Investors are being lambasted from all sides for their ‘short-termism’ when it comes to investment policy. But, in an environment of continued uncertainty, driven by political rather than fundamental factors, the whipsaw between risk on and risk off is creating a series of shorter, sharper cycles as investors increasingly trade in and out of securities at similar times. With heightened volatility comes the greater chance compound short-term losses will wipe out any chance of long-term gains, even for those who have the fundamentals right.
“It is prudent to be more trading-oriented in a risk on/risk off environment. It would be silly to try and fight the markets.”Morten Spenner
In today’s environment, can investors really be blamed for their preoccupation with the short-term? Can it be seen as anything other than prudence to protect themselves from the compounding effects of downside risk?
‘Short-termism’ has become a bad word in financial markets. It has been blamed by many experts, including, perhaps most notably, Professor John Kay, for diminishing the returns of pensioners and savers. And he is not alone. Major players in the investment market have done the same.
Bob Maynard, CIO of the $11.5bn Public Employee Retirement System of Idaho, recently cited the need to tackle the dangers posed by short-term thinking as one of his major motivating factors in joining the 300 Club, a group of leading investment professionals from across the globe committed to raising uncomfortable and fundamental questions about the investment industry. “Overcoming the mind-set of thinking about challenges over the next 12 months and reacting to perceived near-term dangers is the biggest problem institutional investors are facing,” Maynard says. “The slow death of long-term investment thinking in favour of continually ‘doing something’ in anticipation of short-term events has not worked in the past, and will likely not work in the future.”
However, the world is a very different place from the past and investors have to adjust to a new reality where volatility and uncertainty are not only rife, but are unlikely to go away even over the medium term. Gone are the days when pure fundamentals drove markets and those who stuck by a long-term economic view, based on analysis of those fundamentals, would make big returns. Today, the effect of compound losses in the short-term threatens the ability to make long-term gains, even if an investor’s long-term fundamental viewpoint turns good.
A new reality
The last four years have proven to be the most volatile in the history of equity markets, research by CREATE shows. Price fluctuations of 4% in intra-day trading sessions have occurred six times more than they did on average in the past 40 years. The last five years have seen 50% of the 20 biggest upswings in the S&P 500 since 1980 and 65% of the 20 biggest downswings.
In large part, the greater volatility seen over the last five years is down to several fundamental changes in the structure and drivers of markets: politics has become the dominant force and is often contradictory to economic fundamentals, risk management has become as important as generating returns, liquidity has decreased massively as leverage unwound and regulations such as Dodd Frank took many players out of the market, and investors have become increasingly diversified and globalised in their approach. All four factors have generated a massive increase in the level of cross- and inter-asset class correlations.
“The lack of fundamental drivers is a source of frustration,” says Bob Jolly, Schroders’ global head of macro. “You have to become a political analyst and think about what drives politicians. We are in an environment of shorter, sharper cycles. We are not necessarily seeing dramatic swings in the underlying economy, but markets are getting more micro- focused with every bit of data, which brings sharper swings.”
The environment is unlikely to change, even over the medium term, as long as the sovereign debt crisis rumbles on in the West. There are few signs of much resolution yet with governments backsliding on some key reforms already. CREATE found 78% of respondents to its survey anticipated prolonged turbulence with over 60% expecting two or more systemic crises before this decade is out.
The prudent view
With volatility and, therefore, the risk of compound short-term losses remaining high for as much as 10 years, institutions can hardly be blamed for considering those risks as part of a prudent approach to managing their assets. And indeed many are, especially in light of the impact market interventions like quantitative easing are having on their funding statuses.
According to Morten Spenner, chief executive of fund of hedge funds International Asset Management (IAM): “One of the most prevalent trends among institutional investors in recent years has been their increasing reluctance to accept losses.”