Monday, April 11, 2011

World Economic Forum on "The Future of Long-term Investing"

In light of the financial crisis, there has been an increased concern that short-term objectives are outweighing long-term growth and value creation. Long-term investors play a key role in providing direction for corporations and in stabilizing the economy during times of distress. While short-term investing provides liquidity and "accountability on the part of corporate managers…, the market does not seem to be lacking in short-term capital". The World Economic Forum recently released a report, "The Future of Long-Term Investing", which addresses key investment concerns going forward from the financial crisis.

"Long-term investing can be usefully defined as investing with the expectation of holding an asset for an indefinite period of time by an investor with the capability to do so."

The report highlights "life insurers, pension funds, sovereign wealth funds, foundations and family offices" as possible sources of long-term capital. Although these institutional investors manage $27 trillion of the $65 trillion professionally managed assets, there are several constraints (highlighted in the report) that allow only 25% of their assets to be allocated as long-term capital. Moreover, the report expects a "decline in long-term investing by life insurers and pension funds", which have traditionally been the largest long-term investors and have a total of $22 trillion AUM (approximately a third of all professionally managed assets). While family offices, sovereign wealth funds, endowments, and foundations will likely increase their assets…,

"[W]e expect that there will be an overall reduction in the proportion of global investable assets directed towards long-term investing, with potentially significant economic implications."


While the length of time necessary for an investment to be considered "long-term" varies, the report states it is "typically… for at least 10 years or through an entire business cycle". Consequentially, assets ideal for long-term investment are usually riskier and more illiquid. The following classes meet such criteria: direct venture capital, infrastructure, direct private equity, and strategic positions in public equity--the last of which is defined to be, "[m]ajor stakes in public companies often associated with a board position and potential lockup period".

Several constraints hinder long-term investing: liability profile, investment beliefs, risk appetite, and decision-making structure. Moreover, certain constraints impact long-term investors differently. While the constraints for family offices (which have $1.2 trillion AUM) are minimal, the constraints for both pension funds and life insurers (which have $22 trillion AUM combined) are significant--and increasingly so. Consequentially, family offices are able to allocate nearly the same amount of capital toward illiquid investments (~$420 billion) as life insurers, despite having only slightly more than a tenth of the AUM life insurers have. All told, constraints result in total actual illiquid investment by long-term investors being less than one quarter of its potential ($6.5 trillion of $27 trillion potential).


The report lists the three primary benefits of long-term investing,

(1) might offer better returns to certain investors;
(2) could bring benefits to individual corporations; and
(3) may be a 'social good' by helping to stabilize the financial markets, promote global economic growth and bring wider social benefits. (Read the report, The Future of Long-term Investing, for more details)

Long-term investors benefit by being able to access structural risk premia, take advantage of secular themes/ macro trends, impact corporate decision-making, avoid buying high and selling low, and minimize transaction and market disturbance costs.

The report states that while academic literature is unclear on the size and length of abnormal announcement returns due to long-term investor presence, "there is strong evidence presented… that sovereign wealth funds induce positive abnormal returns for target investments, at least for a short [period of time]". (Note - Research papers concerning shareholder activists have generally shown positive abnormal short-term and long-term returns (read more)).

Moreover, many believe that the financial crisis has indicated that the short-term liabilities of a corporation could compromise its long-term investment portfolio and focus. Equally troubling is the fact that some managers have focused on the short-term as a result of principle-agent problems, unfavorable valuations from takeovers due to temporarily depressed earnings and imperfectly informed stockholders (Stein, 1988), and rational market adjustments to earnings inflation (Stein, 1989), to list a few. Hence the importance of shareholder activism,

"If short-termism can be shown to exist, it offers a powerful argument for the offsetting benefits of activist investors with a long-term horizon… [S]hareholders would become aware of the negative effects of [short-termism] and act to prevent them."


During the financial crisis, many long-term investors failed to properly cover their positions and to "reallocate capital to equity when the value of equity holdings dropped". The financial crisis also saw unanticipated highly correlated declines between different asset classes. This experience raised questions concerning ideal portfolio diversification.

"For many investors..., the crisis and the current economic climate have raised tough strategic questions and highlighted the need for rebuilding investment frameworks and governance processes."

Among some of the governance process and investment framework changes we can expect from long-term investors: explicit clarity of investment beliefs and their implications; debate within organizations about risk exposure, especially considering liquidity and regulatory constraints; frequent dialogue with stakeholders; greater accountability balancing short-term considerations with longer-term ones; and the development of compensation schemes beter aligned with the long-term.

In addition, the report states, "There are also signs that long-term investors have become more interested in select hedge funds" for improved alpha, as well as risk and volatility reduction.


For both long-term investors and policy-makers, the World Economic Forum lists six recommendations "to ease the constraints on long-term investing and increase the benefits that flow from it".

In regards to shareholder activism, the report makes clear,

"It is... important to stress that shareholders can and should hold management accountable for their actions and direct them to manage their business towards the creation of long-term value"

The report also goes on to implicitly note the constraints to shareholder activism, "Although this [above statement] sounds like an uncontroversial recommendation, many corporations do not necessarily welcome the active involvement of shareholders". The World Economic Forum encourages "responsible ownership that plays a measured and active role while not exerting undue influence to promote the investor's aim at the cost of the corporations and other shareholders". Accordingly, the report concludes by proposing that long-term investors:

- "make the exercise of ownership rights part of the mandate of an investment manager";
- "investment managers could work with their investee companies to help develop long-term goals and identify long-term risks";
- "long-term investors could work with each other to promote long-term decisions on the part of the corporations in which they invest".

Read The Future of Long-term Investing

Posted by David Schatz