Fostering ‘Long-Termism’ in Investing
Authored By: Keith Ambachtsheer | Publish Date: 05/08/2017
Authored By: Keith Ambachtsheer | Publish Date: 05/08/2017
When one talks about market efficiency, it is important to distinguish between ideas whose implications are obvious and consequently travel quickly, and ideas that require reflection, judgment, and special expertise for their evaluation, and consequently travel slowly. The second kind of idea is the only meaningful basis for long-term investing. ‒ Jack Treynor, 1976
By: Keith Ambachtsheer
Originally published in the May 2017 ‘Ambachtsheer Letter,’ this article is required reading for attendees of the June 2017 ‘Forum of the Rotman International Centre for Pension Management’ where the ‘Fostering ‘Long-Termism’ in Investing’ topic is on the agenda (Long-termism).
There was a time when ‘active management’ in investing meant beating the market through active trading. Economist John Maynard Keynes called it “beauty contest investing” in his 1936 book ‘The General Theory of Employment, Interest, and Money.’ He lamented that most professional investors seemed to show little interest in real investing: the long-term transformation of financial savings into wealth-producing capital. Entering the institutional investment world in 1969, I concluded quickly that not much had changed since Keynes’ days.
However, recently, a new form of active management is unfolding. While the form is new, the ideas behind it are not. A still-small group of institutional investors has taken up Keynes’ assertion that real investing is the long-term transformation of savings into wealth producing capital. A growing body of evidence supports the logic that this ‘active ownership’ form of investing is not only good for society, but for its implementers and their clients as well. The challenge for us today is to foster the wide-scale adoption of a long-termism mindset in investing. This Letter offers eight concrete measures to that end.
Keynes on Active Management
The year 1969 saw my transition from an unfocused PhD (Econ) candidate to a focused implementer of (at that time) Modern Portfolio Theory (MPT) for a large institutional investor. Within six months of entry, I had read the relevant MPT literature and met its key authors. Bill Sharpe and Jack Treynor were especially helpful. At the same time, I began to absorb the culture of the institutional investment world. There was an inside hierarchy of portfolio managers, research analysts, and traders and an outside broker hierarchy of sales people, research analysts, and traders. This self-contained world had its own ‘soft dollar’ transaction currency as well as great lunches, dinners, and other benefits that would be considered outrageous today.
There were also clear rules about how this institutional investing world operated during working hours. Outside clients hired investing institutions such as mine to manage their pension assets for a fee. At the other end of the chain, brokers fed an ongoing stream of trading ideas into our investment department. Perceived good ideas were accepted and acted upon, leading to trades with the broker the idea came from. What was the objective of these trades? To generate higher portfolio returns than other managers trying to do the same thing.
All this triggered a vague recollection. Keynes had described this behaviour in his 1936 book. I dusted off my copy, and there it was in Chapter 12! It offered a good description of what I observed: “beauty contest” investing in action, with the goal of buying stocks now the market would deem most beautiful six months hence, and selling those the market would deem ugly. Keynes observed that while this game might be entertaining for its participants, it was far removed from the economic purpose of investing: transforming savings into wealth-producing capital. As to actual investment performance, logic suggests “beauty contest” investing should be a zero-sum game less costs, and actual outcomes seemed consistent with that logic.
MPT to the Rescue?
Would imposing a dose of quantitative discipline on these mainly qualitative portfolio management processes improve performance? That was my job to find out. It was fine to have access to quantitative optimization tools that maximized net expected returns at different risk levels, but how good were the return forecasts? Measuring the predictive accuracy of these forecasts became my main professional occupation over the course of the 1970s, first inside my employer organization and later externally on a much broader scale. What conclusions did this work lead to? It was summarized in a 1979 Financial Analysts Journal (FAJ) article:1
So at least on paper, MPT-aided active management could indeed add value. However, I found very few portfolio managers willing to operate within the confines of this rigid optimization regimen. The vast majority chose to continue playing the beauty contest game. Why? This is how Nobel Laureate Daniel Kahneman put it in his 2011 book ‘Thinking – Fast and Slow’: “Given the professional culture of the financial community, it is not surprising large numbers of individuals in that world believe themselves to be among the chosen few who can do what they believe others cannot.”
Rethinking Active Management
So as the 1980s came into view, my time had come for another career change. It would be sparked by reading Peter Drucker’s 1976 book on pension economics and management: ‘The Unseen Revolution.’ He envisioned that it would be through boomer demographics and the related accumulation of retirement savings that workers would end up owning the means of production, rather than through Karl Marx’s 19th Century vision of violent revolution. Drucker raised three questions about the implications of the peaceful pension revolution he foresaw:
Even in the early 1980s, the right normative answers to Drucker’s three questions were clear to me:
What does all this have to do with rethinking active management and promoting long-termism? It is the need for pension organizations to generate high-enough long-term investment returns to make adequate pensions affordable. This takes us back to Keynes’ observation that real investing is transforming savings into wealth-producing capital. The quality of this transformation, rather than zero-sum beauty-contest investing, should be the focus of active investment management today. To make the distinction clear, let’s call this form of investing ‘active ownership’ investing.
