Long-term investors: Getting the model right

©Rick Winning RTW/REUTERS

Since the 2008 financial crisis, strains in the financial sector and in government balance sheets mean there is less and less supply of long-term capital. This has profound implications for growth and financial stability. Policymakers should take action. 

An OECD report on Infrastructure to 2030 estimated global infrastructure requirements to be in the order of $50 trillion. The International Energy Agency has estimated that adapting to and mitigating the effects of climate change over the next 40 years to 2050 will require around $45 trillion or around $1 trillion a year.

Demand for long-term capital across the world will increase, not only to help countries exit from the current financial crisis and reinforce growth rates in mature economies, but also to finance infrastructure, innovation, education and environment programmes worldwide. Action is needed to meet this demand and cover the expected shortfalls.

Bank lending, the traditional private source of financing for infrastructure and renewable energy, is under major strain as a result of the post-crisis deleveraging and new banking regulations. In the first three months of 2012, the global volume of new project finance–at $64.6bn–was one third lower than in the previous year and there is an expectation that such financing could shrink further.

Institutional investors, such as pension funds, insurers, mutual funds, and sovereign wealth funds, could potentially take up some of the slack in the market. The main institutional investors in the OECD–pension funds, insurance companies and mutual funds–hold over $71 trillion in assets. In emerging markets, sovereign wealth funds are the main investors, with over US$4 trillion in assets. While these institutions are often referred to as “long-term investors”, they do not always act in this capacity.

There are three types of long-term investment. “Patient” capital, that is the ability to hold investments for long periods, lowers portfolio turnover, encourages less pro-cyclical investment strategies and facilitates investment in less liquid assets. It can therefore lead to higher net returns and greater financial stability.

“Engaged” capital encourages active voting policies, leading to better corporate governance and better managed companies.

Finally, “productive” capital provides support for infrastructure development, green growth initiatives, SME finance etc., leading to sustainable growth.

Despite their seeming contribution to financial stability–acting as shock absorbers in times of financial distress– and capital market development – improving market liquidity and access to finance, institutional investors are often criticised for short-termism. Some objections include facts such as declining investment holding periods and low allocations to less liquid, long-term assets such as infrastructure and venture capital, while those to hedge funds and other high frequency traders have grown in importance. Other related concerns over the behaviour of institutional investors are their herd-like mentality which may sometimes feed asset price bubbles, and their tendency to be “asleep at the wheel”, failing to exercise a voice in corporate governance. “Where were the main institutional shareholders when the banks were going bust and corporate executives being so overpaid?”

So why don’t institutional investors live up to their long-term investing potential? Several complex and interlocking barriers hold them back.

Institutional investors increasingly rely on passive investing or indexing on the one hand and alternative investments (such as hedge funds) on the other. The former can discourage them from being active shareowners while the latter may involve shorter term, higher turnover investment strategies.

Agency problems are another barrier to long-term investment. Pension funds in particular rely increasingly on external asset managers and consultants for much of their investment activity. However, they often fail to direct and oversee external managers effectively–handing out mandates and monitoring performance over short time periods which introduces misaligned incentives into the investment chain. Institutional investors also contribute indirectly to short-termism via some common investment activities, such as securities lending or increasing investment in Exchange Trade Funds (ETFs). Investors may, therefore, be inadvertently contributing to speculative trading activities in the very securities that they own.

Government regulation can also exacerbate the focus on short-term performance, especially when assets and liabilities are valued referencing market prices. For example, the use of market prices for calculating pension assets and liabilities (especially the application of spot discount rates) and the implementation of quantitative, risk-based funding requirements appear to have aggravated pro-cyclicality in pension fund investments during the 2008 financial crisis in some countries.

A lack of long-term investment opportunities, such as infrastructure projects, also acts as a barrier. This can be due to poor planning on the part of government which leads to a dearth of projects in the pipeline as well as of financing vehicles that do not give institutional investors the risk/return tradeoffs that they need. Insufficient investor capability could also be a reason. This is particularly true of smaller pension funds which do not have the knowledge or scale to become involved in such projects.

Finally, conditions for investment may simply be inappropriate due to a need for improved data collection and benchmarking for such projects.

Click to enlarge

So what can policy do to help? The OECD believes that policy reforms can be used to encourage institutional investors to play a longer-term role.

Improving the regulatory framework for institutional investors would help. For instance, by developing risk-management systems to take account of longer term risks, longer-term mandates and monitoring for external managers, removing investment regulatory barriers and addressing potential unintended short-term incentives in solvency and funding regulations.

Policies to encourage active share ownership are also important. Governments should first check that there are no regulatory barriers to institutional investors acting as active shareholders. These might include share blocking, taxation issues, takeover concerns or rules against collaboration. Practical encouragements, such as allowing electronic voting of shares, could also be put in place. Or regulation could be more prescriptive such as by requiring institution investors to disclose their voting policies and records, as well as their governance and conflict of interest policies.

Other incentives, such as giving multiple voting rights to long-term investors, could also be considered. The burden of active engagement can be reduced–particularly for smaller investors–by encouraging collaboration via investor groups, or alternatively using activist fund services or proxy voting firms, assuming appropriate safeguards are in place.

Guidance on behaviour expected from institutional investors is also key, with financial regulators and supervisors also having a role to play in ‘nudging’ institutions towards long-term, active investment.

