Cutting through the noise
“There is almost universal agreement that the world needs long-term investors and, indeed, that short-termism is bad,” says Keith Skeoch, CEO of Standard Life Investments (SLI), addressing a room of European finance journalists at its Edinburgh offices. “And the reason short-termism is perceived as bad is that the charge sheet is long and serious.”
The head of Scotland’s £160bn (€200bn) asset management giant also sits on the UK’s Financial Reporting Council Advisory Panel that is looking into the lessons of the financial crisis, so he is well-placed to discuss the issue. And his “charge sheet” covers: short-termist, absentee shareholders failing to hold boards to account to control risk and rein-in excess rewards for executives; a focus on corporate deals that delivered quick gains at the expense of the wider community in which businesses operate – and even of those businesses themselves; and proprietary trading desks creating webs of interconnectedness that spread financial contagion across the world.
“There’s an undoubted element of truth in each of these charges,” Skeoch insists. “But while so many people are talking about the behavioural aspects of this, very few are discussing the incentives that could stimulate a supply of long-term investment funds.”
This is important, because the natural supply is small and fast diminishing. About $27trn (€21trn) of the world’s $65trn of invested assets is theoretically available for long-term investing, Skeoch reckons. But the demography of developed economies means that $12trn of that wealth is held in short-term cash securities to fund retirement income, or de-risked as part of the life-cycle strategies of those baby boomers nearing retirement. Moreover, he argues that it is also important because long-termism is the only way to capture investment-risk premia in a sustainable way. It makes investment sense. So what is stopping us?
It is often noted that investors like pension funds with multi-decade liabilities should have an incentive to lean towards long-term investing. But SLI research suggests that risk premia in financial markets persist for more like 7-8 years, beyond which there is very little predictability of consistency of return. Ignore the ‘noise’ of market movements out to 24 months and that puts the sweet spot for an investment horizon somewhere between two and five years.
“That’s part of the rationale for the three-year time horizon that’s built into our multi-asset investing products like Global Absolute Return Strategies,” says Skeoch. “In fact, bridging those two time periods is what the entire fund management industry should be about. By doing that, savings are connected with investment opportunities that create employment and sustainable economic growth. It’s what makes fund management an honourable profession.”
But since the turn of the century it has proven more and more difficult for investors to focus on even that 3-5-year horizon because the amplitude of the cycles in risk premia has become greater, the wavelength shorter. Because risk premia are cyclical and markets are driven by different factors at different points in the cycle, there is no ‘silver bullet’ investment strategy that can generate alpha through all periods. But the recognition of that fact has simply led investors to chase the cycle – inevitably with limited success.
“The shape of these cycles is driven by economics, politics and social trends, so you need to have a long-term view on those trends if you are to understand the way in which return is being generated,” says Skeoch. “Research matters deeply. But you need to point your research towards understanding the transition periods from one cycle to the next. That’s when returns are most volatile and things are most difficult, but also when, if you can stay focused on the long-term trend and away from the short-term noise, you will deliver alpha. That is why we think that ‘focus on change’, the philosophy that we put in place in 1998, is incredibly important.”
But even with the best will in the world, Skeoch acknowledges “structural barriers”, in the shape of prudential regulation and macroeconomic policy, that curtail institutional investors’ ability to focus on change. They may even be exacerbating the volatility of risk-premia cycles in the first place.
“A lot has been written about the toxic feedback loop between mark-to-market and risk-based solvency requirements,” he says. “I’d add issues with the macroeconomic policy of inflation targeting. Let’s be clear – there is a very strong intellectual and social case for risk-based solvency, mark-to-market accounting and inflation-targeting in their appropriate places. It’s the combination that causes the issue: there is a material disconnect between prudential policy and macroeconomic policy and nobody is really focusing on the toxic feedback loops between them.”
Inflation targeting has been very successful in achieving very low long-term interest rates, Skeoch explains, but in the context of mark-to-market, risk-based solvency, those low rates have exploded the value of investors’ liabilities and pushed those investors away from “the one golden rule in investment” – buy low.
“There is a social benefit to being able to pool risk so that we can buy at the point in the cycle when risk premia are high – and at the moment risk-based solvency is standing in the way of that,” he observes.
There needs to be recognition that bond yields – whose volatility, particularly compared with the change in average earnings, clearly suggests that they are more than simply future expectations of interest rates – are not an appropriate discount rate for liabilities, Skeoch argues.
“We need something that helps us to build portfolios of assets that deliver a return that will ultimately replicate the growth in savers’ incomes,” he says. “We need a debate within the economics, actuarial and policymaking communities about what that appropriate discount rate is, but it’s a subject that is too important to be left with the technicians – we need a real social consensus about what we are trying to do here.”
Despite everything, Skeoch remains an optimist. In the so-called ‘shareholder spring’, especially, he sees signs that markets are “beginning to go through another phase of evolution in corporate governance norms”, similar to sea-changes of the past such as the governance tussle within the Dutch East Indies Company in 1609, Adam Smith’s exploration of the principal-agent problem in the 1770s, and the twentieth century cases that laid the foundations of modern governance standards. He would like to see that new sense of engagement spreading across the capital structure, as debt issuance overtakes equity issuance as a means of finance in so many sectors – particularly, of course, the financial sector where change is arguably most needed.
“One of the things that I hope will come out of the shareholder spring is a more holistic approach to governance,” he says. Increasing engagement with the real economy in this way will enhance the ability of investors to think about what they are doing within a longer-term context, is the implication.
But, for all the talk of long-termism and patience, the change in attitudes cannot come soon enough for today’s limping economy.
“Corporates have all the cash at the moment,” Skeoch observes. “Why aren’t they spending it to drive economic recovery? Because economic, political and regulatory uncertainty is forcing them to take a short-term view. Politicians’, regulators’ and macroeconomic policymakers’ horizons have to lengthen. But investors need to offer management some certainty by taking a longer-term view, as well.”