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Playing the long game: Investing effectively beyond the market cycle

The investment industry spends far too much time focussing on short-term, benchmark relative performances, entrenched an “era of quarterly capitalism”1. Moreover, short-termism delivers substandard returns for asset owners and for the financial ecosystem. True long-term investing is still extremely rare when it comes to active management in the public markets. In his paper, ‘Playing the long game: Investing effectively beyond the market cycle’, Eoin Murray, Head of Investment at Hermes Investment Management, looks at how long-term investing could be done.

Defining characteristics of long-term investing

Alignment of interests
A crucial component and foundation for successful implementation is to better align the interests of asset owners and managers. Asset owners can set the tone and be leaders in developing balanced, long-term capitalism that ultimately benefits everyone. It is imperative to employ consistent processes and practices that look beyond short-term market turbulence and concentrate on the long-term fundamentals and drivers of a company’s strategy.

Risk
Eoin Murray, Head of Investment, Hermes Investment Management, said: “There needs to be a renewed focus on risk. Like short term investing, long term investing has its own set of issues and investors have to be aware as well as able to manage the uncertainties that will occur. This not only involves looking at the key risks but also the risk appetite and measures that need to be adopted. Risks will vary depending on the organisation and their particular requirements and strategies.”

A primary philosophy should be applied in order to calculate and communicate risk throughout the different levels of an organisation. However, there is no single metric that can fully capture risk, which is why investors will need to apply a range of metrics linked to different time horizons. Equally as valuable is the establishment of minimum acceptable risk levels and acceptable expected returns. This is because too little risk can cause an organisation to miss its performance targets and fall short of meeting its liabilities or other strategic objectives.

Benchmarking
When selecting benchmarks, institutional investors need to review their current stable to see whether they hinder or reinforce long-term investing and, if any adjustments, additions or replacements are required. However, more work is still needed to create benchmarks that foster a longer-term orientation.

Murray stated: “Wider adoption by asset owners and managers could help exert greater influence on boards and management companies to employ strategies aimed at long-term growth and cash flow generation rather than short-term impact on stock price.”

Unlocking value through engagement and active ownership
By integrating ESG into the investment decision making process, mangers are able to alleviate ESG risks as well identify those companies exploiting the benefits. Furthermore, there is a growing body of academic research highlighting the correlation between better company ESG performance and higher-quality management, stronger growth and lower cost of capital as well as superior, risk-adjusted performance over the long-term.2 “Our stewardship and engagement team, Hermes EOS, is focussed on helping institutional investors around the world to meet their fiduciary duties by becoming active owners of public companies and effecting change through engagement3. For us, the link between these topics and long-term value for companies and investors is clear,” said Murray.

Turnover
Additionally, asset owners should be careful of misjudging the impact of turnover on their equity managers’ portfolios, as it can both hide costs, and acts as a reasonable proxy for the short- or long-term behaviour of managers.

Murray continued: “Warren Buffet put it best, ‘If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.’ Going forward, asset owners should monitor asset managers against expectations in turnover as well as portfolio characteristics and drivers of activity.” The actual returns versus the hypothetical buy-and-hold performance of the portfolio should be compared over a given period, to assess the benefit of portfolio turnover.

Portfolio construction and Holdings
There is no ‘right’ size for a genuinely long-term portfolio, but it is reasonable to believe that smaller portfolios enable deeper fundamental research and engagement, which in turn incentivises companies to adopt a longer horizon and more sustainable business practices. By contrast, a larger number of holdings makes it difficult to conduct such comprehensive and detailed research, rendering meaningful engagement impossible, without incurring unacceptable costs.

“Communication is vital and asset managers need to be clear with asset owners that the relationship between the number of stocks in the portfolio and their ability to conduct comprehensive fundamental research as well as achieve the objectives of long-term investing,” stated Murray.

Portfolio construction will differ according to institutional investors’ requirements and restrictions although there are common themes. However, long-term-term investors will be more concerned with a company’s capacity, to generate healthy cash flows and its reinvestment decisions.

Organisational culture
Murray said: “Changing culture within an organisation is often compared to turning a tanker ship around, but there is no doubt that long-term sustainable investing requires a new work environment, mentality and skillset…..Culture can be the glue around which alignment and trust are built, orienting a relationship naturally towards the longer-term.”

In order to effect a change in organisational culture, managers need to have cognitive flexibility; the ability to be creative and think outside the box; a feeling of ownership in the organisation and finally, citizenship, with the desire to go exceed the responsibilities of their role for the good of the company.

Suitability
The relationship between the asset owner and manager is an essential component in cultivating a long-term, sustainable culture. Before selecting a fund manager, asset owners need to conduct stringent due diligence that carefully assesses people, philosophy, processes and potential partnership. While past performance should be taken into account, there needs to be a stronger recognition of the role that luck can play in generating returns over a short period.

Murray said: “Asset owners should look behind the figures at the characteristics and context of performance as well as the portfolios and processes that the manager has built. Lengthening the period of evaluation allows the noise (short-term volatility) to begin to wash out and the signal (alpha skill) to shine through, while for shorter time periods noise dominates. In other words, luck may dominate in the short term, but skill is the key in the long-term.”

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Source: Hermes IM

Measurement
The metrics that calculate the long-term performance and health of companies such as ten-year economic value added, research-and-development efficiency and multiyear returns on capital investments are lacking and do not capture ESG outcomes. At Hermes, we have taken the decision to change our style of reporting and reverse the ordering of horizon – our clients will have their attention drawn to changes in wealth over longer periods over shorter horizons”.

“There is a great deal more work to be done by the asset management industry in promoting and adopting a long-term investment horizon. While all stakeholders have their part to play in reshaping the industry, asset managers should be encouraged to better align their interests with asset owners and move to balanced, long-term capitalism that ultimately benefits investors as well as society. In addition, their boards need to have the requisite skillset and understanding of the issues, there are mechanisms, measurement tools, frameworks and processes that can be implemented to reduce short-term pressures and promote long-term countercyclical performance,” concluded Murray.

Download the full paper.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.

  1. 1Haldane, A G, (2010), “Patience and Finance”, speech given at the Oxford China Business Forum, Beijing
  2. 2Clark, Gordon L., A. Feiner, & M. Viehs (2015). ‘From the Stockholder to the Stakeholder – How Sustainability Can Drive Financial Outperformance’. Research Paper, University of Oxford.
  3. 3https://www.hermes-investment.com/ie/wp-content/uploads/2018/10/hermes-eos-stewardship-brochure-august-2017.pdf

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