(October 3, 2013) — Institutional asset owners could generate higher returns through stronger, more engaged ownership, according to research.
“Behaving Like An Owner: Plugging Investment Chain Leakages,” written by Jane Ambachtsheer and Richard Fuller of Mercer Investments and Divyesh Hindocha, who recently announced he was leaving the firm, found that incentivizing long-term investing patterns and reducing friction costs would improve returns.
These changes, the study concluded, involved significant behavioral adjustments by investors, particularly regarding their relationships with managers.
The paper, published in the Rotman International Journal of Pension Management, outlines two different types of investment “leakages”: downstream and upstream.
Downstream leakage in the financial services industry involves tangible costs from stock turnover, transition activity, and management fees. Upstream leakage is less concrete as it looks into how and why companies behave the way they do. Costs are largely beyond the investors’ control and are difficult to calculate.
According to Ambachtsheer, Fuller, and Hindocha, asset owners could reduce downstream friction costs in a variety of ways. With belief that they are holding the right stocks, investors can avoid excessive equities trading. They could also reduce manager transitions by having greater confidence and trust in the existing managers and adapting a performance standard that measures over a longer period. These behavioral changes would ensure “partner-like relationships” between asset owners and asset managers, the authors found.
Ridding upstream friction costs are similarly behavioral, the study established. Not only does it require a stronger sense of ownership by asset owners, but it also involves a more significant focus on long-term investing. Investors should resist short-terminism, especially in terms of quarterly earnings and material improvements. They should also resolve the “free-rider problem” and take on a more evolved fiduciary duty.
From the authors’ experiment of hypothetically investing $100 over a 20-year period in four different environments, it was clear that addressing both upstream and downstream costs had the most positive impact on returns.
Asset shortfalls were 25% higher than that of a 100% active investment. After 20 years, passive global equity returns was 0.75% higher than passive and active investments as well as a portfolio that addressed only downstream leakages. Active management fees were also lower than those of other scenarios.
“Asset owners are in the best position to be catalysts for the kinds of changes we propose,” the authors wrote. “Asset owners can send powerful signals for change rippling through the investment supply chain.”
Read the full paper here.
Related content: Starting from Scratch: How 28 CIOs Would Build a New Portfolio