How the pandemic changed the terms of investment

It's always tempting in this job to try to construct a narrative to explain a series of disconnected events. In the last few days, trying to impose a pattern on short-term market movements has moved from difficult to impossible, so I'll attempt to focus on the long term.

Five years ago, a band of heavyweights tied to the investment business, led by the Canadian Public Pension Investment Board, BlackRock Inc. and the consultancy group McKinsey & Co., launched their own non-profit group called Focusing Capital on the Long Term (FCLT). After a series of conferences, the idea was to do something more concrete to encourage long-termism. Many believed that companies were growing more short-termist under the pressure of investors to produce quarterly earnings guidance. 

But long-termism is like motherhood and apple pie. Everyone says they like it. How do you define it, and how can you improve it beyond holding a series of conferences that allow cynics to accuse you of virtue-signaling?

FCLT is now rolling out fascinating research, called the FCLT Compass, that attempts to measure exactly how long-term companies and investors are, and how that changes over time and between geographies. There are plenty of rough edges to the assumptions the researchers have made, and long-termism takes a frustratingly long time to research. The report on investment horizons for 2020 has only just been published, with less than a month left of 2021. But that doesn't mean that the research isn't worth carrying out, and it's already produced some  intriguing findings. Here are some of the most important:Looking at the lifespans of the companies' investment projects, and comparing them with the average holding period for debt and equity, FCLT found that companies dug in and looked to the long term, which was maybe the only way to deal with the pandemic. Meanwhile, investors churned both equity and debt much more than usual:

The implication is that maybe — in normal, non-pandemic times — we should blame companies more than investors for short-termist corporate behavior. Managements often complain that their investors give them no choice, but last year corporate leaders showed they could look to the long term and kept their heads while all about them investors lost theirs.Viewed globally, corporations built up their cash balances, as would be expected; there was a pandemic, governments were showering them with cash, and they made sure to hold on to it. However, the way they diverted cash from buying back their own stock and toward capital expenditures, and particularly research and development, suggests a major shift in regime. When a company pays to buy back stock, it should imply that it cannot find any productive investments for that money. These numbers suggest that the corporate sector took the opportunity last year to bolster its position for the longer term:

These numbers exclude high-frequency traders, who are really only trying to provide liquidity rather than invest in businesses. Looking at the average holding period for stocks in active and passive mutual equity funds, we find that active equity managers churned their portfolios much more last year, reversing a decade-long trend for holding periods to lengthen. 

Index funds tend to hold on to stocks for far longer, and this continues. However, the average holding period for stocks in passive funds dropped to its lowest level since 2009. This may be because of index recomposition, or reflect the way many traders now use passive funds as a trading vehicle. Passive investing is a force toward longer time horizons, but not as strong a force as might be expected:

We all know that the world has grown more unequal. However, at a global level, the trend toward greater inequality has been counterbalanced to an extent by the rise of the emerging world. Growing wealth for the vast Chinese population, for example, diminishes inequality. 

FCLT used two popular measures of inequality — the Gini coefficient, and the percentage of wealth held by the top 1% — and their findings reinforced each other. The world had been making clear steps toward more equality in the last five years, and that progress was dramatically reduced by the pandemic, and perhaps most precisely the monetary policy measures it inspired. That left those holding on to risk assets far wealthier than they had been: 

The vast populations of China and the US have starkly opposed ideas over how to allocate their nest eggs, and these can be expected to have huge macroeconomic effects. They also help to reveal how different the two countries still are, and how much less wealthy China continues to be. The following chart divides household wealth into four asset classes for the years 2019 and 2020: cash, "tradable securities" (bond- and equity-based savings), real estate and "others," which in practice means alternative investments such as private equity and hedge funds. 

In China, people regard their houses as the ultimate financial shelter, and they responded to the pandemic by becoming even more reliant on real estate, which now accounts for more than half their wealth. Americans have much the same amounts at stake in stocks and bonds and in real estate. Equities and bonds rose as a proportion of their wealth last year. But what sticks out is that alternatives account for the biggest share of Americans' nest eggs, even though in practice they're only available to a small percentage of the richest Americans. The fact that American households hold more wealth in alternative assets than they do in stocks or in bricks and mortar speaks volumes for how unequal the US has become — although on this note, it's perhaps reassuring that alternatives' share of Americans' wealth did fall during the pandemic:

This is the genuine surprise. Sovereign wealth funds have grown to take great power in the last two decades, and are generally regarded as paragons of long-termism. Planning for their nations' future, FCLT found that they had an intended investment horizon of 20 years, considerably longer than for pensions or insurance funds. But the actual holding period of their investments was less than five years, shorter even than for households. How is this possible?

