The Case for Long-Horizon Investing in DB Plans

Long-horizon investing can generate up to a 1.5% premium on returns, according to a Willis Towers Watson study that modeled pension plan investment practices.

A recent study by Willis Towers Watson (WTW) suggests that a long-horizon investor can stand to gain a net premium return of up to 1.5% annually depending on the asset manager’s size, strategy and governance. The research revolves around the idea that long-horizon investing offers significant opportunities for return, while downplaying drags on return. It identified eight building blocks or strategies for long-horizon investing.

These building blocks were applied to two hypothetical defined benefit (DB) pension plans. The smaller one, with $1 billion in assets, focused on lowering costs and avoiding mistakes by reducing manager turnover and avoiding chasing performance, while moving parts of its passive exposure into smart beta strategies. The net benefit of these strategies was potentially an annual increase in investment returns of about .5% per year. The larger scheme, with $100 billion in assets under management, had the governance and financial resources to employ all strategies and achieved a potential increase in returns of 1.5%.

“Most investors, if not all, would agree that those who are able to take a long-term view have a competitive edge over others,” says paper co-author Liang Yin. “I would summarize that competitive edge as the ability or skillset to identify long-term opportunities and the willingness or mind-set to maintain position in the face of short-term performance volatility.”

The report suggests creating portfolios that actively invest in companies that are focused on the long term as opposed to their short-term peers. It points to research by McKinsey Global Institute indicating that between 2001 and 2014, the revenue of companies with long-term outlooks grew on average 47% more than that of other firms, and with less volatility. WTW also recommends thematic investing and capturing systematic mispricing through alternative weighting schemes, or liability driven investing (LDI) glidepaths. It points to research concluding that “various mispricing effects via smart betas adds more than 1.5% per year relative to the cap-weighted index over decades of data.”

Matt Peron, head of global equity investing with Northern Trust Asset Management, tells PLANSPONSOR that alternative weighting schemes may pose less risk in long-horizon investing as opposed to thematic investing, however.

“You can pick factors that have long cycle lengths and higher return premiums such as value, and you can put that to your advantage,” Peron explains. “With factor-based investing, you have a rich, empirical data set going back to the early 1900s and you see fairly consistent patterns of return profiles of these factors. Thematic investing changes every decade. And you have to pick the right theme every time.”

WTW found that overall, return-seeking strategies were more suitable for larger plans with the resources and expertise to execute them effectively.

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WTW notes that smaller funds can benefit from a shift in mindset by lowering transaction costs and avoiding buying high while selling low, as well as forced sales. Evading these actions can enhance returns at a “much lower governance cost than seeking return enhancements.”

The report cited a study of 3,400 plan sponsors that looked at their selection and termination of investment management firms from 1994 to 2003. The researchers used this data to compare post-hiring returns with returns that would have been delivered by fired managers.

It found that, although managers that would be hired outperformed the managers that would be fired by 4.6% over one year and 9.5% over three years, “a strong signal that plans were chasing past performance,” returns of managers fired due to poor three-year performance experienced a rebound. This led to a cost of 1% three years post manager change. In terms of long-term investing, plan sponsors can benefit from focusing on performance in the long-run as opposed to short-term shifts.

Citing similar research, Peron said it showed “Plan sponsors would hire and fire on a three-year cycle. People tend to hire at the top and fire at the bottom because they look at the three-year horizon. In my view, that’s the wrong measuring frequency to be looking at.”

Yin adds, “Considerable evidence suggests that investors, both individual and institutional, engage in buying high and selling low and as a result they give up substantial returns. This past-performance-chasing behavior is fundamentally incompatible with a long-horizon mind-set.”

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WTW points out that not all building blocks are independent of each other and some are even contradictory. For example, it points to the “liquidity provision” and the “illiquidity premium.”

With the liquidity provision, DB plans can hold a certain amount of cash in reserve and use it at times when other investors need cash and are willing to sell shares below market value, thereby making a positive return on investment. WTW says “Long-horizon investors have the potential to earn additional returns of 1% pa [per annum] by providing liquidity when it is most needed.”

When investors accept illiquidity, however, they stand to gain by locking capital up as long as they can tolerate. WTW notes, “The illiquidity risk premium (IRP) is worth 0.5% to 2% annually—and even higher returns might be available to very long-horizon investors.” Illiquidity risk is not having liquid assets on hand when an opportunity to buy low presents itself.

Still, a paper by the World Economic Forum reports there are key constraints to long-term investing when it comes to DB plans. Challenges among these plans include differentiation in liabilities, risk appetites, and decision-making processes—all of which can enhance or hinder the plan’s ability to engage in these strategies or building blocks. Moreover, all this comes at a price some may not be willing to stomach.

WTW says “Capturing the benefits of long-horizon investing is likely to require a major shift of mindset and significantly expanded skill-sets by asset owners and asset managers. The cost of strengthening governance capability to address these requirements could be significant, depending on the starting place.”

Thus, it is essential to engage in due diligence and evaluate cost as well as potential return when looking at asset managers focused on long-horizon investing. The results, however, could be substantial.

“In fact, it is reasonable to assume the long-horizon premium exists precisely because it is so hard to capture,” says Yin. “However, a return uplift of 0.5 to 1.5%, particularly in today’s low-yield environment, can be extremely rewarding.”  

He concludes, “To put it in context, 0.5% return enhancement equals $5 million in incremental wealth creation, per year, for a $1 billion fund. For a $100 billion asset owner, a return uplift of 1.5%, if achieved, would translate to $1.5 billion additional wealth creation every year.”

The research paper from Willis Towers Watson may be downloaded from here.