Fiona Stewart, principal administrator at the OECD, considers why many institutional investors have failed to live up to their long-term investment potential.
One consequence of the financial crisis is that long-term investing is becoming a popular topic across OECD countries. With governments concerned about financial stability and searching for new sources of financing, institutional investors are in their sights. The OECD has launched a project on institutional investors and long-term investment, through which we hope to add an international angle to a debate, already well under way in the UK.
What is long-term investment?
We define long-term investment as:
• Patient capital: allows investors to access illiquidity premium, lowers turnover, encourages less pro-cyclical investment strategies and therefore higher net returns and greater financial stability;
• Engaged capital: encourages active voting policies and better corporate governance;
• Productive capital: support for infrastructure development, green initiatives or SME finance etc, leading to sustainable growth.
Who are long-term investors?
The main institutional investors in the OECD - pension funds, insurance companies and mutual funds - hold over $65trn (€48trn) in assets. This figure increases if emerging economies are added as sovereign wealth funds (with over $4trn in capital) are the most important source of capital in these countries.
The influence of institutional investors has brought a transformational change in financial systems. Traditionally, these - and, in particular, pension funds - have been seen as a source of long-term capital with investment portfolios built around two main asset classes (bonds and equities) and an investment horizon tied to the long-term nature of their liabilities. These also reduce reliance on the banking system, acting as shock absorbers at times of financial distress. The growth of these institutions has aided the development of capital markets, providing financing and helping to develop mechanisms for corporate and risk governance.
Despite the potential benefits of long-term investment, institutional investors are often characterised as ‘short-term’. Signs of such include declining investment holding periods and allocations to less liquid, long-term assets such as infrastructure and venture capital are low and being overshadowed by allocations to hedge funds and high frequency trading. Other concerns are their herd-like behaviour which may feed price bubbles and a tendency to fail to scrutinise corporate governance.
Barriers to investing
So why are institutional investors not living up to their potential? Several barriers exist including:
• Investment process: Institutional investors are increasingly reliant on passive investing, or indexing, on the one hand and alternative investments on the other. The former can discourage them from being active shareowners, whilst the latter may involve short term, high turnover investment strategies.
• Agency problems: Pension funds, in particular, rely on external asset managers and consultants for much of their investment strategy. They often direct external managers ineffectively, concentrating on short-time periods which creates misaligned incentives in the investment chain. They also contribute to short termism via common investment activities, such as securities lending or exchange traded funds (ETFs). Investors may, therefore, be contributing to speculative trading activities in their own investments.
• Regulation: These can exacerbate the focus on short-term performance, especially when assets and liabilities are marked-to-market. For example, the use of market prices for calculating pension assets and liabilities (especially, the application of spot discount rates) and the implementation of quantitative, risk-based funding requirements have aggravated pro-cyclicality in pension fund investments during the 2008 financial crisis.
• Infrastructure barriers: a lack of suitable long-term investment opportunities also acts as a barrier. This stems from:
• Poor government planning resulting in a lack of a infrastructure pipeline and financing vehicles providing investors the necessary risk/return tradeoffs which they need;
• A lack of investor knowledge or scale;
• Inappropriate investment conditions for investment due to deficiencies in data reporting and benchmarking requiring resolution.
Squaring the circle
The OECD believes reform can be used to encourage institutional investors to embrace a long term role. These could include:
• Improving the regulatory framework: Developing long term risk-management systems, removing regulatory barriers and addressing potential short term incentives in solvency and funding regulations. Building expertise and investor capability will be key as informed, knowledgeable investors are a basis for good governance and proper alignment of incentives.
• Policies to encourage active share ownership: Governments should check that there are no regulatory barriers to institutional investors acting as active shareholders (such as share blocking/taxation issues/takeover issues/collaboration). Practical encouragements could also be put in place (such as allowing electronic voting of shares), or regulation could be more prescriptive (such as requiring institution investors to disclose voting records, and their governance/conflict of interest policies). Other incentives, such as giving multiple voting rights to long-term investors, could also be considered.
The burden of active engagement can be reduced by encouraging collaboration via investor groups (such as the International Corporate Governance Network). Alternatively, funds could use activist fund services or proxy voting firms, keeping in mind that their advice should be free conflicts of interest compromising the integrity of their analysis or advice. Guidance on the behaviour expected from institutional investors is key, financial regulators having a role to play in encouraging long-term, active investment (eg, through supporting national or international codes of good practice, such as the Stewardship Code which is gaining widespread support in the UK) and issue guidance of how they expect institutional investors to behave. In order to ‘nudge’ investors to follow such guidance, supervisors can shift the focus on their investigations, enquiring as to the turnover of funds, the length of mandates given to external managers, how fees are structured, voting behaviour etc.
• A supportive policy framework needs to be developed. Policymakers should help investors address long-term risks, such as longevity by supporting the development of transparent and reliable indices and other aspects of market infrastructure. Government can also issue long maturity and inflation-indexed bonds that facilitate long-term risk management by investors. A transparent environment for infrastructure investment is needed, with a clear pipeline of projects and well structured public private partnerships. Governments should seek to understand the investment needs and requirements of institutional investors and assess the scope for promoting the “right” investment opportunities.
The OECD will continue to explore these themes through its long-term investing project, incorporating data collection, policy analysis, discussions and debate at a series of forthcoming high-level conferences. For further information see www.oecd.org/finance/lti