Investing for the Long Run

Long-horizon investors have an edge. Sadly, they too often squander their advantages. That is often caused by shortcomings in their own governance structure and lack of alignment with their delegated managers. We discuss these issues in our paper, Investing for the Long Run, which was recently made publicly available on SSRN.

Long-horizon investors have the ability to reap risk premiums that are noisy in the short run and only manifest over the long run. They can acquire distressed assets when investors with over-stretched risk capacity have to sell. They can also pursue opportunities to invest in illiquid assets. The paper describes two pitfalls that hinder long-horizon investors in fully exploiting their advantage: procyclical investing and misalignment between asset owners and managers. These are intertwined. Counter-cyclical investing requires strong governance structures to withstand the temptations of selling in blind panics when asset prices drop. Agency conflicts contribute to procyclical investment behavior.

The California Public Employees’ Retirement System (CalPERS) is mentioned as an example of an investor that over the last decade has squandered its long horizon. Many other investors share the same characteristics. First, CalPERS has been pro-cyclical. In the panic of 2008 and 2009 when risky assets were cheap, it failed to rebalance due to severe liquidity problems. CalPERS sold, rather than bought, equities. When real estate was on a tear during the mid-2000s, CalPERS rode the bubble with over-weight positions, which peaked right when the market crashed in 2007. Second, CalPERS’ performance has been hindered by agency problems. It has been affected by pay-to-play scandals. In real estate, it entered joint venture agreements where CalPERS held all the risk and it could not effectively monitor external managers.

To take advantage of the long-run advantage, we advocate four basic steps: 1) institutionalize contrarian behavior, 2) build a robust factor portfolio to harvest many sources of factor risk premiums, 3) create close alignment between asset owners and managers, and 4) demand sufficient risk premiums for illiquid investments.

Investors can institutionalize contrarian behavior by adopting a rebalancing rule. Avoiding procyclicality also requires redefining the concept of risk away from just volatility. Low volatility often coincides with low expected risk premiums, which are a more relevant concept of risk for the long-run investor who can withstand short-term fluctuations. Investors should practice factor investing and build robust factor portfolios. Long-term investors can harvest many sources of factor risk premiums. They should go beyond asset classes and use the underlying factor risk premium drivers as the basis for portfolio construction.

Doing these investment practices requires creating close alignment between asset owners and managers. The decision to take factor risk should be a top-down decision and anchored throughout the organization. To capitalize on the long horizon, there must be consistency and buy-in from both the principal (the asset owner or the stakeholders of the fund) and the agent (the fund manager). In fact, the two most important decisions in fund management should not be delegated to agents—the level of risk to be taken and the key sources of risk premiums to be exploited.

Successful long-horizon counter-cyclical investing can be done only when the principal and agent, in each principal-agent relationship, can tolerate short-term losses. These losses are transitory and the product of investment strategies that earn risk premiums that can only be verified over long horizons. Finally, long-term investors can also pursue illiquid investments. But, acquiring illiquid assets comes at a cost in not being able to rebalance and not having “dry powder” to buy distressed assets during bad times. Investors should charge significant premiums for bearing illiquidity risk. We state that these illiquidity hurdle rates should be large.

Agents often have shorter horizons than their clients as they focus on short-term performance through the fees they generate. Investors often chase returns, so agents have incentives to maximize short-term returns to generate flows. Managers normally know much more about the risk characteristics of their portfolios than asset owners. That asymmetric information generates opportunities to “fake skills” where managers can hide risk so they are paid more than their true value-added relative to the correct risk benchmark. While performance in the long run is a series of short-run returns, the strategies taken by managers to maximize short-run returns often take concentrated risk that is not readily observable ex ante, or take risk that has only a small probability of being realized over short periods, and would not be optimal for a long-run horizon.

Contract design can mitigate agency problems to some extent by defining the investment universe precisely and setting explicit time horizons for performance measurement. Perhaps a more effective way to counter the informational and skill advantages of managers, however, is to upgrade the asset owner’s own investment competence, increasing the ability of asset owners to assess, monitor, and evaluate their agents.

According to the paper, an understanding of the key factor drivers of risk and return, and knowing how to efficient tap into these factor drivers, as a way to counter the traditional disadvantages of asset owners relative to managers should be spelled out explicitly in the asset owner’s investment beliefs, where the asset owner is represented by a Board of Trustees, Ministry of Finance, Parliament, or similar governing entity. The investment beliefs should include the basic reason for taking risk, and the perceived link between risk taking and the purpose and objectives of the fund. The board should have a clear stance on why and how risk taking is compensated and the expected reward to risk ratio that such risk taking should produce. Through time, this should be tested by evaluating realized returns against ex-ante expectations. Finally, the board should write down its view on own ability to select and monitor agents and how it can handle potential agency issues. This procedure will ensure that the board, as representative for the ultimate owner of the fund, will own the bulk of the risk taking of the fund. Crucial to this process is an understanding why losses can occur and forming appropriate responses.

The full paper is available for download here.