Solving short-termism is being held up by the institutional investment industry as some sort of performance saviour. There have been many attempts at uncovering the problems of, and offering solutions to, short-termism with numerous reviews, conferences and papers discussing the need for long-term investing. These include the incentives and behaviour of asset owners, asset managers and companies.
Columbia University’s Committee on Global Thought held an event on long-term investing with presentations from many of the best investment thinkers including Robert Eccles (Harvard), Jeremy Grantham (GMO) and Joseph Stiglitz (Columbia).
“David Dodd said if you don’t like the management of the company sell the stock, but importantly Benjamin Graham added the provision that you can get a good price, and if you can’t then do something about it,” Patrick Bolton, member of the Committee On Global Thought, said.
In their paper Loyalty Shares: How to reward long-term investors, Bolton and Frederic Samama, head of the steering the committee at the Sovereign Wealth Fund Research Institute, suggest that loyalty shares reward shareholders for long-term investing
In practice this would mean that a company would grant a loyalty warrant to every shareholder then, after a specific loyalty period, a warrant would kick in and vests after another time frame of holding the stock.
Much of the thinking at the conference, and in other papers and seminars, is robust. But for institutional investors, solutions such as loyalty shares are also kind of Band-Aid solutions.
If instead the asset owners focus on their expectations, then behaviour will change down the chain of service.
If fiduciaries have been acting in the best interest of their beneficiaries, often with 30-plus-year time frames, then they should be setting long-term asset allocation and managing to that anyway.
The real question then becomes what the long-term return expectations of institutional investors are and whether they are realistic.
To some extent the answer rests in reluctance by investors, and their stakeholders and service providers, to adjust their expectations, particularly around the size and predictability of the equity risk premium.
In a response to the recent Kay Review, Gordon Clark has written a paper to be published in the spring issue of the Rotman International Journal of Pension Management. “In many cases, unfortunately, asset holders and their sponsors hold fast to optimistic scenarios regarding the returns to be had in the equity markets of advanced economies. Expectations about the size and predictability of the equity premium are justified by reference to a bygone era,” he says.
The expectation around the equity risk premium, or the expected return for equities, is important because it affects savings and spending behaviour as well as the allocation of assets between risky and defensive poles.
Rethinking the equity risk premium
The CFA Institute research project, Rethinking the equity risk premium, is a collection of papers that revisits 10-year-old research. Edited by managing director and chief investment strategist at TIAA-CREF, Brett Hammond, managing director of research at Morgan Stanley, Martin Leibowitz, and CFA Institute Research Foundation director of research, Laurence Siegel, it presents some new ideas about the equity risk premium.
In 2001 a number of academics set estimates of the equity risk premium, with the estimates averaging 3.5 per cent but coming in as low as 0 per cent (including Arnott and Bernstein, and Campbell and Shiller). The differences varied according to demand and supply considerations, and the supply of cash flows that companies could inject into the market.
The current CFA project is the 10-year anniversary of that initial one, and started with leading academics and practitioners gathering for a day-long discussion on new developments.
The paper defines the equity risk premium also as an equilibrium concept that looks beyond any given period’s specific circumstances to develop a fundamental, long-term estimate of return trends. It is a forward-looking, expectations-driven estimate of stock returns and is critical to fundamental activities in investing, especially strategic asset allocation but also in portfolio management and hedging.
There are many different and new views in the collection of papers. Roger Ibbotson, shows that investors often fail to differentiate a short-term tactical view of the equity risk premium from the more fundamental long-term, supply-driven equilibrium equity premium.
Robert Arnott supports a view that the equity risk premium is cyclical, smaller and more dynamic than prevailing theory of a more stable and robust premium would suggest. He shows that bonds have outperformed stocks over a significant period, excess return has often been lower than the forward-looking ERP, net stock buybacks are lower than is often assumed, lower earnings yields are empirically associated with lower subsequent stock returns and premiums, real earnings and stock prices grow with per capita GDP rather than total GDP, and dividend yields are lower now than ever before.
“When taking this more sobering evidence into account, he finds that the probability of future stock returns matching the 7-per-cent real historical average is slight. Arnott’s estimate of the future ERP ranges from negative to slightly positive,” the paper says.
While there are varied views, most of the authors agree it will be around 4 per cent in the next few years.
On average, US pension funds have a return expectation of 7.5 per cent, and much of this expectation, needed to meet their liabilities, is based on the expectation of returns from the equity market. From where I sit, that is set up to fail.