Long horizon investors ‘a crazy bunch’

After Amanda White’s now famous interview with Eugene Fama last October in Chicago, in which Fama describes a belief about active investing as a “statement from the moon,” I think that Fama must look at long-horizon investors as a crazy bunch.

When I went to university, I studied finance. I was taught efficient markets theory, the capital asset pricing model (CAPM) and arbitrage pricing theory (APT). No mention of fundamental investing at all. It was like a religion. Lots of Fama, Ross, Sharpe. And I subscribed to the religion.

To do Fama right, efficient market theory has brought a lot to investing that is extremely valuable to most investors in the world. And he is right to wonder why there are not more people investing passively.

A few good things to mention: Market efficiency as a reference point for thinking about investing is a very good idea. A broadly diversified portfolio as a starting point for portfolio construction is smart. And the use of passive investing and benchmarks has brought better and more efficient investing to an enormous amount of people and institutions. A lot of wisdom in a simple package. It transformed intelligent investing into a cheap and efficient commodity, like cars and radios.

So, a move to passive is smart from many points of view: it is cost effective, transparent and simple. Theory applied effectively.

But at the same time, there were some things that haunted me. And as it goes with religions, I have long thought that I was a sinner by even thinking these things.

Keith Ambachtsheer was very important to me in that respect. He is the first person I met who hammered home the term: “turning savings into wealth,” as the core objective of investing with pension money. And he always refers to his source, Keynes’ General Theory of Employment, Interest and Money, chapter 12. A great read.

Investing has everything to do with the real world

So Ambachtsheer does not say: pension funds should be harvesting the market return. Not beta and alpha, no, he says: “turning savings into wealth.” The very important meaning of that statement is that investing has everything to do with the real world.

In efficient market thinking of course, there is no such thing as a good price, a high price or a low price. There is only one price, and that’s the right price.

There is no connection at all between the market price and the underlying economic activity, because the market is always right. Thus, the financial markets can float freely and independently of the real world. I now think this idea has contributed to grave accidents in the financial markets like the global financial crisis.

Also, efficient market thinking has led us to believe that the market, by its invisible hand, will magically steer corporate management towards creating maximum long-term shareholder wealth, by allocating the capital of the firm in the most productive way possible.

I think this is not the case, and also more and more companies themselves feel they are forced into short-term behavior by the myopia of investors.

So it seems to me that there can be too much of a good thing. Efficient markets are pretty good, but I think of it as a partial description of reality. A beautiful room in a bigger house.

Now these things are all fine and not to worry about when you are an “atomic investor,” who really should act as a price taker and depend on others to set the price right.

But together pension funds and sovereign wealth funds own a very substantial part of the world’s productive long-term capital. It would be strange if they acted only as price takers.

Because of their scale, their knowledge and their position in the long financial chain – from the actual saver of capital to the user of capital – they can do things differently, to a certain extent.

And they are important, because they represent the saver and they can, at least in theory, control everything further downstream in the financial chain, such as asset managers and how they operate.

Long-term investing, or being a long-term investor, means different things to different people. Key elements of a good definition of long term investing are to me:

Value and price are not always the same. You have to go back to fundamentals.

• Allocate capital where it will be productive. This implies that you have to have an idea of where value is created in the real world.
• Value creation will (largely) determine price on the longer horizon. Therefore, it is long-term value creation you should focus on, not short-term market returns.
• Be selective about what you own, and be an involved owner.

These simple statements have profound consequences for the way asset management should be organised.

The million dollar question therefore is: can we be reasonably certain that we will be rewarded for being a long horizon investor? Because, if we’re not, then why bother?

A sound answer to this question will determine whether long horizon investing will really take off among asset owners or not.

Jaap van Dam is principal director of investment strategy at PGGM.