Author: Philip Edwards

Long-term investors using short-term strategies

Most institutional investors have long-dated obligations that extend decades into the future. Consistent with their long time-horizon and the need to deliver inflation-beating returns, such investors typically allocate the majority of their capital to public and private equity, real estate and infrastructure assets. Increasingly, such allocations are managed with environmental, social and governance (ESG) concerns to the fore. Indeed, some investors have gone further and now seek to align their investment strategy with the UN Sustainable Development Goals.

Paradoxically, the same investors will often use strategies that are inherently short-term in their approach. The most obvious example is the momentum strategy, which involves buying recent winners and avoiding recent losers. This is a high turnover strategy that has nothing to do with the productive allocation of capital. Moreover, the procyclical nature of the strategy means that it will tend to amplify trends, distort prices and, in the extreme, contribute to bubbles and crashes.

Out-and-out momentum strategies are just the tip of a large procyclical iceberg. The still widespread use of tracking error constraints forces managers to chase the fastest-performing segments of the market to avoid breaching their mandate guidelines. Even in the absence of such constraints, asset managers willingly chase trends in order to manage their own career risk. And performance-driven hire and fire decisions by asset owners further embed a procyclical bias within financial markets.

All this adds up to a situation in which large investors who claim to invest with a long horizon and who wish to be seen as champions of a socially responsible form of capitalism, are in fact contributing to dysfunctional capital markets in which short-termism dominates long-term thinking.

The social costs of asset mispricing and short-termism are less visible than the more widely discussed environmental and social externalities, but may be no less damaging.

Traditional finance theory suggests that in more-or-less efficient markets, a company’s share price is a fair reflection of the fundamental worth of the business. In this idealised world, there is no difference between actions that boost the share price and actions that deliver long-term value. However, in the presence of asset mispricing this no longer holds. As a result, it is possible – and often highly remunerative – for CEOs to engage in financial engineering rather than productivity-enhancing investment. An egregious and widespread example of this arises when share buybacks are used to mask the dilutive impact of stock-based compensation packages under the cover of “returning capital to shareholders”.

Procyclical dynamics also support a tendency towards monopoly: a rising share price confers greater market power on a company, enabling it to buy up competitors, often using their overvalued stock to fund the purchase. Asset owners that employ procyclical strategies are thereby facilitating a gradual shift towards a less competitive, less productive economy in which monopolistic corporations can engage in rent extraction on a vast scale.

Furthermore, procyclical strategies exert positive feedback effects on markets which help inflate asset price bubbles. When these bubbles eventually burst they often inflict significant and long-lasting damage on the economy, resulting in job losses and wage stagnation.

Public calls for institutional investors to recognise the impact of their investment approach have so far been limited to divestment campaigns focused on specific issues – most notably in relation to fossil fuel and tobacco holdings. However, as attention shifts towards broader issues such as excessive corporate power and rising inequality, it seems likely that asset owners will need to justify their investment strategy on much more fundamental grounds.

This would not require a huge leap from where we stand today. Savers and activists are already asking why their pension savings should support anti-social corporate activity. They might also ask why their savings should support anti-social investment strategies. Regulators across many markets have become increasingly assertive in encouraging funds to consider ESG issues. A natural extension of this – and one very much aligned with the underlying objectives of the sustainability movement – would be to ask large funds to consider the extent to which the strategies they employ contribute to market instability and capital misallocation.

Even in the absence of regulatory pressure, socially responsible asset owners will naturally want to understand the impact that their investment approach has on the wider world. This means going beyond the now commonplace integration of ESG considerations and the use of sustainability-themed strategies at the margin. Indeed, it demands that long-horizon investors avoid strategies that undermine the efficient working of capital markets and which consequently impose an unrecognised cost on wider society. If long-term capital was managed with a genuinely long-term mindset, the private and social benefits could be immense.

Misdiagnosing the crisis of capitalism

The Business Roundtable – a body representing the chief executives of America’s largest companies – announced in August an updated statement on the purpose of a corporation. In broad terms, the statement articulated a shift away from shareholder primacy towards a more stakeholder-oriented vision. Advocates of the move welcomed the recognition of issues such as employee welfare and environmental impact, while critics lamented the apparent downgrading of shareholder interests.

