Understanding what success looks like
When is a long-term investor successful? In the authors’ opinion, three things matter: net long-term return, risk and the contribution to societal objectives.
Jaap van Dam says: “In traditional active management, the benchmark is the reference point to achieving your goal; any deviation from it is classed as ‘risk’. One must think relatively and often on a short-term basis to reach an objective.”
The authors argue that, instead of following a benchmark, the route to successful long-term investing requires taking a fundamentally different, holistic path.
Lars Dijkstra explains: “Both in advance and during the journey of a successful long-term investment flight plan, you must be able to explain why it is a better path than the standard route – for example: ‘the portfolio is more resistant to shocks than the benchmark’ or ‘CO2 emissions are lower’. The risk definition is therefore not about relative risk, but about absolute risks. A “trust me” approach will not do in an institutional context. Any argumentation must be firmly substantiated.”
Identifying the governance weakest link
The long-term investor can act fundamentally differently than the average market participant, but this can be highly uncomfortable and lead, the authors say, to a principal-agent problem.
van Dam states: “The pension fund board must have the confidence that both the long-term strategy and the manager will deliver in the longer term. Concurrently, the manager must have the confidence that the outsourcer has the endurance needed to successfully execute the strategy and not pull the plug, in the case of short-term disappointing results.”
“It is a problem of varying stakeholder horizons. The outsourcing of pension funds is typical: The participant with a very long horizon outsources to the pension fund – often managed with a much shorter horizon. The fund outsources to a fiduciary manager or a consultant – often with a contract that needs to be renewed once every five years. The fiduciary manager or a consultant then outsources to one or more asset managers.”
Between participant’s horizon and the long-term investment strategy of the asset manager, exist a number of parties with much shorter horizons. These parties have an interest in not reporting any setbacks on the horizon relevant to them. Thus, the party in the chain with the shortest horizon determines the horizon of the entire chain. But as pension funds need to serve the long-term interests of the participant, it’s critical to reduce this disconnect.
Are principal-agent problems solvable?
Traditional principal-agent issues can, to a large extent, be limited or resolved. The authors assert success starts at the front. If the pension fund does not have the desire to be a long-term investor and reap the potential benefits, chances of success are slim. This requires explicit long-term goals and a good idea of expected interim results. This, the authors insist, must be alloyed with a solid set of investment beliefs.
van Dam says: “Where there is a short chain between asset owner and asset manager, we advocate internal management by the pension fund – provided that, of course, it can organise the associated competencies – or choose external management by a party very close to the outsourcer in terms of culture and investment beliefs.”
Shaping a long-term mandate
The authors also pose the question of what a well–governed, long-term mandate looks like in practice. They apply four factors to shape a successful process: philosophy, performance, people and price.
“In the area of investment philosophy, a deep-seated alignment between the asset owner and asset manager is crucial. ‘Beliefs’ should preferably be a ‘constitution’. And the core of the constitution is a portfolio focus on companies over securities. This may sound trivial, but it certainly isn’t. Over the past thirty years, the vast majority of the financial industry was obsessed about trading shares instead of investing in companies”, Dijkstra argues.
Performance objectives can be defined both absolutely and relatively by the asset owner, the authors argue. The traditional short-term measures of risk that measure the volatility of share prices are not very meaningful. We propose a number of risk measures that provide a better insight into the risks of operational development of the companies in the portfolio. The real risk of the asset owner is not meeting his long-term objectives. Permanent loss of capital is then a much more relevant measure, or e.g. the absolute Value at Risk.
Taking a holistic approach
The establishment of a long-term mandate requires a fundamentally different approach. For an asset manager to be on the right track requires building a shared insight into process, results and trust.
Dijkstra explains: “This means distinguishing between financial risks as well as non-financial risks. ESG risks and opportunities must be identified. It is thereby important the asset manager maps out the efforts (input) and the results (output) of his engagement for all companies in the portfolio.”
Fees are for long-term alignment
In the authors’ shared opinion, incentives can never compensate for the lack of the right people or the right culture. Nevertheless, incentives that contribute to the alignment between asset owner and asset manager are an important part of a long-term mandate.
Dijkstra and van Dam conclude: “Much more alignment should be created between the asset owner and the asset manager over time. Owners can commit to a longer-term relationship by handing out long-term mandates. Decelerating management fees and accelerating incentive fees can provide owners with better alignment and is possible with the commitment to a lock-up period that gives managers more stability. Either fee structure for a long-term mandate should create space for patience and reduce the need to try to time market prices. ”