Four ‘Active Ownership’ Foundations
Luckily, the implications of ‘active ownership’ investing do not have to be developed from first principles. Four key building blocks have been in place for many decades:
Four Large Database Studies
Consider the findings of four studies:
What should we make of the findings in these studies?
Inductively, CP discovered portfolios that combined high concentration and low turnover had materially higher average investment returns than portfolios without these two characteristics. HKM went further by finding that low turnover, high concentration investors favored companies with high scores on governance quality, shareowner proposals, innovation, return on capital, and dividend payouts, and low scores on take-over defenses, incidence of managerial misbehavior, financial leverage, and volatility of sales, costs, and earnings. These findings are consistent with the premise that low-turnover, high-concentration investors are ‘active ownership’ investors.
Deductively, the KSY and McKinsey studies start with the logic that some corporate behaviors are consistent with ‘active ownership’ and shareholder value-creation, while others are not. As ‘active ownership’ proxies, KSY use the KLD corporate sustainability ranking protocol that started in 1988. Their innovation was to weight the KLD scores with SASB’s corporate materiality scores. The McKinsey team used their own databases to create rankings of the quality of corporate investment decisions and public disclosure protocols. In the end, both ‘active ownership’ proxy models were able to distinguish between high- and low-value creating investments over 15-20 year time periods.
The inductively and deductively-derived research findings are mutually supportive. The former discover exceptional investment results and identify ‘active ownership’ drivers supporting it. The latter posit the ‘active ownership’ drivers of corporate value-creation and discover that portfolios that embody them indeed experience exceptional investment results.14
The Cases of Three Active Owners
My re-reading of Keynes’ Chapter 12 back in the 1970s raised a puzzling question: how did he know so much about the strange world of institutional investing that I was just discovering? I learned only recently that as a sideline, he managed the King’s College/Cambridge University Endowment Fund from 1921 to his death in 1946. Keynes was an early institutional investor himself!
Cambridge’s David Chambers and Elroy Dimson computerized the Fund’s 1921-1946 trading and valuation records. Keynes flailed about at first (i.e., behaved like a beauty contest investor). However, he learned from his early mistakes and by the 1930s he had become a low-turnover, high-conviction ‘value’ investor. In a 1938 speech, he said the best strategy ”…is to carefully select a few investments having regard to their intrinsic value for a period of years ahead…”. Chamber and Dimson estimate the portion of the Fund he had discretion over generated a 25-year net excess return of 8%/year over a passively-managed fund with the same risk characteristics.15
And we have already met Graham and Dodd’s most famous ‘active owner’ Warren Buffett. The article “Buffett’s Apha”, reported his 1976-2011 (35-year) net excess return was 13%/year.16 In his 2000 book “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investing”, Yale University’s David Swensen integrates the Keynes and Buffett stories, and summarizes the five common success drivers as:
Swensen himself had already been applying these rules to managing the Yale Endowment for 14 years, as he continues to do to this day. The Yale Endowment Fund has generated a net excess return of 4.3%/yr. for the last 30 years.17
While the Keynes, Buffett, and Swensen case studies stand out in terms of exceptional long-term investment results and wide name recognition, similar additional ‘active ownership’ cases come to mind.18 Taken together, these cases raise an important question: can the ‘active ownership’ style of investing be implemented without the vision and leadership of unconventional, strong-willed individuals such as Keynes, Buffett, or Swensen?
A Fourth Active Owner
This question leads to a fourth case study, triggered in 1986 by Robert Nixon, Treasurer of the Canadian province Ontario. He commissioned an investigation “to determine whether the current methods and approaches of Ontario’s public sector pension funds most appropriately meet the needs of present and future pension beneficiaries”. As a taskforce advisor, I made the case for creating pension organizations based on the three principles Peter Drucker had set out in 1976: clear mission, strong, knowledgeable governance, and the ability to access the requisite resources for mission achievement. This became a key recommendation in the taskforce 1987 report titled “In Whose Interest?”
An obvious candidate for the Drucker treatment was Ontario’s Teachers Pension Plan. It had been a government bureaucracy for decades, with all of its assets ‘invested’ in non-marketable Ontario bonds. Treasurer Nixon and Margaret Wilson, President of the Ontario Teachers’ Federation (OTF), jointly agreed to transform the teachers’ pension plan bureaucracy into a new kind of pension organization. Legislation was drafted to create the Ontario Teachers’ Pension Plan (OTPP) as an arms-length entity jointly-owned by the Ontario Government and the OTF. A board selection protocol was agreed on to ensure the organization would benefit from strong, knowledgeable governance. The board was given a clear mandate to hire a top-notch executive team at market-competitive compensation rates to manage the organization.
