How (Not) to Talk About the Benefits of ESG Investing

At its heart ESG investing is about the responsibility of companies to take accountability for far more than shareholder profit maximisation. Corporate behaviour can and will have profound implications for people and the planet, and this should be a critical element in the decisions businesses make. At times it feels as if this noble aim is lost in the fervour to sell ESG investing; an activity which often relies on unsubstantiated claims about the ability of an ESG approach to boost fund returns. Although lauding a performance advantage might attract investors in the short-term, it is almost certain to undermine the movement long-term. If ESG investing is going to be sustainable the asset management industry needs to change how it talks about it.

Does a Higher ESG Score Lead to Future Outperformance?

Much of the marketing around ESG falls foul of one of the cardinal sins of fund investing. Taking a short, noisy sample and then dubiously extrapolating. The most common approach is to extol the performance of ESG-oriented strategies over the last decade, and then suggest that this is likely to prove a permanent feature.

There are a host of problems with such statements:

– The typical 10/15 year history used is an absurdly short amount of time to draw firm conclusions about the viability of an investment approach. Any random investment strategy – such as picking stocks out of a hat – will enjoy comparable spells of success. Based on this technique, similar comments could have been made about technology in the late 1990s and emerging markets in 2010.

– The time period over which the virtues of companies or strategies with positive ESG credentials are acclaimed is one in which value investing as a style was trounced by quality and growth approaches. It is close to impossible to disentangle returns to ESG investing from what was a broad and sustained market phenomenon of value stocks (a grouping littered with ‘old economy’ names) trailing the wider market.

– Focusing on returns over a relatively brief period (in the context of market history) also falls foul of one of the most dangerous traps in fund investing – the cyclical nature of performance. Our base case should be that strong returns in the recent past are likely to be a prelude to weaker returns in the future. Generally because the market favourites become too expensive, or the environment changes.

– Definitional issues also create challenges for the performance-led arguments that are so often made. Given the understandable inconsistency about what good or bad ESG characteristics really are; it is difficult to make confident claims that there are a stable set of features that have and will deliver superior returns.

Is ESG Investing Lower Risk?

The performance narrative around ESG investing is not solely focused on the returns delivered in the recent past, it also stretches to assertions about it being intrinsically lower risk. The evidence used for this is commonly focused on how companies with positive ESG credentials have fared in periods of market drawdown. The credibility of this case is perhaps even weaker than those based on historic headline returns.

There are two main flaws:

– The sample size used is often ludicrously small. It is not unusual to see the suggestion that because the losses of ESG focused strategies during the March 2020 COVID induced sell-off were less severe than the market it follows that they have permanently lower risk. Leaving aside the dubious nature of conflating temporary drawdowns with risk; we should never make bold prognostications about the future based on one specific market period or event. We can take any style of investing and cherry pick a difficult market backdrop where it fared well. It will tell us nothing about the structural features of that approach.  

– The losses made by any investing style is dependent on myriad of unpredictable factors. The range from the operational features of the companies, the cause of broader market declines, the prevailing economic backdrop and valuations, amongst a host of other elements.  Making forecasts about future risk and losses from specific, narrow instances in the past is dangerous and impossible to robustly substantiate.

When the case is made for ESG investing based on the notion that historic outcomes have been strong and will continue, it not only creates false expectations, but it undermines the entire movement. It makes people invest for the wrong reasons. If the growth in ESG is meant to represent a genuine shift in our approach to investing and become an important lever in our ability to tackle issues such as climate change, then making it about fund performance is exactly the wrong tactic.

We know that investor tolerance for underperforming funds is staggeringly brief. What happens when stocks and funds with positive ESG characteristics start to underperform? Investors are likely to move on to the next outperforming trend, particularly as we told them to focus on the performance prospects.  

It is critical to remember that even if there is a long-term structural return advantage to holding positive ESG tilts in a fund, then it will still suffer prolonged periods of underperformance. Value has one and underperformed the market for the best part of 15 years.

I can entirely understand that strong advocates of ESG investing believe the best way to attract money and attention to the cause is to appeal to the primary driver of fund investor behaviour – past performance. Yet, in this case, taking the path of least resistance means stoking temporary enthusiasm that will be a prelude to a long-term whimper. The use of past performance as a sales tactic is a blight on the industry. It is designed to exploit the worst investor biases and is damaging to long-term outcomes. ESG should be about education not sales.