Ariel Babcock of FCLT told me that the discrepancy lies in the vehicles in which SWFs invest. They tie themselves up for long periods in private equity or venture capital funds, or other alternatives, but that doesn't mean that those funds buy assets and hold them for decades. Indeed, the whole point of having a long lock-up period is to enable them to churn their assets aggressively. With their investors tied up for the long term, private equity funds can buy stakes in companies and flip them, knowing that what matters most is the return they can show at the end of the term. The average time a private equity fund holds a stake is only two years and four months, according to a McKinsey study using Preqin data. This is no longer than an active equity manager tends to hold on to a public equity investment, and much shorter than the typical period for a stock held by an index fund.

The time horizon for hedge funds is even shorter, at two years. Many absolute return strategies rely on high trading, so this shouldn't be surprising. But the notion that the assets ultimately held by SWFs are turning over quicker than those held by the average household, and far more quickly than the assets held by exchange-traded funds is mind-blowing. They can be seen almost as the ultimate enablers of highly sophisticated and leveraged short-term investing. As my colleague Michael MacKenzie suggested, this functions almost like a "SWF Put" for alternative investments, in the same way that many believe in a "Fed Put" underpinning the public equity market. 

Meanwhile, Back in the Short Term

Thankfully, I suggested yesterday that Friday's dramatic "risk-off" move out of stocks and into long bonds was driven more by extreme positioning than anything else. Monday's response, which saw a significant retraction of virtually all of Friday's moves, tends to bear that out.

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If you're in the thick of the trading, you can probably come up with a narrative that neatly explains everything that's happened of late. The rest of us can meekly observe that markets get volatile when investors have left themselves over-exposed and a shocking piece of news comes along. The last few days have brought us two shocks in opposite directions — the Fed's conversion to hawkishness, and the advent of the omicron variant — so volatility was always predictable. 

My favorite illustration for this concerns the tug of war between value and growth. The two styles are strongly linked to the macro environment, with growth tending to do well when people are worried about the economy. This chart shows how the Russell 3000 Value Index has performed relative to the Russell 3000 Growth Index over the last 20 trading days:

You are not going to find explanations in either corporate fundamentals or the incoming macro news to explain that. At this point, the shocks of the last month have almost perfectly canceled each other out. With several more thin trading days to come between now and the end of the year, one last set of meetings by central banks, and another batch of inflation data (led by US CPI numbers this Friday), it's an extremely fair bet that there are more twists and turns to come. It is not, however, a good idea to bet much on whether value or growth, or risk-off or risk-on, ends the month in the ascendant.

One trend that has caught my eye, though, is the decline of stellar stocks from earlier this year. The ARK Innovation exchange-traded fund, managed by Cathie Wood, grew famous in 2020 as it notched up extraordinary gains. There was also great excitement over SPACs — Special Purpose Acquisition Vehicles. Both were symptoms of extreme optimism. And both peaked in February:

Meanwhile, AMC Entertainment Holdings Inc. and GameStop Corp., the two great "meme stocks" that boomed as retail investors launched a coordinated attack on short-sellers, have dropped more than 50% from their peaks. 

To be clear, the meme stocks are still sitting on ridiculous gains for the year, although it's unclear how many investors bought in time to enjoy them. And anyone who has held ARK for the long term is sitting on gains far head of the market. If you remain confident in the long-term case for the undeniably exciting stocks in ARK's portfolio, you have a new entry point. But this is one instance where the short term trumps the long. These stocks were caught up in a short-term frenzy. If the experience of the dot-coms two decades is anything to go by, they will have to put up with poor performance for years yet while that frenzy works its way out of the system.

Survival Tips

This is another thank you to Apple Music, which decided for some reason I wanted to listen to some Roxy Music. They did indeed make a lot of songs in the late 1970s and early 1980s that were really good. Away from the really famous songs like Virginia Plain, Dance Away (introduced in the video by Agnetha and Frida from Abba) or Avalon, I think my favorite is Oh Yeah — a beautiful song with an irritatingly trite lyric. It's also worth trying Over You, Angel Eyes and Same Old Scene. For music that's more than 40 years old, they all sound very fresh. 

Disclaimer: This article first appeared on Bloomberg. It has been edited and published by special syndication arrangement.