By Patrick Thomson
Long-term institutional investing, as practiced by the world’s leading sovereign wealth funds, enjoys large strategic advantages and a decisive tactical edge over investing with a shorter time horizon.
These include:
- A long-term strategy allows for fundamental themes to fully develop.
- By taking positions with high potential payoffs despite possibly uncertain timing, the strategy both shapes the future and profits from it.
- The long view, coupled with ample resources, can exploit tactical opportunities created by short-term investors under pressure to liquidate holdings due to margin calls and liquidity demands.
- More broadly, a long-term strategy stands to benefit from mispricings arising from errors in valuation and elevated risk aversion.
- The ability to absorb liquidity risk inherent in unlisted and illiquid assets can generate a premium return.
These advantages have rarely mattered more than now in a capital market environment of low yields, mounting volatility, unexciting global economic growth and subpar investment returns—nor have they contrasted more sharply with the prevailing transaction-oriented mentality. Yet today, as much as ever, long-term investors can (and should) access the full range of long-term non-public assets—value-added real estate, infrastructure, private equity and private debt—to diversify their holdings, mute the volatility of the public markets and earn steady and favorable risk-adjusted returns.
Indeed, the contrast between transactional markets and the breadth of opportunity open to long-term strategies suggests that investors across the entire institutional spectrum—pension plans, insurers and endowments —should give the approach serious consideration.
The investing marathon
Unlike some of their institutional peers, sovereign wealth funds have the advantage of rapidly growing assets – projected to reach over $10 trillion AUM by 2020, from roughly $7.5 trillion today. However, it is time horizon, not portfolio size that sets a long-term investor apart. They have the luxury of necessity. While many long-term opportunities, particularly in illiquid and non-public markets, are better suited to large pools of capital, the long-term mentality can apply across the investment spectrum.
Conventional wisdom ties market cycles to economic cycles, which, on average, last almost five years. One of the most successful institutional investors, Singapore’s sovereign wealth fund GIC, places market cycles in a similar time frame. Discussing its own investment practices, GIC states “the minimum time horizon for performance measurement is five years.”
Paring down the definition of long-term investing still further not only dispenses with considerations of portfolio size, it also eliminates the time criterion. In the words of GIC, “it is actually not the time horizon that matters most, but rather… mindset and discipline.” The mindset implies two long-term prerequisites: first, that anticipated near term liquidity needs are a controlled and manageable proportion of total portfolio values; and second, that investors have not only the financial capacity to withstand the inevitable intra-cyclical drawdowns but also the political will and emotional aptitude.
The time for long-term is now
The most recent five-year records of eight large SWFs, give an idea of the lift alternative assets have provided in the environment coming out of the financial crisis. According to our research, the median allocation to alternatives among the eight funds amounted to 18.5% of the total portfolio. Returns for the funds with above-median allocations beat the conventional 60/40 benchmark allocation return by 551 basis points and beat the returns of the below-median funds by 316 basis points annually. The top four performers among the eight SWFs, with alternatives allocations ranging from 16% to more than 35% with a mean of 26%, beat the benchmark by an average of 671 basis points.
Whilst SWF allocations to infrastructure have been increasing, the Organisation for Economic Co-operation and Development (OECD) has previously commented that “in principle, institutional investors should be natural investors in infra-structure and venture, but allocations are generally low,” noting at the time that less than 1% of the world’s pension funds had invested directly in infrastructure.
The soundest strategy…. And the most difficult
Over a sufficiently long time horizon, the odds favor the success of many investments. As time horizons shrink, market factors increasingly enter into target return calculations. Bid prices may rise so high that assets may not realise the desired gain over any reasonable time frame. By contrast, assets overlooked in the rush of conventional investors to capture a current fashion—or to sidestep a current dislocation—may stand to reap all the premia on offer: risk, liquidity, lock-up, first mover, distress and so on.
Such assets come with challenges of their own, however. Since the financial crisis, the emphasis on mark-to-market valuation in accounting and regulation has raised the price of patience, for pension funds especially. And even as long-term investors must look past transient volatility to a distant time horizon, they need to remain sensitive to the near-term opportunity— when a flood tide of enthusiasm lifts the value of their positions to their price target, or simply when another opportunity comes along that will improve the calculus of risk and reward in their portfolios overall.
Perhaps the gravest threat to the long-term strategy may arise from the shortsightedness of stakeholders who stand to benefit most. “Mark-to-peer pressure” can undermine the rationale for the soundest contrarian investment, especially in the early years of staking out a first-mover advantage when shorter-term investors are posting better results. This threat is pervasive and it spotlights an aspect of the discipline no long-term investor can afford to ignore. Thorough education, plus open, frank and frequent dialogue with stakeholders, is essential to staying the frequently arduous course that leads to superior returns.
Patrick Thomson, is global head of sovereigns at J.P. Morgan Asset Management
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