January 1, 1990 marked the beginning of the new organization. OTPP almost immediately swapped a large part of the returns on its 100% non-marketable bond portfolio for equity market returns. It began to build internal investment capabilities, especially in private markets. It initiated incentive compensation for its internal investment team. It privatized Canada’s largest publicly-traded real estate company Cadillac Fairview, which continues to be OTPP’s wholly-owned real estate subsidiary to this day. It initiated a formal balance sheet risk-budgeting protocol. It set unusually-high disclosure and reporting standards for itself. Through all this, it became an increasingly visible ‘active owner’ on a global scale, even to the point of acquiring Glass Lewis, the globe’s second-largest corporate governance/proxy advisory firm. Over the 1990-2016 period, OTTP has generated a net excess return of 2.2%/yr. versus an equal-risk reference portfolio, amounting to a cumulative $37 billion in incremental assets.19
OTPP’s unconventional structure and ‘active owner’ investment successes have not gone unnoticed. They were copied in the creation and management of the Canada Pension Plan Investment Board, as well as by other major Canadian pension funds. The Economist publication took note of these developments in a 2012 article titled “Maple Revolutionaries”. The underlying Drucker ‘success’ principles are now taking hold in the redesign of other major pension organizations around the world. These organizations are now banding together in the execution of their ‘active ownership’ investment programs through collaborations such as the Aspen Institute20, the UN-sponsored Principles for Responsible Investing (PRI), Focusing Capital on the Long-Term (FCLT Global), the World Economic Forum (WEF)21, and the Rotman International Centre for Pension Management (ICPM). Silicon Valley is making its own contribution by fostering the creation of the Long-Term Stock Exchange (LTSE).22
Three Barriers to Long-Termism
All this is not to say that the ‘active owner’ style of investing is now decisively winning the day. A recent portfolio turnover study involving 3500 long-only active equity fund managers in the Mercer database reported an average annual turnover rate of 60%.23 This suggests there is still a lot of ‘beauty contest’ trading going on.
Given its social and financial value-creating potential, its strong conceptual foundations, and its growing empirical validation, why is long-term ‘active ownership’ investing still not the dominant investment paradigm today? I see three mutually-reinforcing barriers:
The question is: how do we get to a barrier-breaking tipping point?25
Breaking Down the Three Barriers
Malcolm Gladwell’s 2000 book “The Tipping Point” offers examples of how individuals, groups, or events can trigger changes in what people think and do in such diverse fields as health, education, crime, and transportation. Can we get to the critical mass of people and events needed to act as catalysts to change the short-term ‘beauty contest’ convention in institutional investing?
It will require ongoing sponsorship of academic research and case studies that address a list of relevant governance and investment questions, as well as a material expansion of sharply-focused, strategic governance and investment education efforts.26 At the same time, a continuous, integrated ‘outreach’ strategy involving the institutional collaborations listed above is critical. As to ‘outreach’ targets? The print and electronic media should be high on the list, as should other ‘impact’ bodies such as international and national government, NGO, regulatory, and industry agencies.
Meanwhile, on the exploitation front, the asymmetric information problem continues to siphon billions of dollars out of retirement savings into the pockets of a global network of intermediary agents. Performance studies of actively-managed retail mutual funds show average net return shortfalls of -3%/year versus market indexes, compared to average positive net return outcomes for pension funds with fiduciary mandates.27
Legislators and regulators have started to sever the link between providing financial ‘advice’ and receiving sales commissions from mutual fund manufacturers. Mandatory participation in workplace pension plans (e.g., in northern European countries, Australia, Singapore, and recently, the UK) is also helpful. As these plans operate with fiduciary mandates, they must act in the best interest of their members, rather than exploit them.
A remaining exploitation barrier-breaking opportunity is to reorganize the management of workplace pension plan sectors around the world by fewer, larger-scale organizations with strong governance functions. As empirical evidence of the value-creating powers of scale and good governance continues to mount, the stronger the case becomes that the sponsors and trustees of pension organizations which lack these two attributes are failing the legal ‘reasonable expectations’ test, and are therefore in breach of their fiduciary duties.28
On the information dysfunction front, Drucker defines information as “data endowed with relevance and purpose”. Much of the information being disclosed in the corporate and investment sectors does not pass this test. A number of collaborative efforts underway to change this situation. Examples are the International Integrated Reporting Council (IIRC), the Sustainable Accounting Standards Board (SASB), Accounting for Sustainability (A4S), and the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures (TCFD). Where do these promising ‘information dysfunction’ barrier-breaking efforts go from here? The efforts to date have led to voluntary disclosure protocol recommendations. Is not the logical next step to mandate them?
Getting to ‘Tipping Points’
In conclusion, how can we best accelerate these promising ‘change’ developments? Addressing the question from macro and micro perspectives, here is my ‘to do’ list:
In the end, saying is one thing, doing another. Are you ready to join the move to long-term ‘active ownership’ investing?32
Keith Ambachtsheer is president of KPA Advisory Services Ltd.
32. Thanks to Dominic Barton, Rob Bauer, Stephen Brown, Barbara Petitt, Adam Robbins, Bob Swan, Ed Waitzer, and Sarah Williamson for providing helpful feedback on earlier drafts of this Letter. None are responsibl