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Hermes’ nine rules for genuine long-term investors

19 September 2017

Eoin Murray, head of investment at Hermes Investment Management, explains how investors can break free from “quarterly capitalism” and look to the long term.

By Gary Jackson,

Editor, FE Trustnet

Many critics of the investment industry argue that it has become too focused on short-term, benchmark-relative performance but Hermes Investment Management’s Eoin Murray is a firm believer that things do not need to be this way.

Commentators have pointed out that the investment industry has entered “an era of quarterly capitalism” and suggest this short-termism leads to substandard returns for both asset owners and the financial ecosystem.

In his new paper Playing the long game: Investing effectively beyond the market cycle, Hermes head of investment Murray said: “Although the asset management industry has made some strides, there is still much work to be done in promoting and adopting a long-term investment horizon.

“While all stakeholders have their part to play in reshaping the industry, asset managers should be encouraged to better align their interests with asset owners and move to balanced, long-term capitalism that ultimately benefits investors as well as society.

Outperformance of Hermes funds over various time frames

 

Source: Hermes Investment Management

“Long-term investing may not be the holy grail – it involves sometimes difficult costs and trade-offs that should be well understood, and it also leads to the assumption of different risks. In short, it will not be for everyone. However, for those that are up to the challenge, the task is to identify an overall package of conditions that best suit the end investor and offer the investment manager the greatest prospect of success.”

In this article, FE Trustnet takes a closer look at the nine factors Murray believes investors should focus on if they are to be truly long term in their approach.

 

Alignment of interests

Murray highlighted better alignment of interests between asset owners and asset managers as “a crucial component and foundation” for genuine long-term investing.

So the asset owner and asset manager “remain on the same page”, the paper recommended that they jointly formulate investment beliefs which are flexible but coherent and disciplined, so they remain applicable even when markets are fluctuating.

“This means employing consistent processes and practices that look beyond short-term market turbulence and concentrate on the long-term fundamentals and drivers of a company’s strategy,” Murray said. “It is also crucial to remove the inevitable behavioural biases that creep in because they can distort rational decision making and cause conflicts of interest.”

 

Risk

The second factor in long-term investing is a deeper understanding of the different forms of risk that can affect a portfolio.

Murray said: “There needs to be a renewed focus on risk. Like short-term investing, long-term investing has its own set of issues and investors have to be aware as well as able to manage the uncertainties that will occur. This not only involves looking at the key risks but also the risk appetite and measures that need to be adopted.”


Long-term investors need to be able to apply and understand a range of risk metrics, as no single metric can fully capture risk, as well as knowing over which time frames it is appropriate to measure risk.

 

Benchmarking

Investors should also review the benchmarks they apply to portfolios to determine whether they are reinforcing or hindering long-term investment.

Market capitalisation-weighted benchmarks tend to just mirror the average return while Murray noted that fundamentally weighted ones may have more of a chance of reflecting long-term sustainability risk and opportunity.

There are still relatively few benchmarks that foster a longer-term orientation, such as S&P’s Long-Term Value Creation Global index. But Hermes believes this will change as they move into the mainstream: “Wider adoption by asset owners and managers could help exert greater influence on boards and management companies to employ strategies aimed at long-term growth and cash flow generation rather than short-term impact on stock price.”

 

Unlocking value through engagement and active ownership

Greater use of environmental, social and governance (ESG) principles can support long-term investment as they can help investors to avoid companies that are at risk of, for example, unethical management or flouting environmental regulations.

Evidence of ESG factors in long-term performance

 

Source: Hermes Investment Management

Furthermore, it can help identify stocks with ESG benefits to exploit – there is a growing body of academic evidence to suggest that there is a correlation between better company ESG performance and higher-quality management, stronger growth and lower cost of capital as well as superior, risk-adjusted performance over the long term.

“The exercise of corporate stewardship must lie at the heart of any long-term investment programme – it represents a willingness to engage with firm management to seek change that will benefit shareholders over a long horizon,” Hermes’ paper said. “Engagement is no quick fix, of course, and only those shareholders that stay the course will usually get to enjoy the full benefits of the active engagement.”

 

Turnover

The turnover of a portfolio is another factor that investors have to keep a close eye on, Murray said, as it can have an impact on overall costs and foster short-termist behaviour.

Research by Mercer suggested that an annual portfolio turnover rate of around 25 per cent is close to ideal but found that that actual portfolio turnover rate is currently 58 per cent. The consultancy suggested that asset managers explicitly outlines their time horizons and expectations for their asset-class exposures in a so-called behavioural policy statement.

“Warren Buffet put it best: ‘If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.’ Going forward, asset owners should monitor asset managers against expectations in turnover as well as portfolio characteristics and drivers of activity,” Murray added.

 

Portfolio construction

Portfolio construction will differ according to individual requirements and restrictions, although Hermes’ paper argued that it is “reasonable” to believe smaller portfolios enable deeper fundamental research and engagement, which in turn incentivises companies to adopt a longer horizon and more sustainable business practices.


In contrast, a larger number of holdings makes it difficult to conduct such comprehensive and detailed research. This renders meaningful engagement impossible, unless the asset manager incurs unacceptable costs.

“Communication is vital and asset managers need to be clear with asset owners that the relationship between the number of stocks in the portfolio and their ability to conduct comprehensive fundamental research as well as achieve the objectives of long-term investing,” said Murray.

 

Organisational culture

Professional investors should be attentive to the culture of their organisation and support its transition towards a longer-term model.

This means influencers within the organisation should display characteristics such as cognitive flexibility, the ability to be creative and think outside the box, a feeling of ownership in the organisation and, citizenship, with the desire to go exceed the responsibilities of their role for the good of the company.

Murray said: “Changing culture within an organisation is often compared to turning a tanker ship around, but there is no doubt that long-term sustainable investing requires a new work environment, mentality and skillset. Culture can be the glue around which alignment and trust are built, orienting a relationship naturally towards the longer term.”

 

Suitability

The relationship between the asset owner and asset is “an essential component” in cultivating a long-term, sustainable culture for a portfolio, according to Hermes’ paper.

Before selecting a fund manager, asset owners need to undertake stringent due diligence that carefully assesses people, philosophy, processes and potential partnership. While past performance should be taken into account in this analysis, there needs to be a stronger recognition of the role that luck can play in generating returns over a short period.

“Asset owners should look behind the figures at the characteristics and context of performance as well as the portfolios and processes that the manager has built,” Murray said. “Lengthening the period of evaluation allows the noise [short-term volatility] to begin to wash out and the signal [alpha skill] to shine through, while for shorter time periods noise dominates. In other words, luck may dominate in the short term, but skill is the key in the long term.”

 

Measurement

Finally, investors need to be attentive to the metrics that are being used to calculate the long-term performance and health of companies.

The paper argued that common measures such as 10-year economic value added, research & development efficiency, the patent pipeline, multi-year returns on capital investments, and energy intensity of production are generally lacking and fail to capture ESG outcomes.

Linked to this, Hermes has changed its style of reporting and reversed the ordering of horizon, so clients will have their attention drawn to changes in wealth over longer periods rather than shorter horizons.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.