In a world where public portfolio managers are evaluated on quarterly performance, the average mutual fund holding period is less than one year and investment analysis focuses on a narrow range of quarterly and annual financial measures, there are significant pressures on pension funds and their trustees to focus on the now. As a result, funds and their trustees are perceived as searching for short-term gains to the detriment of their long-term investment horizon.
This short-term focus affects risks and returns over the long term for both investors and their portfolio companies. A significant side effect of this short-term investor focus is that corporate executives feel under pressure to manage their businesses to meet the expectations of investors, potentially to the detriment of long-term performance. In a recent survey of corporate executives by the U.S. National Bureau of Economic Research, 78% of respondents said they would decrease spending on long-term value builders, such as research and development, to meet short-term financial targets. The fact that companies are giving up future value to hit short-term targets is bad for long-term investors and bad for the economy.
Short-term investor focus has another side effect of pushing companies out of the public markets, where they are often forced to spend too much time on short-term performance. One of the reasons many private equity and buyout funds have, notwithstanding recent markets developments, outperformed other public investments might be because they allow management the ability to take a long-term view. This enables private investors to capture future long-term performance upside that public equity owners often leave on the table. It is illustrated by two trends:
• The increasing number of companies that are being taken private to pursue strategies that involve plans for more than one or two years; and
• The growing allocations to private markets managers for example $600 billion was invested in corporate buyouts globally in 2006.
Research by McKinsey & Co., New York, shows, across industry sectors, up to 80% of company share value is attributable to cash flow expectations beyond three years out. This value has to be evaluated through analysis of current intangibles or extra financial issues that cannot simply be accounted for in the numbers or pure financial analysis of companies.
However, a major issue is that public market investors lack long-term data and analyses to focus on the bigger picture. The sell-side brokers and other analysts who provide information to mutual and other fund managers tend to focus their research on short-term financial aspects of companies rather than the longer-term issues that have a significant impact on value.
One group of investors pension funds and fund managers has recognized this market failure. The Enhanced Analytics Initiative, London, is a market-based response to the lack of appropriate long-term information upon which to make investment decisions. It addresses the need to cultivate creative sell-side research that better serves the investment needs of pension funds and other investors that have long-term portfolio mandates.
How does EAI do this? The process is simply that it uses the one resource that we know the market responds to: money. EAI members allocate, or encourage their external managers to allocate, 5% of their existing research or broking commissions to generate research targeted to long-term factors and other issues that are harder to quantify. What EAI does is direct this small proportion to firms deemed best (using an independent evaluation process) at producing research that covers non-traditional, longer-term issues.
Enhanced analytics research includes industry regulatory risks, product cycle limitations, company reputation trends, stability of brand strength, environmental liability exposure, personnel turnover and corporate governance. The goal of the EAI is to enhance investment returns over the long-term and reduce exposure to risks not identified through standard financial analysis. This falls squarely within the fiduciary duties of pension funds and mutual funds alike.
EAI was launched in Europe. Now it has 27 members with almost $2.5 trillion in combined assets under management. Members in North America include the California State Teachers Retirement System, Sacramento, New York City Employees Retirement System and the Canada Pension Plan Investment Board, Toronto. Other members include the two largest Dutch pension funds Stichting Pensioenfonds ABP, Heerlen, and Stichting Pensioenfonds PGGM, Zeist, and the two largest U.K. pension funds BT Group PLCs pension scheme and the Universities Superannuation Scheme Ltd., both of London.
Fund manager members include AXA Investment Managers Inc., Greenwich, Conn.; BNP Paribas Asset Management Inc., New York; Hermes Pensions Management Ltd., London; Investec PLC, London, and Robeco Group, Rotterdam, Netherlands.
Research institutions that have received the 5% allocations of brokerage and research fees under the initiative include Goldman Sachs & Co., JPMorgan Worldwide Securities Services, Citigroup Inc., UBS Securities Ltd. and Sanford C. Bernstein & Co.
One of the strengths of EAI is that it does not dictate to research houses what topics should be covered by their research. It only requests that analysts provide increased research on medium- to long-term investment value drivers or other factors that are harder to measure and outside the standard accounting analytical framework. Analysts are the experts in the factors that affect the values of the companies, sectors and markets that they cover, and therefore have insight into potential medium- to longer-term issues.
Pension funds are long-term owners of capital, and as such we should be making investment decisions that maximize long-term performance of assets. EAI provides one mechanism for encouraging relevant information to make these long-term investment decisions.
Christopher J. Ailman is chief investment officer of the California State Teachers Retirement System, Sacramento; David McCann is vice president-relationship investment, Canada Pension Plan Investment Board, Toronto; and Michael Musuraca is an assistant director of District Council 37 of the American Federation of State, County and Municipal Employees and a designated trustee of the New York City Employees Retirement System.