Long-term investing is a necessity as much as a choice
The long bull market and QE have led to a drastic change in thinking
Amin Rajan
Aston Martin executives celebrate the car group’s trading debut in October. The number of IPOs is falling in the UK and US (Luke MacGregor/Bloomberg)
John Maynard Keynes said: “When the facts change, I change my mind. What do you do?” The current late-cycle phase of the markets has led many pension plans to do likewise with regard to investment periods.
These funds have always been long-term investors with liabilities spanning many decades but the risk-on/risk-off cycles seen in the early 2010s elevated the sequence of returns risk — the time taken by a portfolio to recover after a big hit.
Since asset prices went up step by step but came down in the lift in that period, it was no longer possible to ignore large short-term losses just at a time when ageing memberships meant pension liabilities were fast maturing.
However, the fresh highs scored by the markets have turned the tables by increasing regret risk: sadness at missing out on what is the longest bull market in history with no reversal in sight.
Time in the market is now more important than timing the market. It necessarily means riding it out while the going is good but being prepared to extend holding periods to recover losses when the bears finally arrive.
Such an extension is evident in both the passive and active space, according to my recent surveys. Currently, 80 per cent of pension plans hold their traditional indexed funds for more than two years as part of their core portfolio. The corresponding figure for exchange traded funds is 45 per cent.
Similarly, 63 per cent of pension plans have a holding period of more than five years for their total equity portfolio and 64 per cent for their total bond portfolio. In all cases, the numbers are up lately and expected to rise over the next three years.
They range from pragmatists at one end, who think they have to accept today’s investing as it is, to believers at the other, who opine that it’s time to go back to basics. Indeed, on that spectrum sit four groups.
The first comprises momentum investors who hold that central banks’ quantitative easing has overinflated asset values by borrowing against future returns. It seems wise to go after juicy returns while they last and let time heal all wounds.
The second group is made up of long-suffering value investors who say that current asset valuations, distorted by QE, appear to be defying gravity. With or without policy unwinding, mean reversion will kick in, if history is a guide. The question is not if but when. The third comprises those keen to minimise that most silent of portfolio killer: implementation leakage. It has become all too clear that how asset allocation works on paper is one thing, what it delivers is quite another; the ex post returns rarely match the ex ante promises.
The implied leakage is due to a variety of factors, including style drift that results in unintended exposures, fees and charges that put a drag on returns, and overtrading that creates all manner of hidden costs and inefficiencies.
The problem is exacerbated by the fact that simulations at the portfolio construction stage concentrate on asset choices. They do not take into account how investors’ own actions and reactions introduce new risks, as do the reactions of other investors as they weigh up new situations. Such feedback loops are nigh impossible to unravel, except perhaps in hindsight.
The final group comprises pension plans with strong governance and skillsets that have embraced long-term investing as a part of a new mantra: active ownership. Their view was recently articulated by Stuart Dunbar, the Baillie Gifford partner, in a provocative paper. According to Dunbar, “what passes for active management is simply the second-order trading of existing assets, with the main focus being to try to anticipate the behaviour of other investors. This has little to do with actual investing”.
Thus, equity markets are no longer conduits between savers planning for a decent nest-egg and borrowers who deploy savings to create wealth, jobs and skills. Mr Dunbar’s view is not only supported by the falling number of initial public offerings in the UK and US, but also by the fact that most of those that come to market aim primarily to help owners to cash out rather than raise capital for future growth.
The EU’s second Shareholder Rights Directive, effective from June, seeks to remedy the situation by strengthening the role of shareholders, enabling them to act like active owners rather than passive holders of paper assets. It promotes a new form of stewardship that is free of fads and clichés. Long-term investing is an idea whose time has come. It remains to be seen how it develops from now.
Amin Rajan is chief executive of Create-Research and a member of The 300 Club
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