But commentators largely missed the key point: companies will disappoint both stakeholders and shareholders unless the underlying problem of short-termism is addressed. The widespread assumption that corporate activity is today mostly driven by a focus on long-run shareholder value is mistaken. In practice, many corporate leaders are instead focused primarily on short-run share price maximisation.

The fundamental problem to be addressed is therefore not one of broadening the perspective of CEOs away from a narrow focus on shareholders. Rather, it is to address the incentive problem, afflicting the entire investment chain, that results in an obsession with short-term share price performance rather than long-run value creation.

Share price myopia

Today’s crisis of capitalism originates not in the boardroom but in the capital markets, and is a result of the agency issues that arise from a highly intermediated financial system. In the modern publicly listed corporation, shareholders typically stand a number of steps removed from company management. For example, in the case of a pension fund, the end saver’s interests are represented by a group of trustees; those trustees usually delegate the management of the assets to an external asset manager (often further intermediated by a fiduciary manager); and the asset manager builds a portfolio and engages with company management in line with their mandate. Agency issues exist at every stage in this chain, but arguably the critical principal-agent problem arises in the relationship between the trustees and the asset manager.

Facing the challenge of assessing a manager’s ability, trustees typically employ market cap benchmarks to measure the ongoing success of a strategy. However, this creates an incentive for managers to herd around the benchmark and engage in performance-chasing activity to control the risk of short-term benchmark underperformance. Trustees themselves also engage in procyclical decision-making, tending to hire managers after strong performance and fire managers after poor performance. And the clearest example of procyclical behaviour comes from momentum and trend-following strategies that exploit the performance-chasing activity of asset owners and managers for private gain, while amplifying price trends and exacerbating asset mispricing.

With an asset management industry so obsessed with short-term performance, it is hardly surprising that CEOs engage in strategies designed to maximise share prices over the short term. Reinforcing this dynamic, remuneration arrangements that are heavily skewed towards equity-based compensation ensure that CEOs are financially rewarded for actions that boost share prices.

Finance theory must share the blame for this share price myopia. In particular, a paper by Michael Jensen and Kevin Murphy published in 1990, titled “CEO incentives: it’s not how much you pay, but how”, made a forceful argument in favour of remuneration structures that link CEO pay to shareholder wealth. When combined with the idea that share prices are an accurate reflection of the fundamental worth of a company – as embodied in the efficient market hypothesis – the natural conclusion is that CEO pay should be closely linked to share price performance. CEO pay in the US exploded during the 1990s, with stock options quickly becoming the largest share of total remuneration.

However, if share prices can depart substantially from fair value, then the argument in favour of equity-based compensation breaks down. Indeed, in the presence of mispricing, CEOs are incentivised to maximise share prices and simply become another procyclical participant in the system. When executives act with the sole intention of inflating stock prices, this will often be at the expense of long-run value creation. As a result, short- and long-run shareholder interests come into conflict, rendering the concept of shareholder value – when abstracted from time horizon – meaningless. Given the nature of executive incentives, the resolution of this conflict will often favour the short-term over the long-term.

Reconciling shareholder and stakeholder concerns

An excessive focus on share price maximisation is often viewed as a side-effect of the shareholder primacy ideology. The natural corollary of this view is that there needs to be a levelling of the playing field in order to place stakeholder concerns on a par with shareholder interests. This line of thinking places shareholders and stakeholders in opposition to one another and ignores the importance of time horizon.

While it is true that shareholder and stakeholder interests may come into conflict over the short term, their interests are in far greater alignment over the long term. For example, a company that seeks a short-term boost to its bottom line by cutting employee benefits, will suffer from a demotivated workforce and will lose talented staff in the long term. Similarly, a company that squeezes its suppliers for short-term gain, puts at risk its ability to meet customer demand over the long term. In both cases, actions which ignore the value and importance of a company’s stakeholders also undermine the goal of delivering long-term returns to shareholders.

This is to argue that over the long run, shareholder concerns coincide to a large extent with stakeholder concerns. Put differently, well-run businesses that are focused on long-run value creation will generally not exploit their employees, suppliers, customers or wider society. This is especially true given the power of social media to shine a spotlight on corporate behaviour that is deemed to undermine their social license to operate.