A major problem at the core of the performance angle for ESG investing is the assumption that believing that something is either good or true, means that you also must believe that it will outperform. If you are sceptical that ESG stocks or funds will outperform, it means that you disregard the entire concept.

This is not how investing works.

At the height of the dot-com craze I could have had a very high level of conviction that returns from internet-based companies would be terrible; this would not have meant that I didn’t believe in the internet.

They are not the same thing. Everything has a price.

How Might an ESG Approach Boost Returns?

Reading this piece so far, you might think that I believe all expectations about the future returns of ESG investing to be spurious. This is not the case. The issue is how the arguments are made. We should never make forward looking assertions about returns based solely on past performance. It is perfectly reasonable, however, to do so if we have a clear rationale as to why something is likely to fare well in the future.

If we have an investment view then we need to state our case.

So, why might ESG investing generate greater long-term gains from here? We can use a very simple model of equity returns to see how it could happen.

Our future equity returns will be driven by a combination of starting valuation + valuation change + growth. Any fundamental view about better performance from ESG investing should be based on one or more of these elements*.

We can take each in-turn:

Starting valuations: It is possible to argue that valuations of companies with positive ESG credentials are priced so that the yield / return we receive from here is more attractive than other areas of the market. This notion leads us directly to one of the main shortcomings in the discussion around the performance attractions of positive ESG stocks – the idea that companies with a lower cost of equity should outperform stocks with a higher cost of equity. This inverts a core principle of investing by stating that lower risk comes with a higher return. If a company manages ESG risks incredibly well, then its cost of financing from equity should be lower, as consequently should be the returns to investors.

Valuation / cost of equity change: Starting valuation is not the end of the story. Strong returns to ESG investing can come from the change in cost of equity / valuation. This can work in two main ways – companies that manage ESG better are rewarded with higher valuations / a lower cost of equity; or companies who manage ESG risks badly suffer from a spiralling cost of equity and major de-ratings. In the latter instance, investors require significantly higher returns to bear the risk of holding equity.

In these scenarios, an ESG investor can generate superior returns by either avoiding the companies with a rising cost of equity or owning those where it is moving in the right direction.

There is, however, a significant issue here with how the industry is reporting ESG. The pace and scale of the movement means that there is a drive for all types of investors to ‘prove’ their ESG mettle, which is typically done by displaying ESG scores or carbon metrics versus a benchmark. Everyone wants to look ‘more ESG’ than the index and peers.

What’s measured is what matters.

This makes no sense. A rational investor would want to be investing in companies with weaker ESG characteristics now but where they think there will be improvements in the future. Why? For two reasons. First, if we are right then we profit from the valuation / cost of equity change as the risk of the business falls. Second, they can use their ownership influence to push for the desired change.

Investing in this type of company means that we might look inferior from a headline ESG perspective. That to many is unpalatable.

The worst possible outcome for ESG investing is that optics matter more than materiality.

Growth: The final element is growth. Earnings growth could be far superior from companies with stronger ESG characteristics, and this is not reflected in current prices. This growth advantage is typically thought of being delivered by companies better positioned to access the opportunities presented in a shifting landscape (almost always related to climate); but it can also be about the reverse. Companies on the wrong side of environmental and societal developments could struggle to deliver earnings growth. An ESG performance edge may arise from avoiding such businesses.  

None of these potential arguments as to why a positive ESG tilt may lead to enhanced performance suggests that there is some ingrained feature that make it an empirically robust factor or risk premia such as value or quality (although ESG and quality are likely correlated). It is simply an expression of an investment view about why positive ESG traits may be currently undervalued and therefore likely outperform in the future. It could apply to the wider ESG complex, or individual companies.

The point here is not to suggest that these arguments are true, but that if anyone makes claims about the potential for improved future returns from ESG-oriented strategies they must explain how this will occur. Even if you disagree vehemently with them, it is surely far better than saying it will work in the future because it has worked for the past 10 years.

Any predictions about the performance potential from ESG investing is an investment view, which needs to be supported and owned like any other.

What is the Real Potential of ESG Investing?

