Long-term investing is a win-win. It’s good for investors — and also for the companies they invest in. But the focus of most investors is on the short term. That’s partly down to market noise and partly the seductive nature of fund industry marketing. So, what can be done to redress the balance? For JOE WIGGINS, the time has come to incentivise long-term investing by offering lower fees to investors who are willing to leave their money alone.
Investing for the long-term has never been more difficult. Not only do we have to face an incessant cacophony of market noise, but we can trade on a daily basis. An environment heavy on stimulus and light on friction is of detriment to both investors, who are constantly tempted by the next shiny object, and asset managers who operate as if the money they are responsible for might be withdrawn tomorrow. This destructive myopia is endemic across the industry. There must be a better way.
One path is to think about the power of incentives. Can behaviours be changed by reducing fees for investors willing to commit to investing for the long term?
It is not that the benefits to investors of greater choice, access and control are non-existent or immaterial, it is simply that the behavioural costs are both hidden and profound. The more that technological advancements make the lives of investors easier, the harder it becomes to reap the benefits of long-term investing. We spend far too little time considering this damaging dichotomy.
Good for investors — and for fund managers
We should also not ignore how increasing short-termism creates entirely the wrong incentive structure for asset managers. If they know that money in daily dealing funds can be removed in a moment, what types of behaviours does this encourage?
– Obsessing over short-run results.
– Launching flavour-of-the-month funds.
– Firing managers for poor short-term performance.
– Rewarding short-term decision making.
Asset managers and the fund managers who work for them won’t make long-term decisions if they don’t believe they will be here for the long-term. Short-term survival becomes the primary goal.
This creates a vicious circle where investors exist in against a backdrop that fosters short-term decision making and asset managers react to that perceived need by operating in a fashion that exacerbates such behaviour. And so, the cycle continues.
This situation is not in the interests of investors or well-intentioned asset managers.
Is this an inescapable reality, or can changes be made to improve the situation?
Harnessing the power of incentives
Given the power of incentives to drive behaviour there must be a means of rewarding investors for making long-term choices. Although long-term investing has substantial benefits, these accrue slowly and we only become aware of them when it is too late — we need something more prominent.
One option would be for asset managers to offer discounted management fees on special share classes which investors can only redeem after a set period. The same daily dealing, public market fund we would normally invest in but with certain ‘commitment’ share classes available for long-term holders. Think of it as a means of accruing the real illiquidity premium of private equity — behavioural temperance — but without the costs, opacity and other drawbacks.
So, how might it work?
Let’s say I want to invest into an global equity index fund in my personal pension (20 years+ horizon). The standard management fee is 20bps, but there are three other ‘commitment’ share classes available. Exactly the same fund but differing liquidity terms and management fees, such as:
Three years: 15bps management fee.
Five years: 10bps management fee.
Seven years: 5bps management fee.
(The fees could also be set relative to the cost of the primary daily dealing share class to account for declining charges over time).
These are hypothetical numbers, but I hope the point is clear. Funds could have share classes that are tagged with a certain vesting date, which cannot be sold until this point is reached. Upon vesting the share class can default to again become daily dealing (as per the standard type) or provide the option for a renewed long-term commitment. Fund groups could launch share classes with new vesting date tags over set periods — I may have found a use for the blockchain!
Benefits for investors
What are the benefits for investors? The fee reduction would be attractive but more importantly it incentivises and compels long-term investing behaviour. Once the decision is made, we must buy and hold.
What are the benefits for asset managers? They have a level of certainty over funds under management across time horizons greater than a day and can make business decisions on that basis. Their fund managers can also be confident that they have more assets committed for the long-term.
Alongside these benefits there are inevitably a range of limitations. While investors will be prevented from making lots of poor decisions through time, they might simply make one and be locked in for five years or more. Long-term investing is only a good idea if we make a sensible decision at the start, it is a disaster if we make a poor choice and are stuck with it – being trapped in a thematic fund at its performance peak for the next seven years doesn’t feel like the right type of commitment to be making. Of course, there could be protections against this, such as only making it available for funds with a substantial track record.
There are also drawbacks related to investor flexibility. A change of individual circumstance might mean that cash needs to be raised, but this cannot be achieved in a share class with a five-year commitment. This means such an approach only works where the investment must be long-term (such as a pension, where we cannot drawdown before a certain age) or in asset classes where we should never invest unless we have an appropriate time horizon (equities being the obvious example).
There is also a wider question of whether it could work for actively managed funds. The principles and advantages remain similar as with the passive example above, indeed the benefits of long-term capital might be greater for active managers. Yet there are nuances that make it more problematic. For example, what if we buy a seven-year vesting share class with an active fund manager and they leave, or the company is taken over, or they begin to behave in a manner that was inconsistent with expectations? For this approach to work for actively managed funds, there would need to be a range of covenants which, if broken, would see the fund revert to its daily dealing structure.
The other problem is liquidity. If a fund manager was aware that they had a high proportion of investors committed for five years they might be tempted to take on positions with poor liquidity. This would not be the desired outcome. The model would only work if funds were managed as if they were 100% daily dealing.
A diluted version of this concept is simply to create share classes where the management fee ratchets down as the ownership period increases but with no lock-in. To my earlier example, the management fee is 20bps for the first three years, then declines to 15bps, then 10bps and then 5bps after holding for seven years.
This does incentivise long-term behaviour, but the risk is that the reduction in fees would be easily overwhelmed by the powerful drivers of short-term decision making. It would also not change the situation for asset managers in any material fashion. It would, however, be far easier to implement.
A derivation of this technique would be to award bonus units in a fund (or even cash) once certain holding period thresholds are reached – like a fee reduction, but perhaps more salient.
I am uncertain about these ideas and am not oblivious to the drawbacks and technical challenges. Yet, I am certain that the industry needs to do far more to promote and reward the right type of behaviours. A good place to start would be by incentivising long-term investing with lower fees.
JOE WIGGINS works in the UK asset management industry. This article was first published on Joe’s blog, Behavioural Investment, and is republished here with his permission.
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