Most people would expect pension fund managers to take a long-term view of the investments they manage but, as Prince Charles recently pointed out, that isn’t always the case.
In a short video to the National Association of Pension Funds, the Prince outlined why pension fund managers arguably have a duty to “identify and manage” a variety of sustainability risks. Sustainability risk is a broad term, but to me it means anything which will have a large negative impact on the ability of a portfolio to sustain acceptable levels of growth over the very long-term (think decades, rather than years).
In the Prince’s opinion, the pension fund industry is simply not doing enough to reduce these risks through their investment decisions, leaving potentially avoidable long-term risks for pension fund beneficiaries.
There are two major problems which, to a large extent, drive this lack of holistic thinking about long-term outcomes.
The rise of quarterly capitalism
The trend towards shorter time horizons for investors has been going on for at least a century. While it cannot go on forever, it has already gone on long enough to materially impact investor returns as well as the health of the economy (short-term thinking on the part of owners/shareholders and managers was a major factor in the recent credit boom and bust).
Many years ago investors would typically own a share of a business for five or ten years, which was more than long enough to see what financial progress (if any) the company had actually made.
Today things are different. Most investors are likely to own (or “hold”) shares for five to ten months rather than five to ten years. In such a short time the company is unlikely to change to any meaningful degree, and share prices are driven instead by investor’s reactions to meaningless news stories rather than financial realities.
That’s why most market participants today are not investors at all, they are simply momentum traders, looking to buy what’s going up and sell what’s going down. The company, its products and long-term prospects are often of little interest.
If shareholders are only interested in the next few months then the board and management of a company will tend to focus on that too.
After all, what’s the point of positioning a company for the next decade when your investors are only interested in your next set of quarterly results? Some shareholders even complain if management sacrifice profits today for greater (but uncertain) profits a few years from now.
So we end up with companies run by managers who think little about the long term sustainability of their businesses (or the economic, social and biological systems in which they exist), and much about the short-term. And that’s rational because that’s what their largest investors implicitly or explicitly tell them to do.
The rise of index investors
As if it wasn’t bad enough that investors and managers are often short-term in their thinking, we have the efficient market hypothesis telling investors that they shouldn’t even bother thinking about the short-term. In fact, they shouldn’t waste any time thinking about the companies they’re invested in at all.
The theory says that because there are so many smart and rational investment analysts researching, buying and selling stocks, shares are always priced “efficiently” anyway. This means that you can’t beat the market, so why bother trying?
Your best bet is to own an index and forget about it. Let the companies do their thing and let all those other investors who want to engage with and analyse companies do the hard work of valuing and monitoring.
This is a hugely popular approach because it means investors can get the results of the market with very little costs. Costs matter because they’re one of the biggest hurdles that active managers have to climb, and index fund managers can almost eliminate costs because they have almost nothing to do. After all, an index fund can probably be run by a man in a shed with a ZX81.
But here the problem of absent owners and “home alone” company management is even worse.
The index fund “manager” probably doesn’t even know what companies are in the index, let alone care what they do or how they’re run. The only consideration is how closely the index tracker tracks the index.
As this strategy becomes more popular, more and more of our companies will be owned by these “asleep at the wheel” investors, and so management has, in theory, little incentive to do anything other than think of their own welfare first, and the welfare of other stakeholders a distant second.
Of course not all or even most companies are run like this, but the trend has been relentless for decades. Shorter holding periods and more index tracking means less and less consideration for sustainability and the long-term.
Towards sustainable pension funds
Whether the pension fund is my directly invested SIPP, or a multi-billion pound fund managed by a professional fund manager, it’s important for the fund manager to think about where that fund will be in 50 or 100 years.
It’s not enough to simply track the market and assume that the market will always produce the best results possible, because it won’t. The dot-com bubble and financial crisis are ample evidence of that.
Instead, large pension fund managers, and other long-term investors, would do well to think about how their capital can steer the economic system towards the best possible outcome, rather than blindly accepting the “most likely” outcome. This is even more important when the “most likely” outcome is not a good one.
As Alan Kay (who effectively invented the iPad in 1968) said, “The best way to predict the future is to invent it”, and the best way to invent the future is to invest in it.
Some related links
There are many smart people out there thinking about how we can deploy pension capital to produce better long-term outcomes. Here are some links to a few of them:
Accounting for Sustainability – Set up by HRH The Prince of Wales in 2004 “To help ensure that sustainability – considering what we do not only in terms of ourselves and today, but also of others and tomorrow – is not just talked and worried about, but becomes embedded in organizations’ “DNA”.
Global Sustainability – Short film giving an overview of the issues that Accounting for Sustainability is working on.
Jeremy Grantham – Speaking at the Accounting for Sustainability Forum in 2011 on the major issues facing the global economy.
Jeremy Grantham – Speaking to Charlie Rose on those same issues in 2012.
Dr Paul Woolley – Chairman of the Paul Woolley Centre for the study of Capital Market Dysfunctionality, London School of Economics, speaking at “Resilience and the Long-Term: Rethinking Portfolio Strategy” in 2013
The City and capitalism for the long-term – A series of videos covering an event hosted by the Chartered Institute of Management Accountants and Tomorrow’s Company. Keynote speech by Dominic Barton, Global Managing Director of McKinsey & Company is the most relevant video (you can read a related article from Dominic here).
Long-term capitalism – McKinsey & Company’s web page and short videos on this subject.
Filed Under: Value Investing,
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