Are You Really Able to Think and Act Long Term?
Investing like the New Zealand Super Fund is surprisingly easy—in concept. In practice, of course, it’s devilishly difficult. Otherwise, we’d all be rich.
To see why this is the case, let’s examine some of the key features of the Super Fund’s investment approach.
Thinking and acting long term. We pointed out last week that merely having a long investment time horizon wasn’t necessarily an advantage. What matters is thinking and acting like a long-term investor. The Super Fund’s description of the key advantage of thinking long term goes like this: “For us, the most useful definition of a long-term investor is ‘an investor who can hold any investment for as long as they wish.’”
An investor who is thinking long term never has to sell anything. That doesn’t mean it won’t sell, but just that it doesn’t have to sell—say, when the market has just collapsed and prices are suddenly much lower.
Thus, being a long-term investor is more a state of mind than anything else. It means that you won’t make foolish, short-term decisions: chasing returns, chasing hot managers, constantly changing your strategy, selling in a panic just because the market has declined significantly.
To avoid being pressured into making short-term, self-sabotaging decisions, the Super Fund communicates regularly with its stakeholders about what a long-term focus means and why they are invested as they are. Thus, when the market turns against the fund or when a strategy has underperformed for a significant period of time, there is less pressure to sell good long-term investments.
One investment strategy in particular needs to be undertaken with a long-term view in mind: taking advantage of the phenomenon of reversion-to-the-mean. Over time, returns in any asset class tend inevitably to revert toward the mean long-term return of that asset class. Unfortunately, the time it takes for prices to revert can be v-e-r-y l-o-n-g.
Consider, just as examples, the recent outperformance of growth stocks over value stocks, and the outperformance of U.S. equities versus non-U.S. equities, both of which have persisted for roughly a decade. If your family doesn’t understand why you are tilting toward value or international (if you are), they will likely be questioning your judgment. Communication is all.
Governance matters. Many pension funds and sovereign wealth funds face constant interference from the governments that funded them. And families, too, often have poor governance when it comes to investment issues – family members sometimes can’t agree or can’t make timely decisions. Poor governance virtually always leads to poor investment results.
If your family is exercising poor governance on the investment side, you need to fix the problem. Establishing an investment committee that includes non-family members might be a useful fix, since it will ensure that you have people with sound judgment in the room with you.
Using best practices across the board. At the margin there is disagreement about whether certain activities represent best practices, but for the most part those practices are well understood and are religiously followed by successful investors.
For example, paying attention to investment costs is a best practice. In this regard, the objective isn’t so much to minimize costs, but to optimize them. Avoid paying high fees unless the manager has clearly demonstrated the ability to outperform net of those fees. Avoid frequent turnover, which generates transaction costs and taxes.
Diversification is a best practice, as long as it isn’t taken to extremes. Properly done, diversification can significantly reduce the risk level of your portfolio without reducing its return. It’s one of the few free lunches in the investment world.
But don’t overdue diversification. Rather than having six U.S. large cap equity managers, switch to one cheap index fund. Avoid active managers who are really closet indexers, that is, they own way too many stocks and have real conviction in only a few of them.
But always diversify at the asset class level. Just because U.S. stocks have outperformed for a decade doesn’t mean that you should avoid non-U.S. stocks. On the other hand, of course, your exposure to non-U.S. stocks needn’t necessarily be the same as the global capitalization would suggest.
The Super Fund, for example, invests in seven equity markets (e.g., the U.S., Europe, emerging markets, etc.), six fixed income markets, eight currency markets, and one real estate market (the U.S.). And it invests in these sectors via both public and private investments, and via both long-only managers and hedge funds.
Paying attention to price is a best practice. Investors who forgot this principle, and who paid 90 times earnings (or infinite times earnings) for tech stocks in 1999 found this out the hard way. Always compare the current price level of a market sector with the level at which that sector has traditionally sold. If the current price is extremely high, sell. If the current price is extremely low, buy. If you’re unsure, hold.
Strategic tilting of a portfolio is a more controversial “best practice,” but if done right it can both add to your returns and help you avoid serious losses. Strategic tilting is related to the mean reversion issue mentioned above. From time to time various sectors of the market can become very expensive or very cheap. Tilting your portfolio away from expensive sectors and toward cheap sectors makes sense, as long as you are – like the Super Fund – disciplined about it and thinking long term.
Trading liquidity for return is a best practice, assuming you can truly withstand the illiquidity and that the illiquid strategies in your portfolio are best-in-class. Most family portfolios own too much in liquid investments and not enough in illiquid investments, and that leaves a lot of return on the table.
On the other hand, don’t just buy random illiquid investments and expect to capture the “illiquidity premium.” Some illiquid asset classes are extremely difficult to navigate successfully. Venture capital, for example, is virtually impossible for most families to invest in successfully, simply because there are few best-in-class venture funds and those are almost always over-subscribed.
Next week we’ll continue our exploration of how we might invest like the Super Fund.