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Funds need to consider building a brand around long-term investing. Specific improvements on performance measurement and disclosure to stakeholders can be found in the article.
A complaint I heard from asset managers, after I wrote my piece on long term investing, is that investors tend to compare quarterly or annual performance of mutual funds that hold the stock for say seven years with the quarterly or annual performance of the S&P 500 or the Russell 1000 index.
Would it make sense to measure the performance of long-term holders using a methodology that recognizes the costs and benefits of holding stock for the longer run? And, if yes, what might such an investment framework and the associated metrics and processes look like?
What is long term investing?
It is perhaps easier to answer that question by positing what is not “long-term investing.” Cremers and Peek (2016) find that mutual funds seem to hold equity for 1.3 years at best. Perhaps a holding period much longer than that could be considered long term investing.
This does not mean long term owners don’t sell stock before such long-term holding period, should they believe that valuations have peaked. Nor does it mean short term investing is unconditionally undesirable. Or that long term investing is always profitable. Moreover, my focus here is mutual funds and public equity. The underlying incentives and frictions are arguably different for other long-term owners such as pension funds, college endowments and family offices.
What should new performance metrics or strategy look like?
1.0 Build a brand around long-term investing:
Warren Buffet is a textbook case of how to build a brand around long-term investing. As an initial step, given the confusion surrounding the term, “long term investing,” it might be useful for the fund to define what long-term investing means to them, why they believe that long term investing is a good strategy for this particular asset manager and how do they intend to implement such a strategy and, how much of the assets under management are devoted to such a strategy.
2.0 Publish the fund’s average holding period:
This is perhaps an obvious metric that is often missing from the factsheets and related literature of funds that hold equity for the long run.
3.0 Benchmark to a simulated counter-factual short term focused fund:
One of the biggest obstacles to measurement of performance of a long-term fund is the absence of a counter-factual fund that follows a short-term objective function. Would it be useful to draw a scenario or even several scenarios that imagine how a short-term fund with the same capital would have bought specific securities and sold them quickly?
This might be a way to highlight the implicit costs incurred by a short-term fund by way of transaction costs, any differential between higher short term capital gains taxes relative to lower longer run capital gains taxes, unwillingness to stomach short term losses, of certain dollar magnitude and duration and the like, and the usual psychological urge to buy high and sell low. Granted that these scenarios are likely subjective. A coalition of long-term owners could potentially agree on the parameters of what such scenario might look like and publish those parameters. A similar arrangement has arisen somewhat successfully in the world of climate and net zero emissions scenarios.
In the short run, before such counter factual scenarios are developed, we need interim quick fixes. One idea is to use a benchmark fund that explicitly follows a short-term strategy from the same fund family. Another idea is to publish turnover ratios of assets in the fund relative to that of a short run benchmark fund.
4.0 Publish performance over the fund’s holding periods:
Most funds today tend to publish performance data over 1 year, 5 year and 10 year holding periods. Why not publish performance data over the average holding period of the fund?
5.0 Highlight the importance of equity risk premium to returns:
Equity risk premium refers to the excess returns earned by stocks relative to treasury bills over time. Short run funds do not expect to make money on equity risk premium, but long run funds do. Benchmarking a long-term fund to individual year’s S&P 500 returns ignores the potential contribution of equity risk premium to the fund’s performance. It might be worth highlighting the role of equity risk premium in the fund’s returns. The caveat with this point is that, in some cases, equity might not outperform treasuries for long periods of time.
6.0 Decompose returns to understand where value is added by long term investing:
Along the lines of the previous comment, the fund might want to decompose the returns it earns on account of:
(i) skill versus luck- so many mutual funds are merely closet indexers and hence do not deserve the expense ratios they charge.
(ii) If a fund were to follow the proverbial Yale model of investing in illiquid long-term assets, can we decompose the returns earned on account of illiquidity versus the rest?
(iii) If a VC fund earns returns because she invests in complicated opaque companies, could we potentially decompose those returns into some kind of opacity premium versus the rest?
7.0 Decompose returns into capital appreciation and flows such as dividends or stock buybacks:
In the short run, most of the returns relate to capital appreciation. In the long run, returns are a combination of capital appreciation and dividends and buybacks. In one of my papers with Sanjeev Bhojraj and Ashish Ochani, we show that even for stocks, in the long run, flows defined as income or free cash flows, are relatively tiny for most companies. If the fund has truly picked winners, one would expect to see greater contributions from dividends and/or earnings growth.
8.0 Communicate the risk appetite of the long-term fund:
The essence of long-term investing is the willingness of the asset manager to stomach an unrealized loss in the short-term. Measures such as downside capture ratio don’t quite pick up such risk appetite. It might be useful to communicate to investors how the fund thinks about conditions that will trigger a sale to convert an unrealized loss of a certain amount over a certain period to a realized loss.
A related point is that long term investors can be countercyclical investors when markets or economies tank. The value derived from such counter cyclical moves or contrarian moves needs to be quantified and highlighted.
9.0 Incentives and governance structure
As I have highlighted before, we know every little about how the decision makers running the fund are compensated and governed. Greater disclosure on how the long-term mission of the fund is reflected in the compensation structure of the decision makers would help. Moreover, we usually know little about the cultural architecture and governance structure used to ensure that the decision makers are adequately motivated and monitored to ensure that the fund walks the long-term talk. Fixing this disclosure gap can help educate investors and attract the right clientele to the fund.
10.0 Engagement metrics
Long term equity investors can engage with the company to influence its strategy. Metrics that highlight the nature of these engagements and potential payoffs from such engagement could also be communicated to investors. Potential estimates of returns that stem from engagement would be even more useful.
It is also helpful to publish and publicize the voting record of the fund to communicate its brand of long-term ownership. Moreover, long term institutions might want to become more aggressive in demanding accountability from companies that are index laggards that have underperformed for long periods of time, should they hold such firms in their portfolios.
These are a few opening thoughts on how performance and governance systems could be potentially modified to build a brand around long-term investing. Constructive comments welcome.
