In the long run, we are all dead,” said John Maynard Keynes. True enough, of course, but there is the not-quite-so-long run in which we live to think about, too.
Given the current credit crunch that has left corners of the equity and bond worlds reeling, it must be even more attractive for investors to gaze towards distant horizons since what is in front of them looks rather unappealing.
In theory, long-term investing smooths out the peaks and troughs of business and market cycles to produce good average returns. In practice, it is an area of investing as prone to its own volatility at the hands of fashionable thinking as any other corner of the market.
Investment swings in the long-term world do not perhaps have the immediacy of the banking sector’s wholesale rush into collateralised debt obligations that is causing such pain right now, but developments in thinking over the past decade have still been dramatic, shifting from equities to bonds to the beginnings of a move back towards the former.
At the moment, established thinking still largely leans towards favouring long-term bonds in a swing which took place after the late-1990s stock market boom turned into a crushing bust.
The preference for bonds, with their fixed income and lower volatility, came about as the crash coincided with the ongoing rise in life expectancy, driving up the present value of funds’ future liabilities. As stocks slumped – made worse by forced selling from insurers struggling to maintain strict solvency rules – the values of pension fund investments fell. Spooked investors piled into the safety of bonds, pushing down yields on those instruments which in turn weighed on the discount rates for calculating present values. This made the whole situation look worse still.
The answer for pension funds shaken by the volatility seemed to be a big switch into long-term bonds. Less volatile, with long durations, they seemed a better match for long-term liabilities.
From advising ratios of a 70-30 equities-bonds split, actuaries started promoting ratios nearer to 40-60. Boots, the UK retailer, grabbed headlines in 2001 when it revealed it had steadily switched all its pension fund equity holdings into long-dated corporate bonds.
The demand was so strong that even governments took advantage. The US, for example, brought back the famous “long bond,” or 30-year Treasury, that it had scrapped in 2001.
The UK went one step further with 50-year gilt sales. The first, in May 2005, saw the half-century paper offer a coupon of just 4.25 per cent. By December that year, demand for the paper had pushed the yield below 4 per cent. On the inflation-adjusted 50-year paper, investors picked up less than 1 per cent.
Yield curves in many regions, including the US, inverted, implying investors were prepared to accept lower returns on longer-term lending despite the extra risks it brings. Since its nadir in 2006, the US curve has returned to a more normal shape but the UK curve remains inverted.
It is not surprising, in these circumstances, that the opinion pendulum has been moving away from its extreme bond focus.
“Even some investors previously in the van of the pro-bond hedging movement… started to wonder whether they may have perhaps too many eggs in the new basket,” says Kevin Gardiner, an equities analyst at HSBC. “A wholly bond-financed portfolio can guarantee little beyond the lifetime of the bonds within it.”
While duration, a measure of interest rate sensitivity (the longer, the less sensitive) that essentially gauges the mid-point in any investment’s cash flow, is normally applied to bond investing, HSBC analysed the duration of equity investments which do, after all, produce regular dividends not unlike bond coupon payments.
The 2005 study showed durations at between 20 and 30 years in the UK and 30 to 40 years in the US and rising steadily.
“In one sense, equities are the ultimate duration play,” says Mr Gardiner. “There is no explicit repayment of capital: investors own the business and in theory this could last into perpetuity.”
There are other criticisms of the bond focus, namely that the supposed hedging of interest rate risk has more to do with the current focus of pensions accounting than the real risks the funds face. Bringing pensions liabilities on to balance sheets and marking them to current market values – in the name of making them clearer for shareholders – has had the knock-on effect of focusing managers’ attention on their volatility.
“Increasing longevity is actually the main risk to defined benefit pensions and bond investment is no hedge to this,” says Tim Bond of Barclays Capital. “Equity investments are probably a better hedge to longevity, given their open-ended duration, in contrast to bonds that offer a limited duration and significant reinvestment risk.”
Historically, equities outperform bonds. According to the long-running annual equities/gilts study from Barclays Capital, equities have returned an inflation-adjusted average of 6.31 per cent a year in the UK and 7.2 per cent in the US over the past 80 years. Bonds, by comparison, have offered 2 per cent and 2.3 per cent respectively over the period.
There is, therefore, a seeming irrationality in long-term investors’ fondness for bonds which suggests a switch to stocks might be in the offing.
Perhaps, however, fund managers are just being mindful of another oft-quoted Keynes maxim: “Markets can remain irrational longer than you can remain solvent.”