Although I have spent some time attempting to explain the type of contention that must be made to credibly establish a view about the efficacy of ESG investing from a pure performance perspective; I actually think that specific claims about the returns of ESG funds and strategies are incredibly unhelpful. It is often little more than a sales and marketing strategy attempting to exploit the worst performance chasing, behavioural impulses of fund investors. It also blithely ignores the two main prospective ‘return’ benefits of ESG investing.

The two most credible positives of the ESG movement have nothing to do with fund level alpha; they are far broader:

– The shift towards stakeholder capitalism and away from short-term, shareholder return maximisation could have profound benefits for the environment and society. If it assists in slowing temperature rises, reduces biodiversity degradation, or helps limit modern slavery; these are powerful returns, just a different type.     

– Even if you are sceptical about the need or ability of the private sector to drive change in such areas and don’t think such externalities qualify as a type of ‘return’; there is a way that ESG investing may help boost long-term financial returns. If the broad embrace of ESG factors in investing contributes to limiting the rise in global temperature this could improve future asset class performance. Whilst by no means certain, it seems likely that equity returns would be higher in an environment without unchecked warming.

Although these are potentially the most powerful features of ESG investing, they don’t really get as much focus as the fund performance angle. Why is that? Because they don’t sell. If ESG as a movement helps the long-run returns and interests of everyone, that doesn’t help market my fund relative to the competition.

So, instead, we end up making dubious claims about the potential performance persistence of ‘high scoring’ ESG companies, fill our portfolios with businesses exhibiting the best current ESG metrics and dispose of the stragglers (to other investors who might have a different agenda to our own).

This might work in boosting asset flows in the near-term but undercuts the viability of ESG investing in the long-term. Fund investors will lose faith when the inevitable spells of difficult performance arrive, and the potential impact of a positive approach to ESG will be neutered by the desire of asset managers to manage optics and look better right now.   

If we really believe in it, it’s time to change the narrative.

* We might not have a fundamental view at all and simply see it as a momentum trade. This is perfectly reasonable; we just need to make sure we have a plan for when to get out.

Why Do Investors Keep Buying the Most Expensive Assets? 

I try to avoid engaging in the folly of making predictions about financial markets, but here is one. Returns over the next decade from most asset classes will be significantly lower than they have been in the past decade. 

It doesn’t take a soothsayer to foresee this. Valuations in many areas are stretched and the expected return from a traditional 60/40 approach is close to historic lows. Of course, this forecast could be wrong; there are scenarios where returns run even hotter from here, but that should be considered a low probability path. 

What’s puzzling about the current backdrop is not that it is one defined by low expected returns – markets are cyclical and these environments will occur – but the investor response to it. We might anticipate a rational reaction to be an increased interest in out of favour areas with more appealing valuations, but that’s not what happens. Instead, we keep buying the most expensive assets. When confronted with lower expected returns we buy more of the asset classes and funds that are likely to have the lowest future returns. 

Rather than consider this activity to be incongruous however, it is exactly what we should expect to see. The structure of the industry, it’s incentives and our own behavioural foibles combine to make it close to inescapable.

What are the main drivers? 

Extrapolation: One of the most damaging investor traits of all and one which Charlie Munger labelled “massively stupid”, is our tendency to extrapolate the past. What has come before will continue. When we persist with buying expensive assets, we ignore the price being paid and simply extrapolate the strong performance into the future. In doing so we ignore every lesson and piece of evidence about capital cycles, valuations and mean reversion. It is why we happily pile our money into thematic ETFs at the peak of stratospheric performance. 

Charlie was right. 

Narratives: Compounding the problem of extrapolation is the power of narratives. Strong past performance is always accompanied by stories to explain and justify it. This creates a virtuous / vicious circle where stellar returns are given a compelling narrative and that narrative further boosts performance. Expensive assets always have great stories. There is nothing investors love more. 

Time Horizons: Most investors operate with time horizons that render valuations irrelevant. By time horizon I don’t mean our ultimate end objective, but the period we care about enough for it to influence our decisions. The latter is typically far shorter than the former. If our patience stretches only to one or two years, then we will rarely notice the importance of the price we pay. Until it is too late. 

Career Risk / Incentives: For professional investors, increasing purchases of expensive assets is about the management of career risk. As money flows into the most richly valued areas they become a dominant feature of benchmarks and the main driver of performance. Almost everyone comes to believe that owning more of these assets is obvious. As this phenomenon persists, we have the choice of either joining the party, or losing assets and our jobs. Our incentives are aligned with buying outperforming, expensive assets and funds even if the evidence suggests it is likely to be of detriment to future returns. 

