing has ever been done to address it. The policy horizon of corporations has shortened further over the past decade, leaving them especially vulnerable to extraordinary shocks like Covid-19.
The absence of a remedy can be explained by the failure to adopt an operationally useful definition. I suggest using the motivation for buying securities rather than the length of holding period as the defining difference between long and short horizon investing.
All investing boils down to a choice of two distinct strategies implemented in a variety of ways. One is buying securities that are priced cheaply in relation to their expected future cash flows, which is what everyone assumes is done with their savings.
Bizarrely, the other is almost the exact opposite: buying securities whose prices have recently been on the rise or that have already gone up most, both without reference to fundamental value. Another version of this, though present on a lesser scale, is selling assets that have recently been going down in price.
This second strategy has its origins in what might justifiably be termed “the curse of the benchmarks”. Most large funds delegate to external asset managers by setting index benchmarks, often with limits on how far returns should stray from the index return. Benchmarking is now shown to amplify mispricing by forcing managers to chase prices instead of fundamental value.
Trend-riding momentum investors successfully game this response, pushing prices higher knowing that benchmarkers are likely to come along later and be prepared to pay more. Price-only investing explains much of what is going wrong in financial markets. It is also the essence of short-termism.
When investors obsess about prices, corporate bosses are encouraged to do the same. With the added incentive of early-exercise stock options, they seek to maximise the company’s share price instead of building the business for the future. Among the ways to do that are reducing capital expenditure and research and development, focusing on quick pay-off projects, share buybacks and raised debt levels.
The onus is on giant funds to collectively shift their stance towards longer-term investing in both the public interest and that of their ultimate beneficiaries.
As a first step these big funds should measure and report their use of the two basic strategies. They should assign scores for each sub-portfolio as well as the total fund, with a range from one for price-only to 10 for pure cash flow, broadly matching the implied investment horizon in years.
Separating out the contribution of the two strategies may often be challenging but that is no excuse for not doing it. The trend-riding strategy damages markets while the other improves them. Funds also need a clearer understanding of where manager returns are coming from.
Trading data and changes in portfolio composition are both good indicators of how a portfolio is run. High turnover of holdings is consistent with a short horizon, and so too is a propensity for purchases being made when prices are on the rise.
Any form of close tracking to an index benchmark is effectively a hybrid strategy warranting a score in the middle range. This is because market prices are set by investors using both strategies.
Scoring also helps to establish manager skill. Funds will have a better idea of where the gains and losses come from and what they are paying managers for: the skill of fundamental investing or the luck of trend-following. The analysis will also help to substantiate managers’ claims to be genuinely long-term investors.
The horizon score should become one of the standard metrics for describing a portfolio or fund. Trustees and fund staff mostly recognise the private and social merits of long-term investing and this new measurement will empower them to find ways to move closer to that goal. This will be the best way of dealing with short-termism in the system and far preferable to policy intervention by regulators.