The financial crisis has brought about a renaissance in Keynesian thinking, especially in relation to the debate over austerity vs. stimulus. But the great economist John Maynard Keynes was, perhaps, even more insightful in his analysis of investment behavior: “Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable,” he wrote in his 1936 book, “The General Theory of Employment, Interest and Money.”
This remark would fit just as comfortably in today’s narrative on the excessively short-term behavior of companies and investors; indeed, the World Economic Forum together with a range of other policymakers and commentators have argued for reforms to address the dangers of short-termism that plague the current corporate and investment environment. If anything, we might conclude that we have moved even further from the ideal of long-term investing since Mr. Keynes first identified the incentives that encourage short-term thinking almost 80 years ago.
But before jumping on the Keynesian bandwagon of long-term investing, we should first of all ask: what is wrong with short-term investing? The near future is presumably more predictable than the distant future and a certain volume of trading might be explained by a rational response to the emergence of new information over time. In addition, an actively traded market creates liquidity and there are surely return opportunities to be captured via short-term trading.
We accept the validity of these arguments and instead of simplistically arguing “long term good/short term bad” we would suggest that it is the balance between long-term and short-term thinking that needs to be addressed. Moreover, we think that the predominance of short-term thinking in the financial markets means that the potential rewards to long-term investing are underexploited, thus creating the necessary incentive for a shift toward longer-term approaches.
In the equity market, we might characterize short-term approaches as those where the primary focus is on the share price and long-term strategies as those placing a greater emphasis on the business. Given this distinction, there is evidence to suggest that both short-term and long-term approaches can generate attractive returns over time — for example, there is significant academic support for momentum strategies (which are, by definition, focused on short-term share price movements) and Warren Buffett is perhaps the most famous long-term investor, noting that his “favorite holding period is forever.”
More generally, we believe that both long-term and short-term investment approaches have merit when executed well. However, institutional investors are arguably under-using one of their most significant competitive advantages — their longer time horizon than many other market participants. Investors are overweight short-term strategies and underweight long-term strategies and this is not necessarily by design.
A behavioral preference for quick results and management processes that tend to place a great weight on short-term information drag investors’ portfolios towards short-term thinking. To address this bias requires conscious action on three fronts.
First, at the asset class level, genuinely long-term investors should seek to harvest opportunities only available to long-horizon investors and consider the potential impact of secular trends that might have a dramatic impact on a range of assets and markets.
Secondly, at the asset manager level, investors should consider strategies which behave more like owners of the businesses in which they invest. Managers running concentrated portfolios built without any reference to a benchmark are likely to be less prone to unhelpful short-term behavior driven by benchmark-relative measures (such as tracking error) and are more likely to be able to engage effectively with portfolio holdings.
Finally, at the investor level, more thoughtful monitoring of asset managers should be designed to reflect the nature of the underlying strategy and encourage a constructive dialogue between the asset owner and the asset manager. Monitoring information should focus on measures that are tailored to the strategy, investors should seek to better understand the reasons behind portfolio changes over time, and the manager’s engagement with the company management of the underlying holdings should be scrutinized.
We believe that investors will be rewarded for addressing the balance between the short- and long-term focus within their investment strategy. Specifically, we suggest reviewing the extent to which long-term thinking is reflected at the asset class, asset manager, and investor levels. Investors who do so should be well-positioned, as Mr. Keynes famously put it, to “succeed unconventionally.”
Phil Edwards is European Director of Strategic Research and Nick Sykes is Director, Manager Research, both within Mercer's Investments business.