Emotions: How we feel has an overwhelming impact on the investment decisions we make. Owning expensive assets is, for the most part, anxiety free. They are performing well, everyone else is buying them and the stories provide validation. For cheaper assets the reverse is true; the narratives are bleak, returns have been poor, and owning them means separating ourselves from the crowd.

Much of our investment activity involves doing things that make us feel good in the moment. We can then repent at leisure.

Overconfidence: We are happy to own assets with stretched valuations even if we acknowledge they are prohibitively expensive because we have an exaggerated belief in our ability to time our exit. We will stay invested whilst things are going well and then change course when things turn sour. Whilst this is an attractive idea, the history of market timing suggests the reality is unlikely to be so favourable. 

Studying investor behaviour is typically about identifying the gaps between what we should do and what we actually do, but sometimes it is more profound than that. Our behaviour is often paradoxical.

Consider the following:

The more extreme the outperformance and rich the valuations of an asset class or fund, the greater the likelihood of disappointing returns in the future.     


The more extreme the outperformance and rich the valuations of an asset class or fund, the more attracted investors will be to it.*

Given that most investors are seeking to maximise future returns this inconsistency seems absurd, but it is not. Our instincts and environment make the behaviour both damaging and almost inevitable.**

We shouldn’t be asking why do investors chase performance and buy expensive assets but rather, why wouldn’t they?

* Momentum investors get a free pass here because – in the simplest terms possible – chasing strong performance trends is their deliberate process.

** The behaviour won’t persist indefinitely – expensive assets don’t keep attracting assets and outperforming – market conditions will change and valuations will matter again. It is just impossible to predict when.

Should Passive Investors Be Happy Buying Equities at 100x Earnings?

At the pinnacle of its bubble in 1989, a toxic combination of loose monetary policy, rampant loan growth and a spiralling cost of land led the Japanese equity market to trade at close to 100x cycle adjusted earnings. Inevitably this heralded decades of disastrous returns. Between 1990 and the end of 1999 the annualised return from Japanese equities was -4%; over the following decade it managed to fare even worse posting -5% returns per year.[i]

Although investing at such extreme prices seems foolhardy; passive global equity investors would have been increasingly exposed to Japan as the bubble inflated with their allocation hitting 45%. On an EAFE basis the concentration reached 65%:

Does this trait of growing exposure to astronomically priced assets mean a market cap based country allocation is a terrible idea?

No, it is perfectly rational. It just comes with costs and limitations. As with any investment strategy.   

In this binary world our default view is to stridently take one side and vehemently oppose the other. Committed passive investors will claim that an active country allocation is non-sensical given the underwhelming performance history. Active management advocates will argue that any approach that ingrains objectively bad decisions – like allocating half of our assets to staggeringly expensive markets – runs counter to all evidence about what drives long-term returns.

Financial markets are just too noisy and uncertain to take such forthright and singular views. Often two statements can entirely contradict each other whilst both being true.

Take the below examples:

A passive, market cap approach to global equity investing has and will prove to be an effective long-term option for many investors.


Investing near half of our equity assets in a market trading at 100x cycle adjusted earnings is an awful strategy.  

If we accept the evidence that buying very expensive assets is a recipe for poor future returns; how is it possible to claim that passive global equity investing can also be a sensible course of action?

There are several valid arguments a passive investor might make:

1) We do not believe there is another method that can consistently put the odds in our favour. It is not enough to say that a market cap, global equity allocation is deeply flawed; we need to have confidence in a robust alternative.

2) The long-run return of global equity markets incorporates incidents of bubbles and manias; they are a known and expected feature that must be withstood.

3) We have no way of telling where a bubble will occur, how far it will rise or when it will crash. Therefore, it is best simply to weather them.

4) It is easy to lament the cost of a bubble or the impact of buying expensive assets in hindsight; it is much more difficult to accept the years of painful underperformance which will come when we reduce our exposure early, yet the momentum continues. The behavioural challenges of an active approach are far too great to bear.

5) Country allocations based on market cap are a reasonable proxy for future earnings on average, despite being wildly inaccurate at times.

