It may sound obvious but a fundamental differentiator between long-term and short-term investors is time: while long-term investors have the ability to wait until difficult market conditions have passed, short-term investors are under pressure to act.
Sarah Williamson, chief executive of FCLTGlobal, a not-for-profit organisation dedicated to encouraging long-term behaviours in business and investment decision-making, argues the additional element of time enables long-term investors to generate more return because they can earn this “patience premium”.
This, she says, allows investors to ride out some ups and downs and absorb some volatility – and yet, difficult market conditions can push long-term investors into faltering in their investment beliefs. “Theoretically, they have the ability to earn that patience premium by waiting – but people are people and, when things get stressful, they tend to become nervous and shorter-term,” Williamson explains to Expert Investor.
Sustainable value creation
Sustainable long-term value creation strategies can generate higher returns from individual companies through longer holding periods, a 2016 report by the University of Cambridge Institute for Sustainability Leadership (CISL) has found. Investors can capture longer-term value from these strategies – including, for example, lower costs from lower trading levels, the report notes.
Since British economist John Kay published his report on long-term decision making in 2012, discussions on how to shift financial markets away from excessive short-termism have been ongoing.
Excessive short-term pressure on companies to deliver returns leads to underinvestment, economic inefficiency and poor decision-making by corporations, the CISL report writes, adding that short-termism in investments is regularly cited as a barrier to companies advancing sustainable growth. As a result, regulators have increased their efforts to promote more long-termism in financial markets – one example being the evolving EU sustainable finance regulation.
While no commonly agreed definition exists, CISL defines long-term and sustainable investments as those that increase long-term value creation by companies and are characterised by a clear and disciplined investment philosophy, process and culture.
Rather than looking at short-term factors determining share prices, these investments focus on how long-term factors generate companies’ earnings. These, it adds, have a likely timeframe of five or more years and include committed stewardship.
For its part, FCLTGlobal recommends investors take five core actions to improve long-term outcomes in their portfolios: form investment beliefs; write a risk appetite statement; create a benchmarking process; carry out evaluations; and set up incentives and investment mandates.
Target setting is key
Williamson explains the purpose of an organisation should drive its beliefs, long-term strategy and target setting while a report by FCLTGlobal notes: “The best long-term investors set internally consistent targets for expected return, final shortfall and interim drawdown.
“Importantly, these funds can then maintain those strategies during periods of stress rather than changing course in the face of short-term pressure.”
Even so, investors’ target-setting is often out of kilter with their actual comfort level. Williamson emphasises that investors need to be prepared to take a drawdown if they set themselves unrealistic return targets. “If they’re unwilling to take the risk of losing money, then it’s very hard to meet a more aggressive, long-term return target,” she says, calling on investors to have an honest conversation about their ability to afford higher risks and losses.
Examples
As Ontario Teachers’ Pension Plan director Mark Blair explains: “The partners understand the balance we must achieve between appropriately managing our risk of loss and being able to take enough risk to earn our overall expected return and fulfil our mandate.
“As such, they are very realistic about setting these parameters, which in turn helps Ontario Teachers design an overall investment strategy and asset allocation, allowing us to earn our expected return without undue risk of loss,” he notes in the FCLTGlobal report. Over a five-year period, the fund returned 8% net, as at 31 December 2018.
The Canada Pension Plan Investment Board, with $409.5bn (€375bn) of assets under management, relates its actual investment portfolio to its strategic and reference portfolios (see chart below).
It tracks the effect of strategic asset allocation decisions, which can help boards to learn from experience and improve their risk management skills. The CPP fund returned an annualised rate of return of 10.3% net over five years.
The FCLTGlobal argues that, as institutional investors have liabilities towards their beneficiaries, “meeting both long-term obligations and short-term expectations means that even the longest-term investor must manage across multiple time horizons”.
Win long and win short
In Will Oulton’s view, however, long-term investors do not need to manage multiple time horizons and accommodate short-term volatility. Oulton is global head of responsible investment at First State Investments and a lead author of the CISL report.
“Our investment horizon comprises three, five and 10-year periods, which means short-term volatility of three months is a little bit of noise when, generally, you’ve got that view”, he tells Expert Investor. “Environmental, social and governance (ESG) driven funds tend to perform well during those type of [short-term] conditions, because they don’t tend to be subject to that kind of volatility. They tend to be a bit more stable.”
First State Investments changes holdings based on its stewardship process, which is central to the firm. Accordingly, Oulton sees the biggest risks to investments coming from a company’s management team rather than from the market.
Federated Hermes also believes in the overall larger value that can result from long-term investments. Michael Viehs, head of ESG integration, international, at Federated Hermes, explains that a long-term perspective matters also for short-term investments, making it a win-win situation, adding: “There’s always this benefit from this longer-term engagement in a shorter-term world.”
Viehs highlights how stewardship engagement makes companies “more resilient to certain ESG externalities” and leads to a significantly lower risk profile in terms of downside risk from a cost of capital perspective.
A 2019 survey, in which Viehs participated, found that “while ESG factors may more broadly reflect longer-term considerations, they represent potential short-term risks that can impact money market and liquidity instruments”.
“Integrating ESG factors into money market and liquidity portfolios helps maintain utmost confidence in the high-quality, minimal credit risk requirements to achieve the objectives of principal stability and liquidity while maximising return,” the study concludes.
Stress-testing results
The European Insurance and Occupational Pensions Authority (Eiopa) stress-tested Institutions for Occupational Retirement Provision (Iorps) on their resilience. It also surveyed them on their preparedness to integrate sustainability factors in their risk-management and investment allocations.
Of 176 Iorps surveyed, 30% have processes in place to manage ESG risks and 19% assess the impact of ESG factors on investment risks and returns, showing a great variation.
Sandra Hack, principal expert at the risks & financial stability department of Eiopa, found in her cashflow analysis that European pension funds are able to withstand short-term volatility. “Short-term volatility of asset values does not necessarily affect the balance sheet of pension funds,” she explains.
That said, Hack says, “adverse developments will have an extreme long-term effect on some pension funds – in particular on their members and beneficiaries”.
ESG factors can play a central role to future investments, Hack adds, concluding that, while ESG cannot protect you from short-term volatility, if integrated properly, the chances that investments will be more sustainable and ‘survive’ are improved.
