Opinion piece by David Neal, Managing Director of the Future Fund, submitted to the Australian Financial Review and published on 5 April 2016.
Every day short-term decisions taken on behalf of long-term investors risk destroying value.
This is a structural flaw in the investment system that many long-term investors, including Australia’s sovereign wealth fund the Future Fund, are increasingly focused on fixing.
The problem arises because long-term investors rely on a series of relationships between principals and agents to achieve their objectives.
These relationships form a series of links in an investment value chain from the management of investee companies through their Boards, to fund managers, to institutional funds and on to beneficiaries seeking to achieve long-term objectives. Within each link there are multiple participants each with their own incentives and priorities.
Misalignments in principal/agent relationships occur when there is a significant gap in knowledge and understanding between two parties. In the complex world of investing, this is a particular challenge.
Add “long-term” to the equation and the challenge is magnified, as humans are biased to place heavy weightings on more immediately available information. At each step in the chain, agency issues put at risk achieving the original objective of the ultimate beneficiary.
We see this when asset owners focus more on performance relative to peers than delivering outcomes for beneficiaries. Or when companies defer value creating capital investments to hit short-term earnings expectations.
Traditional monitoring processes exacerbate this. Investment benchmarks are easily set and offer an objective and apparently comforting baseline against which to track performance to the minute.
The result is long-term investment horizons are shortened. Concerns created by short-term underperformance are given disproportionally high weight in the management of the relationship. Agents in the value chain are driven towards consensus positions, wary of standing out from peers and competitors. Long-term results are impaired.
Smart incentive systems can help. This includes setting longer-term benchmarks and aligning rewards to longer-term performance. That goes for remuneration systems in investee companies and institutional investors as well as the fee arrangements for fund managers.
But it remains hard to build incentive systems that link rewards to the 10 year plus horizons of most relevance to institutions.
Some institutional investors are responding by cutting out the middle man and bringing more investment in house. But internal teams can also be drawn to short-term benchmarks and consensus.
A more fundamental approach is to rethink traditional models of delegation, monitoring and control. This shifts the emphasis from objective, clear but ill-fitting measurement to a more subjective and fuzzy form of assessment. Being roughly right, rather than precisely wrong.
The principal would focus on understanding the thinking, processes and decisions of the agent, helping it assess whether the agent is acting in alignment with the principal’s true objectives. Hard benchmark measures provide support to this assessment, but no more.
The Future Fund adopts this approach, going to great lengths to build alignment with external fund managers. We engage in deep and regular dialogue to explain our objectives and priorities, to understand the strategies being applied and how they create long-term value.
Working with fund managers and understanding their thinking and decision-making offers a route to acting as equals and driving alignment rather than relying on short-term data to monitor remotely.
This kind of engagement between actors can be applied at each link in the chain. At the Future Fund it applies between the Board and management and between the layers of accountability within our team. We hope and expect that it occurs between our managers and their investee companies.
This immersed monitoring demands effort. Reducing reliance on benchmarks, investing in internal expertise and applying the commitment to move relationships from service provision to partnership is difficult.
It also requires a cultural change so the investment industry has a more professional, client-centric focus. But driving better alignment for the benefit of the ultimate beneficiaries can only be good for the long term health of the industry and its participants.