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Funds should consider building a brand around long-term investing. Specific improvements to performance measurement and stakeholder disclosure can be found in this article.
A complaint I heard from asset managers after I wrote an article about long-term investing was that investors should compare the quarterly or annual performance of a mutual fund that holds stocks for, say, seven years to the quarterly or annual performance of the S&P 500 or S&P 500. There was a tendency to compare. Russell 1000 index.
Does it make sense to measure the performance of long-term holders using a methodology that recognizes the costs and benefits of owning stocks over the long term? And if yes, how do such investment frameworks and What will the metrics and processes involved be?
What is long-term investment?
Perhaps it is easier to answer this question by assuming something that is not a “long-term investment”. Cremers and Peek (2016) found that mutual funds are likely to hold stocks for at most 1.3 years. Arguably, a much longer holding period could be considered a long-term investment.
This does not mean that long-term holders will not sell their stocks before such a long-term holding period if they think valuations have peaked. Nor does it mean that short-term investments are unconditionally undesirable. Alternatively, long-term investing always pays off. Additionally, my focus here is on mutual funds and public stocks. The underlying incentives and frictions are likely different for other long-term owners such as pension funds, university endowments, and family offices.
What should the new performance metrics and strategies look like?
1.0 Build your brand around long-term investing.
Warren Buffett is a textbook example of how to build a brand around long-term investing. As a first step, given the confusion surrounding the term “long-term investing”, it is helpful to define what long-term investing means for the Fund and why we think it is a good strategy in this particular area. It might be helpful. How do you intend to implement such strategies with your asset manager and how much of your assets are dedicated to such strategies?
2.0 We publish the average holding period of the fund.
This is probably an obvious indicator, but it is often not mentioned in the fact sheets or related literature of funds that hold stocks for the long term.
3.0 Contra-factually Simulated Short-Term Concentration Fund Benchmark:
One of the biggest obstacles to measuring long-term fund performance is the lack of counterfactual funds that follow short-term objective functions. Would it be useful to draw one or more scenarios that imagine how a short-term fund of the same capital might buy and quickly sell a particular security?
This could be a way to highlight the implicit costs incurred by short-term funds, such as transaction costs, the difference in higher short-term capital gains taxes compared to lower long-term capital gains taxes, and an unwillingness to tolerate short-term losses. there is. Things like dollar size and duration, and the usual psychological urge to buy high and sell low. Admittedly, these scenarios are likely subjective. A coalition of long-term owners could agree on the parameters of what such a scenario would look like and make those parameters public. Similar arrangements have had some success in the world of climate change and net-zero emissions scenarios.
In the short term, interim quick fixes are needed before such counterfactual scenarios develop. One idea is to use a benchmark fund that explicitly follows a short-term strategy from the same fund family. Another idea is to publish the turnover of assets within a fund relative to that of a short-term benchmark fund.
4.0 Publish the performance of the fund over its holding period:
Most funds now tend to publish performance data over one, five and ten year holding periods. Why not publish performance data over a fund’s average holding period?
5.0 Highlights the importance of equity risk premium on returns:
Equity risk premium refers to the excess return earned by stocks compared to Treasury bills over the long term. Short-term funds do not expect to earn returns on equity risk premiums, while long-term funds do. Benchmarking a long-term fund with each year’s S&P 500 return ignores the potential contribution of equity risk premiums to the fund’s performance. It may be worth emphasizing the role of the equity risk premium in fund returns. One thing to keep in mind here is that in some cases, stocks may not outperform government bonds over the long term.
6.0 Breaking down returns to understand where long-term investing adds value:
In line with the previous comment, a fund may wish to disaggregate the income earned for the following reasons:
(i) Skill and Luck – Too many mutual funds are just closet indexers and are therefore not worth the expense ratios they charge.
(ii) If a fund follows the proverbial Yale model of investing in illiquid long-term assets, can it disaggregate the returns earned from illiquidity and other returns?
(iii) If a VC fund makes profits because it invests in complex and opaque companies, can those profits be broken down into some kind of opacity premium over the rest?
7.0 Decomposes returns into capital appreciation and flows such as dividends and share buybacks.
In the short term, most of the gains are related to capital appreciation. In the long run, profits are a combination of capital appreciation, dividends, and share buybacks. In one of his papers with Sanjeev Bhojraj and Ashish Ochani, we show that even in equity, in the long run, flows defined as income or free cash flow are relatively small for most companies. I am. If the fund truly picked winners, one would expect the contribution from dividends and income growth to be larger.
8.0 Communicate long-term fund risk appetite:
The essence of long-term investing is the asset management company’s willingness to tolerate unrealized losses in the short term. Indicators such as downside capture rate do not fully reflect this risk appetite. It may be helpful to tell investors how the fund believes about the conditions that trigger a sale to convert a certain amount of unrealized losses into realized losses over a certain period of time.
A related point is that long-term investors can become countercyclical investors during market and economic downturns. The value gained from such countercyclical and contrarian moves needs to be quantified and emphasized.
9.0 Incentives and Governance Structure
As we have previously emphasized, we know every detail of how the decision-makers who run the Fund are compensated and governed. More detailed disclosure about how the long-term mission of the fund is reflected in the remuneration structure of decision-makers would be helpful. Additionally, we typically discuss the cultural architecture and governance structures used to ensure that decision-makers are appropriately motivated and monitored to ensure that funds deliver on their long-term plans. I know very little. Correcting this disclosure gap will help educate investors and attract the right customers to the fund.
10.0 Engagement metrics
Long-term equity investors can engage with companies and influence their strategies. Metrics highlighting the nature of these efforts and the potential benefits to be derived from such efforts can also be communicated to investors. An estimate of the potential revenue generated from the engagement would be further helpful.
It can also be helpful to publish and publish a fund’s voting record to convey a long-term ownership brand. Additionally, long-term investment institutions may want to be more proactive in demanding accountability from index laggards that have long-term underperformance in their portfolios.
These are some initial thoughts on how performance and governance systems could potentially change to build a brand around long-term investing. Constructive comments are welcome.
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