Tamp down agency risk to promote long-term investing

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21/03/2017

OPINION | The chain of stakeholders in an investment organisation encourages short-term thinking. Applying the right levers to align incentives with longer-term behaviour and outcomes can solve this problem.

There are many things required for an institution to be successful in adopting a truly long-term approach to investing. Over many years of studying the obstacles to long-termism, I have come to the conclusion that it’s a question of latitude and attitude, and that perhaps the most important variable is how organisations manage their agency risk.

Obviously, fund flows have to be secure enough to give an asset owner the latitude to act as patient capital. Most superannuation funds, with the exception of those losing members, do have the long-term funding model in place to support a long-term investment strategy.

But even when the latitude to think long term is there, it is equally important to develop an organisational culture in which all decisions are taken with an attitude consistent with long-term investing goals.

These are some of the conclusions drawn from four separate Centre for International Finance and Regulation (CIFR) research projects in 2016 that examined the characteristics of long-term investors.

Most people think of long-term investing as synonymous with value investing, but it’s not necessarily. A growth investor that buys a company for long-term growth is a long-term investor.

Similarly, people often consider holding periods the measure of whether or not an organisation is a genuine long-term investor, but this is too simplistic.

It’s all about agency

One of CIFR’s projects completed in 2016 was undertaken in close collaboration with The Future Fund, Australia’s $146 billion sovereign wealth fund. The first thing Future Fund managing director David Neal said to me was that he thought the biggest barrier to long-term investing was “the agency issue”.

It took a while to sink in, but the more I thought about it, the more I realised that Neal was right; the agency issue is at the nub of our problem with short-termism.

A typical investment organisation has stakeholders who delegate to the governing board, who delegate to a management team, who may even have sector heads to whom they delegate, and quite often that money gets delegated to external managers. That is a chain of agency delegations filled with risks.

Remuneration and tenure policies are two of the most important levers in mitigating this risk.

The problem with long-term investing is that the end-goal is a long way into the future. You never quite know if a strategy is going to be successful.

It would be sort of nice to say, ‘Here is the money for 10 years. Go away and I’ll come back and evaluate you then.’ But the world does not operate that way and it probably shouldn’t. People should be held accountable along the path.

This is where it all gets tricky.

Align pay

A combination of regular rewards and long-term conditional vesting is one approach to accountability that I like.

Under these arrangements, a manager might earn a bonus, but that bonus wouldn’t vest unless the performance is sustained over, say, five years.

Another useful tool The Future Fund employs is the inclusion of subjective components in bonus structures. This is critical for long-term investing. If a portion of a bonus – perhaps 30 per cent – is about behaviour, rather than just outcomes, it encourages the long-term-oriented actions that you want.

Tenure expectations are also important for fostering long-term investing. If managers think they will be burned and turned every two or three years, then they are going to start behaving in a short-term fashion. I suggest setting an expectation for preferred manager tenures of about 10 years or more.

Fund flows within the industry (both internal and external mandates) respond to short-term performance, particularly with external investment managers, because it affects their profitability and the ability to sustain long positions. Benchmarks and peers act as anchors to short-term behaviour.

Building a culture of transparency and trust right up and down the agency chain is critical if super funds want to deflect attention away from short-term returns and act in accordance with behaviours that lead to long-term outcomes.

This column is based on a presentation to the 2017 Conexus Financial Chair Forum. This article first appeared in the March print edition of Investment Magazine. 



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