Long-Term Investing as an Agency Problem

David Neal

Future Fund

Geoff Warren

Australian National University (ANU) – School of Finance & Applied Statistics; Centre for International Finance and Regulation (CIFR); Financial Research Network (FIRN)

July 1, 2015

CIFR Paper No. 063/2015

Abstract:

The agency problems that pervade delegated investment management are exacerbated when investing for the long term, where the payoff is distant and often highly uncertain. These conditions compound the difficulty of aligning and monitoring the agents (managers) responsible for making investment decisions, particularly across multi-layered investment organizations. Problems arise from differences in investment horizons; the tendency to evaluate and reward based on short-term results; and failure to commit. We delve into these issues, and offer some solutions. Investment organizations intending to pursue long-term investing should aim to create an environment where all principals and agents along the chain of delegations are aligned, engaged on an ongoing basis, incentivized to work towards long-term outcomes, and committed to investing for the long run.

Long-Term Investing As An Agency Problem – Introduction

Concerns over short-termism within financial markets have led to calls for more long-term investing. Nevertheless, investors who genuinely pursue investing for the long run remain in the minority. The quandary of why long-term investing is not more prevalent can be better understood as an agency problem. Investing is often undertaken under principal-agent arrangements, particularly within investment organizations involving multiple layers of delegation. Meanwhile, long-term investing entails taking positions where the ultimate payoff may not arrive anytime soon, and is often subject to high and ongoing uncertainty. Two particular challenges arise. The first is securing alignment along the chain of delegations when horizons may differ. The second relates to the unavoidable need for principals to monitor agents, without having the option to reserve judgement for, say, 10 years. It is this potential discord in horizons – both between principals and agents, and between the investment and monitoring horizon – that makes long-term investing so difficult to pursue and sustain. We outline various facets of this issue, and offer solutions. In doing so, we take an institutional investor perspective. Our discussion is illuminated by the experiences of Australia’s sovereign wealth fund, the Future Fund, which is structured to align the Board, internal management and external managers with pursuit of a long-term approach.

Why Should We Care?

Long-term investing offers both public and private benefits. The public benefits relate to helping mitigate the effects of short-termism, which has been charged with contributing to mis-pricing and excess volatility, pro-cyclicality, corporate myopia, less effective corporate governance, and less efficient financial intermediation.i As engaged and responsible asset owners, long-term investors can act as a stabilizing force in the market, and providers of finance for long-term productive activities. However, the prospect of public benefit provides insufficient incentive. Investors must also perceive a private benefit.

Long-term investing offers three advantages. The most widely-recognized is potential to invest in unlisted and other illiquid assets, which gives access to different return sources and some diversification benefits. A second advantage is capacity to pursue investments when payoff timing is open-ended. That is, long-term investors have the luxury to be primarily concerned with if, rather than when, there will be rewards. A third advantage is ability to exploit opportunities arising from the actions or aversions of short-term investors. At times,market prices can be set by investors who are over-focused on immediate risks or other transitory influences, or perhaps forced to trade in response to funding shifts. When such activity pushes prices out of kilter, long-term investors can take the other side of the trade. These advantages combine to make long-term investors well-suited to strategies such as: capturing risk premiums related to short-term fears; providing liquidity when paid to do so; value investing without regard for when value is recognized; enhancing economic value through ongoing engagement and control; and pursuit of long-term themes.

In spite of its purported benefits, long-term investing is comprehensively practiced only in certain niches. This notably includes private investors with the predilection to invest for long run, some sovereign wealth funds, and those (such as Warren Buffett) who have the unquestioning trust and faith of investors. In some situations, a short-term focus accords with objectives, e.g. running trading books, or managing money for investors who are averse to short-term drawdowns or require liquidity. But this is not the entire story. Short-term behavior often occurs where the purpose is long term. For instance, defined contribution pension funds can become concerned with shorter-term performance in response to competitive pressures; while defined benefit pension funds may be managed with one eye on year-to-year fluctuations in funding ratios. Investment managers, who are responsible for directly managing a large slice of funds in the system, often do so through chasing short-term relative performance in accordance with their incentives. However, this does not always align with the needs of their end-investors.

Hence the issue is that long-term investing is less prevalent than stakeholders whose underlying objectives are long-term in nature. To understand why, and what might be done about it, one needs to take a closer look at the principal-agent relationships that exist within the investment management industry.ii Before doing so, we first establish what distinguishes long-term investing, and makes it so difficult to pursue.

Long-Term Investing

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