Developing a supportive policy framework is also crucial. Policymakers should also help investors address long-term risks, such as by supporting the development of transparent and reliable indices. Government can issue long maturity and inflation-indexed bonds that facilitate longterm risk management by investors. A well structured public-private partnerships environment would also be boon, with governments working with institutional investors to assess the scope for promoting the “right” investment opportunities.

Having extolled the virtues of long-term investing, it is important to note that short-term financing also plays an important role in our financing systems–it is not a case of “four legs good, two legs bad.” Indeed, it was the so-called short term investors (hedge funds and the like) who often made the “right” call in the unwinding of the mortgage backed securities markets which were the catalyst for the financial and economic crisis. What we need to strive for is a more balanced financial system where investors are supported to play their most productive role.

For further information, including work with G20, see www.oecd.org/finance/lti

Della Croce, R., Stewart, F., Yermo, J., (2011), “Promoting Longer-term Investment by Institutional Investors: Selected Issues and Policies”, in OECD Journal: Financial Market Trends Volume 2011–Issue 1.

Della Croce, R. (2011), “Pension Funds Investment in Infrastructure: Policy Actions”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 13, OECD Publishing.

Della Croce, R., C. Kaminker and F. Stewart (2011), “The Role of Pension Funds in Financing Green Growth Initiatives”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 10, OECD Publishing.

OECD (2011), The Role of Institutional Investors in Promoting Good Corporate Governance, Corporate Governance, OECD Publishing.

OECD, (2010), “Pension Funds Investment in Infrastructure: A Survey”, in International Futures Programme, Project on Strategic Transport Infrastructure to 2030.

©OECD Observer No 290-291, Q1-Q2 2012




Economic data

E-Newsletter

Stay up-to-date with the latest news from the OECD by signing up for our e-newsletter :

Twitter feed

Editor's choice

  • Composite leading indicators
  • 2015, a year full of dangers? Laurent Bossard, director of the Sahel and West Africa Club, acknowledges that the situation in the region is complex and unstable but refuses to give in to fatalism.
  • The 5th Anti-corruption conference for G20 governments and business in Istanbul on 6 March will address how all businesses can play their part in contributing to growth and investment, and can operate with clean hands in a safe environment.
  • Success story. Discover the story of this young Ethiopian woman who launched a successful business in the footwear industry and became a UN Goodwill Ambassador for Entrepreneurship.
  • Transports in Asia. The Asian Development Bank advocates sustainable transport in a continent where vehicle ownership is perceived as a sign of social success.
  • Vote for your favourite photograph! This World Bank #EachDayISee photo contest aims to display visual stories from all over the world through which people express what they would like to see changed and improved.
  • Why is investment so low in the euro area? This short IMF blog post gives you an insight into the causes of the euro-zone's drastic decline in investment.
  • Have your say! The UN wants to know what matters most to you: pick six global issues in the list and send it to the United Nations.
  • Clear air and healthy lungs: how to better tackle air pollution. From New Delhi to Accra, millions of people breathe polluted air. A new report examines the World Bank’s experience working to improve air quality.
  • The boring secret of great cities. Plenty of things make a city great but what really makes a difference originates in the structure of municipal government according to the OECD's report "The Metropolitan Century".
  • Guinea gets $37.7 million in extra IMF financing to help combat Ebola
  • Towards an international carbon pricing framework? Designing a unified international carbon pricing system could help to move towards a fully functional low-carbon global economy.
  • Putting the global economy on a more virtuous path. Current potential growth rates are well below pre-crisis levels. To avoid stagnation, governments have to put in place robust structural reforms.
  • World Water Day: 22 March 2015 For World Water Day, UN-Water identifies upcoming challenges and sets the theme for the years to come. In 2015, the theme for World Water Day is Water and Sustainable Development.
  • What drives street-based child labour?The ILO, UNICEF, Save the Children and the Lebanese Ministry of Labour launch a first-ever study assessing the scope and characteristics of the increasingly visible phenomenon of one of the worst forms of child labour.
  • No “Grexit”. Speaking to CNBC, OECD Secretary-General Angel Gurría says he would do everything to make sure Greece does not leave the euro. "Everybody wants Greece to stay in, everybody wants Greece to prosper and to get out of its short-term morass," he told CNBC. Watch the video.
  • engaging citizens
  • Interested in citizen engagement? The World Bank Group offers a four-week online course which aims to teach how citizens can engage in both policymaking and public service delivery.
  • 2.1 million jobs could be created in Europe by 2018 under the three-year investment plan put forward by European Commission President Jean-Claude Juncker, according to the ILO.
  • Become involved in urban flood risk management. This World Bank two-week online forum gives you the opportunity to discuss how to preserve cities from these natural disasters with experts and development leaders.
  • Promoting decent work for migrant workers.This ILO report highlights the need to ensure decent work for migrants, which is part of the global agenda on sustainable development.

Most Popular Articles

Subscribe Now

<b>Subscribe now!</b>

To receive your exclusive print editions delivered to you directly


Online edition
Previous editions

Poll

What issue are you most concerned about in 2015?

Euro crisis
Unemployment
Global warming
International conflict
Other

OECD Insights Blog

NOTE: All signed articles in the OECD Observer express the opinions of the authors
and do not necessarily represent the official views of OECD member countries.

All rights reserved. OECD 2015