The best way to align shareholder and stakeholder interests is therefore to ensure that CEOs are incentivised to deliver long-term value – to customers, shareholders and wider society – rather than seeking to maximise the share price over the short term. This will require a re-setting of relationships along the investment chain and a re-thinking of executive compensation practices.

Extending the investment horizon

An essential precondition for long-term thinking to prevail in boardrooms is for long-term thinking to predominate across the asset management industry. This will only happen if asset owners demand asset management strategies that focus on long-term value creation rather than short-term benchmark outperformance.

A first step in this direction would be for asset owners to recognise the incentives that drive share price myopia across the asset management industry and to counteract their effects. This could include an overhaul of the traditional approach to manager monitoring – with the aim of deterring performance-chasing – as well as a re-framing of the mandate given to asset managers.

From a regulatory perspective, the goal of policymakers should be to foster an asset management sector that is focused on identifying and nurturing sustainable business models. A move in this direction could include an explicit recognition of the damage done by short-horizon strategies that respond primarily to price trends with little concern for business fundamentals.

Returning to the Business Roundtable statement, the shift from shareholder primacy towards a more stakeholder-oriented vision is likely to benefit neither shareholders nor stakeholders unless the underlying disease of short-termism is treated. An excessive focus on share prices by investors and CEOs inflicts long-term damage on shareholders and wider society. Conversely, extending the horizon of asset managers and corporate leaders could benefit shareholders and stakeholders alike. Regulatory interventions will still be required to curtail the negative effects of monopoly power and certain systemic externalities, but a greater focus on long-run value creation in the capital markets – instigated by long-horizon asset owners – could help restore trust in the financial system and deliver meaningful benefits to society.

Looking less at the scoreboard

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”
– Warren Buffett (2014 annual letter to shareholders)

Performance monitoring reports play a central role in supporting investor decision-making, providing a snapshot of the returns achieved on a portfolio over time. While their content and format vary widely, they invariably contain a summary of fund and benchmark performance for each underlying strategy over a range of time periods. By emphasising benchmark-relative performance, these reports encourage procyclical decision-making that reduces returns and contributes to destabilising market dynamics.

In the Intelligent Investor (1942), Ben Graham wrote that “price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” Here Graham hints at a monitoring approach that de-emphasises price data, focusing instead on the underlying health of the businesses within the investor’s portfolio.

Benchmark myopia

As we have described elsewhere, we believe that procyclical dynamics in financial markets are both privately and socially damaging. A powerful driver of procyclicality is the tendency for asset owners to hire managers after a period of strong performance and fire managers after a period of disappointing performance. One of the primary inputs into this decision-making process is the manager’s performance versus their stated benchmark, often reported to investment committees on a quarterly basis.

Such performance monitoring reports are often adopted without much thought given to the usefulness of the data provided. Do the benchmark-relative performance numbers provide information on whether the manager is doing a good job? Do they provide any insight on the manager’s skill level? Do they provide a useful trigger for reviewing the mandate? Over anything less than a five-year period it is difficult to answer “yes” to any of these questions.

The fact that managers know that performance data is presented to asset owners on a regular basis also creates a commercial incentive to ensure that short- to medium-term benchmark-relative performance is controlled, to avoid the appearance of incompetence. This in effect embeds procyclicality within asset managers’ decision-making, since to avoid significant underperformance, a manager will at times need to chase the best-performing securities or sectors within their benchmark.

As a result, traditional performance monitoring reports do more harm than good. They encourage an excessive focus on performance data and contribute to procyclicality in decision-making by asset owners and asset managers. Some have suggested that altering the presentation of performance data – to give greater prominence to longer-term figures – might help address the issue. However, minor tweaks to the existing approach are unlikely to achieve very much. Instead, a more fundamental re-think is necessary.

Monitoring without procyclicality

The first step towards developing an effective monitoring framework is to recognise that short-term performance data has very little informational content for strategies that have long-term objectives. Whether the manager or the benchmark has produced a greater return over the last quarter or year tells us more about market sentiment than it does about the manager’s ability. Even over periods of five years or longer we should be wary of drawing overly strong conclusions.

We suggest that instead of trying to gauge manager success based on regularly updated performance data, investors seek to make an assessment of whether the underlying portfolio is delivering what might be expected, given the manager’s stated philosophy and approach. This requires investors to shift their sights away from performance numbers and towards the fundamental characteristics of the stocks held in the portfolio.

