There is more opportunity to capture value-added returns by focusing on the long-horizon end of the investment spectrum, than join the over-crowded short-horizon end where most investment management is conducted, according to president and chief executive of the Canadian Pension Plan Investment Board (CPPIB), David Denison.
Speaking at the Conference Board of Canada and Towers Watson 2010 Summit on the Future of Pensions, he said the vast majority of the considerable intellectual capital devoted to the investment industry is actually focused on a 0-24 month time horizon.
“Rather than us joining this hyper-competitive universe, we quite simply believe there is a better opportunity for us to capture value-added returns by focusing on the long-horizon end of the spectrum where there are far fewer participants and far less competition because of the effective barriers to arbitrage,” he said.
Denison believes only a handful of investors qualify as long-term investors under a set of pre-conditions that enable long-term investing include: an appropriate business model; a tolerance for volatility; rigour around portfolio construction; an enabling governance model; and the design of the investment process.
He said what has become evident over the past two years is that most investors do not have an appropriate business model that provides sufficient stability of the investors’ asset base to allow them to operate with a long-term horizon.
In addition he says the most recent financial crisis has shown that many market participants have been compelled to alter their investment approach, indicating they do not have a tolerance for volatility.
“At the risk of oversimplifying the concept, I do think a useful descriptor of the long-term investor is someone who is never obliged to sell assets because of prevailing market conditions, with the decided emphasis on obliged to sell,” he said.
He said the liquidity dimensions of portfolio construction have never been clearer, pointing to the implications of having fixed or tight bans of allocations to asset classes. The crisis also highlighted another failure in portfolio construction – the failure to factor in future capital requirements.
“Appropriate governance is another requirement to be able to act as a long-term investor. Irrespective of an investor’s business model, if its governance regime is focused on short-term profits or performance, is nervous about reporting results that may be different than the mainstream, is unable or unwilling to grasp the principles of long-horizon valuations and risk, or has relatively short tenure for directors or trustees, then it won’t likely succeed in operating as a long-term investor or at least won’t for very long.”
He said very few investment processes actually incorporate long-horizon valuation factors.
Investment managers that are measured, rewarded and can be hired/fired over increasingly short periods are not likely to build investment processes that identify valuation anomalies that may take five years to materialise.
In practice, he said, this means those managers are not likely to, for example, buy real estate in a falling market with the expectation they will have to mark it down in the near-term even though its risk-adjusted returns over a 10-year timeframe may be compelling. Or, managers are unlikely to invest resources into researching and identifying long-horizon factor models that are different from most standard investment programs.
The triennial valuations of the CPP are done over a 75-year time horizon on a steady state versus full funding basis and the fund is not required to meet any solvency tests.
“Consequently from an investment perspective, we have much greater flexibility to deal with the volatility of market returns than almost any other pension fund or pool of capital,” Denison said.
The CPPIB’s total portfolio approach to portfolio construction means asset labels are ignored and investment decisions are focused on underlying economic and risk/return attributes.
“This focus on economic exposures versus asset classes allows us considerable flexibility in constructing and managing our portfolios and avoids some of the perils of fixed weights.” he said.
Its internal investment programs incorporate some elements of long-horizon value drivers and investment decisions are based upon return streams that can play out over extended timeframes.
