[Editor’s Note: When Cuffelinks published an article on index investing recently, globally-renowned pensions expert Keith Ambachtsheer wrote back to me, “Graham, it isn’t as simple as ‘active vs. passive’.” He attached the May 2017 Ambachtsheer Letter (usually only available by subscription, but attached later), ‘Fostering Long-Termism in Investing’, and gave permission for us to distribute it to our readers. This summary is for readers looking for a shorter version.]
“When one talks about market efficiency, it is important to distinguish between ideas whose implications are obvious and consequently travel quickly, and ideas that require reflection, judgement, and special expertise for their evaluation, and consequently travel slowly. The second kind of idea is the only meaningful basis for long-term investing.” – Jack Treynor, 1976
Long-term investing
In the past, ‘active management’ once meant outperforming the market through active trading. John Maynard Keynes, who laid the groundwork for modern economic theory labelled it as “beauty contest investing” in 1936. That is, investors aim to buy stocks the market would deem to be the ‘most beautiful’ in the near future and sell those the market would deem ‘ugly’ – a zero sum game less costs. He noted professional money managers had seemingly little interest in ‘real investing’ – the long-term transformation of financial savings into wealth-producing capital. Since then, not much has changed. However, recently, a new form of active management has begun to unfold, with some institutional investors returning to a first principles investing approach. That is, a return to investing through a long-term lens, riding out the short-term volatility of markets in favour of unlocking long-term value for investors.
Rethinking active management
Peter Drucker’s 1976 book on pension management, The Unseen Revolution, first foresaw the accumulation of retirement savings and the significant role pension funds play today. He raised three fundamental questions:
- What kind of organisations would evolve to manage retirement savings?
- In whose interest would these savings be managed?
- What will be the implications of the answers to these questions for how growing retirement savings pools are invested and managed?
The answers to these three questions have laid the framework for how pension funds are shaped today:
- Special-purpose vehicles would have to be created, capable of designing and managing transparent, sustainable pension arrangements. They should have a clear mission, good governance, and be able to access the requisite resources to achieve their mission.
- Pension organisations should be managed solely in the interests of their clients and beneficiaries.
- Retirement savings pools should be managed to achieve the dual goals of payment safety and affordability. This is best accomplished through managing separate payment-safety and payment-affordability sub-pools. The former pool matches asset maturities to payment obligations. The latter pool transforms the power of long-term return compounding into affordable pension contribution rates.
How does this relate to rethinking active management and advocating long-termism? It is the need for pension funds to generate sufficient long-term investment returns to make adequate pensions affordable. As Keynes noted, real investing is the transformation of savings into wealth producing capital, and it is the very quality of this transformation rather than the short-term beauty contest investing that should be at the front and centre of active management today. We will call this form of investing ‘active ownership’ investing.
Four ‘active ownership’ foundations
The four fundamental building blocks that underpin active ownership are not new:
1932: In their treatise “The Modern Corporation and Private Property”, Adolf Berle and Gardiner Means examine the role and internal organization of the modern corporation. They warn that wide diffusion of corporate ownership places much power in the hands of corporate boards and managements. This raises the question of how to ensure that this power would not be misused.
1934: Benjamin Graham and David Dodd’s Security Analysis is published. In their view, professional investors have an obligation to thoroughly understand a business before making any valuation judgment or buy/sell decision.
1970: Nobel Laureate George Akerlof’s article The Market for Lemons: Quality Uncertainty and the Market Mechanism is published. He reminds us that much of microeconomic theory assumes that buyers know as much about what they are buying as sellers know about what they were selling. If this is not the case, buyers are at an informational disadvantage, and will pay too much for too little. Therefore, if retirement savers don’t know ‘beauty contest’ investing is a zero-sum game less fees, they will collectively pay too much for too little. A large body of empirical evidence confirms this to be the case.
1976: In response to the Efficient Market Hypothesis and its implications for active management, FAJ Editor Jack Treynor publishes his classic article Long-Term Investing. He distinguishes between the ‘fast’ ideas of Keynes’ beauty contest investors and the ‘slow’ ideas of Graham/Dodd’s deep investment thinkers. He argues that these ‘slow’ ideas are the only legitimate basis for successful long-term investing.
Outperformance by ‘active ownership’ investing
Cremers and Pareek: found that investment managers with low portfolio turnover and concentrated positions outperformed managers without these two combined characteristics by a statistically significant 2.3% p.a. over 20+ year observation periods.
Harford, Kecskes, and Mansi: found investment managers with low portfolio turnover and concentrated positions were disproportionately invested in a subset of companies that had relatively higher-quality boards, more innovation, higher returns on capital, and higher dividend payouts. The subset of low turnover/high concentration managers outperformed the rest of the manager universe by a statistically significant 3.5% p.a. over 20+ year observation periods.
Khan, Serafeim, and Yoon: found that portfolios made up of companies with high sustainability scores outperformed portfolios of companies with low sustainability scores weighted by SASB materiality by average annual return gaps ranging from 3.1% p.a. to 8.9% p.a. over 20+ year observation periods, depending on the degree of portfolio concentration.
These findings highlight that portfolios which embody ‘active ownership’ characteristics indeed produce exceptional investment results over a long time horizon.
Shift towards active ownership
Given the allures of short-term beauty contest investing, how can we accelerate the shift towards a longer-term, pragmatic and sustainable approach to investing? We can address this through both a macro and micro lens:
Macro
a) Accelerate systems-level work towards building a global financial system that is stable, credible, and transparent.
b) Integrate ‘active ownership’ investing into governance and investment education and accreditation programs.
c) Initiate ‘active ownership’ investment messaging to the media, and to key governmental, regulatory, and business agencies.
d) Expand workplace pension plan coverage with effective pension delivery organizations with fiduciary mandates.
e) Repurpose stock exchanges to promote and facilitate long-term investing.
f) Transform the voluntary disclosure protocols developed by IIRC, SASB, A4S, and TCFD into a coherent set of mandatory principles-based reporting requirements for the corporate and investment sectors.
Micro
a) Continue to develop the ideas and protocols first proposed by Graham and Dodd in 1934. Promising exchanges are underway in both the academic and professional communities on defining and measuring such concepts as corporate sustainability, organizational effectiveness, ‘value for money’ measurement and benchmarking, and incentive compensation.
b) Actually implement these ideas in ‘active ownership’ institutional investment programs rather than just talk about them.
It is one thing to talk and another to execute. Are you ready to become an ‘active ownership’ investor?
Wilbur Li is a final year student studying Bachelor of Commerce (Honours in Finance) at the University of Melbourne and is a Portfolio Manager with Sharewell. He has worked at Unisuper (global equities) and PwC (debt and fixed income).
Keith Ambachtsheer is among the world’s leading pension authorities and was named as one of the ’10 Most Influential Academics in Institutional Investing’. He is Adjunct Professor and Founder at the International Centre for Pension Management based at the Rotman School of Management at the University of Toronto. This article is general information that does not consider the circumstances of any individual.
The full May 2017 Ambachtsheer Letter is attached here.