This can be broken into two parts:

  1. Has portfolio activity been consistent with the stated philosophy?
  2. Do the fundamentals of portfolio holdings provide evidence of skill in stock selection?

The first element is a backward-looking analysis intended to confirm that the mandate is being managed in line with expectations. In relation to a listed equity mandate, important elements of this assessment would include turnover statistics, active share, an analysis of changes to portfolio holdings over time, and stewardship activity. The portfolio holdings analysis would primarily be intended to determine whether the manager has an unstated momentum (performance-chasing) bias that could be motivated by career risk or commercial considerations.

The second element builds on Graham’s suggestion that investors focus more on the operating performance of their holdings than on price movements. For an equity mandate, the characteristics of interest could include measures such as the growth in cashflow, earnings, book value or dividends of the portfolio. These measures are likely to be less volatile than performance data driven largely by market prices, while providing a more useful indicator of the ongoing success of the strategy.

It is important to note that the most relevant measures of success will vary from one manager to the next – the objective here is not to achieve total uniformity in the monitoring approach. Indeed, performance-chasing at the asset owner and asset manager levels can be traced, at least in part, to the homogenous performance monitoring reports produced across the industry on a quarterly basis.

In some respects, the proposed approach mirrors the way in which a private equity general partner has to monitor their portfolio. Without access to a frequently updated market valuation, the private equity owner instead focuses on the operating performance of the underlying businesses and their ability to influence outcomes by engaging with management. While there is plenty to criticise about the private equity business model, public market investors could become better long-term investors by borrowing some elements from their private market counterparts.

There is no perfect way to monitor an asset manager. Separating luck from skill will remain deeply challenging and it is impossible to eliminate all principal-agent problems. However, it would be difficult to design a performance monitoring system more likely to encourage procyclical decision-making than the current one. By looking less at the scoreboard and focusing more on the playing field, we believe that investors can incentivise a shift towards longer horizons within financial markets that will be both privately and socially beneficial.

Defensive diversification

“Diversification is the only free lunch” is one of the most over-used – and perhaps dangerous – phrases in finance. The idea derives from Modern Portfolio Theory (MPT), developed by Harry Markowitz in the 1950s, for which he shared the Nobel prize in Economics in 1990. MPT provided mathematical tools, in the form of mean-variance optimisation, to help investors maximise their expected return for a given level of risk. In essence, such tools embedded the idea that by diversifying across a range of assets, investors could obtain a more attractive risk-return trade-off.

The legacy of MPT is that diversification has become one of the easiest and most commonly used justifications for any investment decision. However, rather than being seen as a universal good, diversification should more accurately be viewed as a trade-off: we can reduce the downside of being wrong, but only at the cost of reducing the upside from being right. As Buffett once remarked: “diversification is protection against ignorance; it makes little sense if you know what you’re doing.”

Putting this a little less bluntly, we might think of diversification as a useful defence against uncertainty; but one that dilutes the impact of our highest conviction insights and often raises the governance burden. The dilution effect is clear in relation to actively managed portfolios: the more diversified a portfolio, the less impact any high conviction positions can have on overall performance. The governance cost relates to the additional work – in the form of due diligence and ongoing monitoring – that results from adding new assets to a portfolio.

That diversification, conviction and governance considerations are in tension is perfectly natural. However, in the presence of principal-agent dynamics, the temptation is for asset managers to over-diversify portfolios – by moving in the direction of a flawed benchmark – resulting in a less attractive risk-return profile for the end investor.

Defensive decision-making

In his 2014 book, Risk Savvy, the decision-making expert Gerd Gigerenzer defined defensive decision-making as follows: “a person or group ranks option A as the best for the situation, but chooses an inferior option B to protect itself in case something goes wrong.” Much of the literature on defensive decision-making focuses on the medical setting, where examples of “defensive medicine” include ordering unnecessary tests and over-prescribing medications in order to reduce the risk of being sued for malpractice. However, Gigerenzer points out that defensive decision-making is commonplace in the modern world, often arising in relation to political or corporate decisions where blame can easily be assigned.

