Stan Dupré: The mismatch of time horizons across the investment chain

Members of HLEG share their thoughts on key topics under discussion

This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.

Sign up for a free trial to Responsible Investor

Mismatching of time horizons. In theory, the patience of investors is rewarded: investors with long-term liabilities (e.g. 15, 20, 30 years) can invest in illiquid and more risky assets and wait until it is the right time in the business cycle to sell them (up to 6-8 years), leading to better returns than short-term strategies. However research suggests that the relatively long-term investment horizon of end-beneficiaries with long-term liabilities (pension fund beneficiaries, household savers, sovereign wealth funds, etc.) is not reflected across the investment chain, due to principal-agent concerns, as well as inadequate performance metrics and incentives. For instance, in order to match short-term objectives based on benchmarks, 90% of equity managers turn their portfolio in less then 3 years, even though research suggests that a low turnover would increase long-term performance (Mercer/2Dii/Generation, 2017).

No demand for long term risk analysis. As a consequence, for liquid assets, there is no demand for long-term risk analysis. Not only equity research analysts and credit rating agencies primarily serve short-term traders, but the minority of ‘long-term’ investors have a very limited horizon. Therefore most analysts assess risks and forecast cash flows over the next 3 to 5 years, and then simply extrapolate the value (2Dii/Generation, 2017). For an average stock, 80% of the Net Present Value is based on the cash flows that are simply extrapolated, without specific analysis of risks (2Dii/Generation, 2017).

Long-term risk management discouraged. This short-term focus in turn reduces the horizon of non-financial companies. Companies are not required to discuss long-term risks and actually face more legal risk if they do so in many jurisdictions. This absence of disclosure requirements indirectly discourages the exploration of long-term risks internally to avoid hiding information to investors. The analysis of the disclosure of MSCI World companies shows that they do not disclose forward-looking data (e.g. investment plans, sales forecasts) beyond 1 year and do not discuss long-term risk (2Dii, 2017). For instance only 7% of MSCI World banks discuss the potential disruption of their business related to FinTech (robo-advisors, automation of trades, etc.), while experts consider this trend as the number one threat for the industry (e.g. PwC, 2016). Overall, only 6% of companies disclose the results of scenario analysis, and almost always in very vague and qualitative terms. ‘Viability statements’ that discuss the resilience of the business model to adverse scenarios only exist in the UK and South Africa and are usually limited to a 3 years time frame (maximum 5 years).

Non-conventional risks ignored. As a consequence, certain social and environmental issues, likely to materialize only on the long term, with financial consequences in the real economy and for end-beneficiaries, become externalities ‘not financially material’ for financial markets. If long-term opportunities are likely to be identified by early stage capital providers, the downside long-term risks face by established players (listed companies, bond issuers) are likely to be simply mispriced by financial markets, leading to sub–optimal returns.This blindness is not limited to social and environmental issuers. It applies more broadly to all ‘non-conventional’ risks that are non-cyclical (observation of past trends do not help), non-linear (extrapolation of current trends are therefore misleading) and only likely to materialize after 5 years (therefore not material in a 1-3 year window). Past examples include the subprime mortgage bubble, the impact of the energy transition on German utilities, and automakers’ defeat device practices for pollution tests.

Potential current risks include energy transition risks, as well as the disruptive impact of artificial intelligence and automation in various sectors like asset management. All these risks that are not unpredictable ‘black swans’: their likelihood is high and weak signals exist years before they materialize. There are ‘white swans’ that are ‘left in the dark’ due to the ‘low beams’ of financial analysis.

One of the conclusions of the HLEG is that this issue is largely unaddressed by the financial regulatory framework that focuses on ‘short-term’ risks to financial stability:
• The guidance on fiduciary duty usually does not address this specific issue, and refers to the ‘prudent investor’ in very broad terms;
• Central banks and other supervisory authorities usually focus their risk analysis on short-term financial stability risks. For instance the time frame of European Stress tests is 3 years. As a consequence, they cannot possibly capture non-conventional risks (2Dii, 2017).
• More broadly, financial supervision is fragmented (e.g. different authority for banks, pension funds, insurers, stock markets, etc.), and have limited resources to manage such cross-cutting issues with no immediate impact on financial stability.

To address this challenge, the HLEG is currently exploring several avenues:
• The main one is to clarify the role of European Supervisory Authorities (ESAs) on this topic. The ESAs coordinate and provide guidance to national supervisors such as central banks and market authorities. They can play a key role in clarifying the mandate of supervisors and developing the toolkit to allow proper supervision of “non-conventional risks”. In the short-term, ESAs can build on the work of certain national central banks (Netherlands, UK, France, Germany, etc.) regarding climate-risk analysis. The idea discussed is the development of coordinated scenario analysis on climate-related risks: the equivalent of a stress test, but with a long-term horizon in mind.
• A second avenue is to reform the definition of fiduciary duty, to make clear that the risks should be managed over a timeframe consistent with the horizon of the beneficiary. This approach can implies changes in regulation, or simply clarification of existing rules.
• Finally, the HLEG will explore reforms in corporate and investor disclosure requirements, along the lines of the TCFD recommendations and the French Article 173. The approach of scenario analysis, recommended by the TCFD (for climate-related risks) and by the UK corporate governance framework is clearly relevant in this context.

Stan Dupré is Founder and Global Director of the 2° Investing Initiative

To give feedback on the group’s interim report, published in July, see here.