Long-term investors: Getting the model right
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.
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
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