Defensive decision-making flourishes in situations where decisions are taken by one party (the “agent”) on behalf of, or that impact, another party (the “principal”). The danger is that instead of assessing the risks and opportunities in a balanced way, the agent chooses to focus primarily on managing downside risk, fearing that poor outcomes will be felt more intensely by the principal than good outcomes. Such principal-agent problems abound in the investment industry, where trustees often take responsibility for decisions on behalf of beneficiaries, and trustees invariably delegate stock selection to external asset managers – sometimes further mediated by a fiduciary manager. The aggregate effect of these layers of intermediation is a potentially serious misalignment of interests which creates the conditions for defensive decision-making.

An example of “defensive diversification” would be where an asset manager holds a security primarily in order to reduce the risk of underperforming the benchmark, but where there is little or no expectation of positive long-term returns. Diversifying a portfolio to manage benchmark-relative risk in this way may reduce the portfolio manager’s career risk, but does nothing to improve the end-saver’s long-term return prospects. Indeed, there is a growing body of academic work suggesting that over-diversification imposes a cost on the end saver in the form of lower returns.

In Best Ideas, Cohen, Polk and Silli show that active equity managers’ highest conviction positions outperform the market and other stocks in their portfolio by a large margin (c.4-10% p.a. depending on the methodology and benchmark employed). The results are statistically and economically significant and robust across a range of specifications. The authors suggest “that while the typical manager has a small number of good investment ideas that provide positive alpha in expectation, the remaining ideas in the typical managed portfolio add little or no alpha.”

The authors put forward a number of reasons why managers might proactively choose to dilute their best ideas with what turn out to be value-destructive diversifying positions. These include a desire to avoid extreme benchmark-relative performance; attempts to maximise risk-adjusted returns (as opposed to just returns); or a commercial preference for running a strategy with a large volume of assets (which precludes holding a small number of relatively concentrated positions).

Related research by Cremers and Petajisto (2009) showed that the most active stock pickers – as measured by Active Share – delivered the greatest long-term outperformance. Managers seeking to remain within a certain distance of the benchmark ultimately delivered disappointing long-term returns. This work supports the idea that an overreliance on benchmarks as a solution to the principal-agent problem creates a situation in which diversification undermines managers’ ability to deliver alpha.

This is not to lay all the blame for defensive diversification at the feet of the asset management community. In many ways, managers are simply responding to the instructions and incentives provided by asset owners. In particular, any shared understanding between the asset owner and manager on what would constitute a tolerable limit for short-term underperformance (whether formalised in a tracking error constraint or not) would tend to mitigate against holding a concentrated portfolio dominated by high conviction positions. Procyclical hire and fire decisions on the part of trustees – terminating managers after a bad 3 years, hiring after a good 3 years – also provides a strong motivation for managers to avoid concentrated bets that might give rise to extended periods of benchmark underperformance.

Furthermore, the widely followed and reported Morningstar Ratings disincentivise concentrated portfolios by penalising volatility in their rating methodology. In order to maintain a high Morningstar Rating, managers need to avoid benchmark underperformance over 3- and 5-year periods and to minimise the overall volatility of their portfolio. So while most institutional investors should be able to diversify manager-level volatility themselves, asset managers are presented with a host of reasons to reduce portfolio volatility – both in absolute and benchmark-relative terms – in the process diluting their highest conviction positions.

Mitigating defensive diversification

While MPT has created the impression that diversification is always and everywhere a good thing, asset owners would benefit from a more sceptical attitude. Indeed, the argument outlined above suggests that over-diversification favours managers – giving them the ability to raise larger funds while managing career and business risk – at the expense of returns to investors.

Long-horizon investors, whose beliefs and governance structure enable them to tolerate substantial benchmark-relative risk, may wish to consider whether their managers are running portfolios that adequately reflect their high conviction views. Clearly there is no “right” level of diversification, but asset owners conscious of the incentives leading managers to over-diversify, should be willing to challenge their managers over the extent to which their best ideas can have a meaningful impact on performance.

Concentrated portfolios offer no guarantee of superior long-term performance. But asset owners pursuing an active investment strategy need to ensure that principal-agent conflicts do not undermine their ability to deliver long-term returns in the interest of their beneficiaries. This requires careful scrutiny and engagement with managers at the outset of any relationship, a monitoring approach that identifies performance-chasing and defensive diversification, and a decision-making process that can cope with volatile benchmark-relative performance at the individual manager level.