Long-term investors may measure their horizons in decades, but performance can be measured every day. Could the way investment success is evaluated encourage shorter-term behaviour?
Some of the world’s largest investors also have some of the longest investment horizons. Pension funds, insurers, endowments and other institutional investors can make decisions today whose consequences may still be felt decades from now.
In principle, that should give them an advantage. They can potentially look beyond temporary market volatility and allow an investment thesis time to develop.
Yet the infrastructure surrounding long-term investment often operates on a much shorter timetable. Portfolios can be valued daily, performance reported monthly or quarterly and managers regularly compared with benchmarks and their peers.
There is nothing inherently wrong with this, as investors need transparency, accountability and effective risk management. But it creates an interesting contradiction: can capital genuinely be patient when the system used to measure it is considerably less so?
Long-term objectives, short-term scorecards
The FCA describes patient capital as a broad range of investments intended to deliver long-term returns, including venture capital, private equity, private debt, real estate and infrastructure. Such assets are usually illiquid and require investors willing and able to commit capital for significant periods.
But the tension between long-term objectives and shorter-term evaluation extends much further across institutional investment.
A pension scheme, for example, may be investing against liabilities stretching decades into the future. An infrastructure project can take years to mature, and even in public markets, a corporate restructuring or investment programme may require several years before its success becomes clear.
Yet financial markets are exceptionally good at telling investors what an asset is worth today.
That information is valuable. The harder question is whether today’s valuation always tells us enough about the progress of a strategy designed around a much longer timeframe.
Is performance the same as progress?
Performance and progress are related, but they are not necessarily the same thing.
Performance tells an investor what has happened to the value of an investment. Progress asks whether the assumptions underpinning the original investment case are developing as expected.
Consider a company whose shares have underperformed the wider market for a year. If its margins are improving, debt is falling, cash generation is strengthening and a long-term investment programme remains on schedule, the investment thesis may actually have progressed despite disappointing share-price performance.
The reverse can also be true: a rising share price does not automatically mean that the underlying investment case has strengthened.
This creates a challenge for investors. If the investment horizon is 10 years, how much should a 12-month return tell us about whether the strategy is working?
Short-term performance still matters, but it may not provide enough information on its own to judge whether a long-term investment strategy remains on track.
When measurement starts influencing behaviour
The issue becomes more complicated when measurement itself begins to influence decision-making.
Investment managers know that their performance will be reviewed. Trustees, investment committees and clients understandably want to know whether capital is being managed effectively. Consequently, benchmarks and peer comparisons provide valuable ways of assessing those results.
Research provides an interesting perspective on the relationship between patience and active management.
A study published in the Journal of Financial Economics found that among US equity portfolios with high active share – meaning holdings that differed substantially from their benchmarks – patient strategies with holding periods of more than two years outperformed by more than 2% a year on average.
Frequently trading funds generally underperformed. Importantly, the research did not find that patience alone produced superior performance; the result applied to funds combining patience with genuinely active portfolios.
It is an important distinction because simply waiting longer does not create investment skill.
However, frequent evaluation can potentially create competing incentives. An investor may believe that an unconventional position will produce superior returns over many years while also knowing that several years of relative underperformance could be difficult to defend.
The challenge is not that performance is measured too frequently; it is whether the timeframe used to judge success becomes shorter than the timeframe required for the investment strategy to succeed.
Patience has its own risks
There is an important counterargument: patience is not automatically an investment virtue.
Companies deteriorate, management teams make mistakes, competitive advantages disappear, technologies change, and assumptions that looked perfectly reasonable when an investment was made can subsequently prove wrong. A long investment horizon should never be an excuse to ignore evidence.
The distinction is therefore not simply between patient and impatient investors. It may be between investors who can distinguish temporary underperformance from deterioration in the original investment thesis.
Being patient with an investment can make sense as long as the evidence supporting the investment case remains intact. Continuing to wait after that evidence has changed is something quite different.
What should patient capital measure?
Perhaps the answer is not to measure long-term investments less frequently, but to measure them in more than just financial terms. The appropriate measures will vary according to the original investment case.
For a company, investors might consider margins, cash generation, debt, market share or progress against strategic objectives. Infrastructure investors might focus on construction milestones, utilisation or contracted revenues. A pension scheme may need to consider whether its portfolio remains aligned with its liabilities and long-term risk objectives.
None of these measures replaces investment returns; ultimately, capital still needs to generate an appropriate return for the risk being taken.
But intermediate measures can potentially help investors determine whether an investment is progressing towards the outcome for which it was originally selected. This suggests that some of the most useful measures of progress should be identified when an investment is made, rather than retrospectively when performance disappoints.
Patience needs accountability too
Financial markets have become extraordinarily effective at measuring performance quickly and precisely. Investors can see what their portfolios are worth and how they compare with a benchmark almost instantly.
That represents progress in itself, but the more difficult task is ensuring that the availability of short-term information does not inadvertently redefine a long-term objective.
Recent TIAA Institute research, drawing on interviews with institutional investors across the US, Europe, Australia and Asia, sheds further light on this tension. The report highlights increasing pressure on institutions to justify their value and maintain accountability to stakeholders, even as they consider strategic issues over a five-to-ten-year horizon.
Patient capital should not mean ignoring performance, tolerating failure or waiting indefinitely for an investment thesis to come good. It means recognising that different investments may require different periods over which success can reasonably be judged, while continually testing whether the original reasons for investing remain valid.
Perhaps that is the real challenge for long-term investors; patient capital requires more than a long investment horizon. It may also require an accountability framework capable of being patient too.