When behavioral economists get a secret handshake, it will be a shrug, a self-deprecating nod to how financial institutions initially greet their ideas.
Ricardo Research’s brilliant analysis of how short-term behavior predictably ensues from the usual mandate contracts between asset owners and asset managers – together with the commentary in Top1000funds.com – is what brings this to mind.
“The first step towards a more effective monitoring approach is to recognise that short-term performance data are at best a weak indicator of success for strategies with long-term objectives”, write Paul Woolley, Phillip Edwards, and Dmitri Vayanos. “Investment cycles can be long-lasting, so even over periods of 5-10 years investors should be wary of drawing overly strong conclusions from performance data alone.”
FCLTGlobal’s experience bears this out exactly.
Last year we released the second edition of our toolkit for investors to build long-term mandate contracts. A key part of this update was adding case studies of how asset owners and asset managers have used these provisions in the real world. The most widely used provision, by far, is a seemingly-minor behavioral nudge: reordering performance tables so that longer-term data comes before short-term returns.
The list of institutional investors that have made this change and talked publicly about it is long, including Ontario Teachers’ Pension Plan, CalSTRS, MFS, Federated Hermes, Kempen, and Brazil-based NEO Investimentos. The evidence of this nudge’s effectiveness is the enthusiasm investors have for talking about it with others.
It must be noted that this is not a change of the performance data that gets presented. All of the return figures remain. These long-term investors merely have reordered the data. The impact comes from knowing that people give the most attention to the information that they see first, often to the point of not giving any attention to the last information in a sequence, so these investors are being intentional in how they use this focus.
It’s really no more complicated than saying what you mean to say (and not saying what you don’t).
This longer-term mandate practice is most widely-adopted, but it is far from singular. Woolley, Edwards, and Vayanos also emphasize the importance of fee arrangements, and very appropriately so. It is stunningly common how often asset owners get what they pay for – but pay for something other than what they want.
Fee arrangements can nudge longer-term focus in a number of ways. Just for example, OTPP also has used a longevity discount with asset managers, accepting higher up-front costs in exchange for steeper reductions over time, and agreed that it would pay a penalty in the event if no-cause termination. Both provisions give OTPP’s asset managers confidence that it really is committed for the long term, and that they must be too.
Risk parameters also need to be on the list because they frame the investable universe for asset owners and managers. Woolley, Edwards, and Vayanos emphasize how multiple times horizons matter. Investors with sincere and strongly-held beliefs about the long term often are surprised by short-term disruptions in the interim period and panic – even though such disruptions are generally foreseeable. Long-term investors agree in their mandate contracts to project risk across multiple time horizons so that they have sound estimates not just about where they are going but also what it will be like to get there.
“Short-termism” is a euphemism for a suite of behaviors in which one individual’s or institution’s time horizon does not match another.
Woolley, Edwards, and Vayanos are entirely correct that the origin of these behavioral mismatches often is the mandate agreement that asset owners and asset managers use to set the incentives and parameters for their relationships. The investors referenced above are leading in this regard.
Practical – indeed, practiced – alternatives are available for other long-term investors that are ready to follow suit.
Matthew Leatherman is a research director at FCLTGlobal, a non-profit organization whose mission is to rebalance capital markets to support a long-term, sustainable economy.