None of these arguments suggest that buying extremely expensive assets is prudent, rather they accept the drawbacks of a passive country allocation, whilst believing it to be the best (or least worst) option.

As guilty as active investors are of dismissing the evidence around the efficacy of index funds however, passive investors are equally culpable in rarely acknowledging the shortcomings they suffer. Even committed passive exponents should ask themselves whether there are any scenarios where index exposures become so extreme that they would be willing to go against everything they believe and take active positions away from the benchmark.

What would they do in a repeat of the Japan scenario?

Situations like the one we observed in late 80’s Japan will likely occur again; perhaps we are entering such a phase with the US.

It is easy to be complacent about the rise of US equities to close to 70% of the MSCI World Index. The strong performance that has led to it and the narratives used to rationalise it make extrapolation and justification easy. But we should not ignore that passive investors are becoming progressively more exposed to one of the most richly priced global equity markets.

So, is the US a Japan redux? No. The valuations are nowhere near as extreme (which is not really saying much) and the corporate fundamentals do justify a high US weighting. The FTSE RAFI Developed 1000 index, which weights companies based on factors such as dividends, cash flow and sales has a US equity allocation of c.59%. Not quite 70%, but even if we disregard stretched valuations, the US is still the world’s dominant equity market.

Not being Japan does not mean investors should blindly accept the situation. History would suggest that stretched valuations lead to disappointing returns. It is hard to argue that valuations in the US are not elevated (even relative to other regions).

I have heard passive advocates justify the increasing US weighting by making claims about US exceptionalism and the incredible profitability / market dominance of the tech and consumer names. Whilst this might be a credible case it is conflating an active investment view with the use of index funds.  The correct argument – as mentioned above – is that this type of situation is a known and expected feature of a market cap, global equity allocation; and they believe it to be the best method for capturing long-run global equity returns.  

There are many awful ways to invest that we should avoid at all costs, but there is also no right way -just a range of reasonable techniques all of which come with advantages and serious drawbacks.  Most investors align themselves with a particular religion (active or passive) and summarily dismiss the other. This is unhelpful and belies the realities of hugely uncertain financial markets with often conflicting evidence.

In simple terms, passive country allocators need to accept that they will buy increasing amounts of punitively expensive assets; whereas active investors (at least those with a valuation discipline) will endure multiple years (maybe decades) of severe underperformance even if they are right in the end.

No approach is perfect, we must pick our poison.

[i] The Age of Disorder – Deutsche Bank (

The Dog and the Frisbee – Why Investors Should Consider a Simple Approach to Complex Markets

At the 2012 Jackson Hole Economic Policy Symposium, Andrew Haldane, who went on to become Chief Economist at the Bank of England, gave a speech to the gathered central bankers entitled: ‘The Dog and the Frisbee’. It was about simplicity and complexity. The speech began:

“Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to apply Newton’s Law of Gravity”. [i]

Dogs are good at catching frisbees, does that mean that they understand Newtonian Physics? No. A dog can make a successful grab for a frisbee by applying a simple rule of thumb: running at such a speed that the frisbee is maintained at an approximately constant angle.

The unusual but eloquent point being made by Haldane was that simple rules are often the best approach to solving or managing complex problems. Complex solutions are often too slow, ineffective, or designed to deal with yesterday’s challenges.

Financial markets are far more complicated than catching a frisbee, but we often seem resistant to adopting simple approaches.

Haldane’s speech drew heavily on the work of German psychologist Gerd Gigerenzer who is an advocate of using fast and frugal decisions rules, or what he calls simple heuristics, to make judgements and predictions in certain environments. There have been countless examples of studies testing Gigerenzer’s ideas. In one such study, researchers looked at the Wimbledon 2003 tennis tournament and found no difference in the quality of match predictions between laypeople simply choosing the name they recognised and the complex, computer generated rankings. [ii] This is known as the recognition heuristic.

A more pertinent example for investors regards portfolio optimisation; creating the mix of securities that can deliver the best or optimal returns for a given level of risk. A study showed that rather than utilising complex, computer-driven optimisation approaches incorporating returns, risk and correlations, the most effective rule was 1/n, which means to equally weight all available options.[iii]

This is the approach Harry Markowitz – the father of modern portfolio theory and winner of the 1990 Nobel Memorial Prize in Economic Sciences – is said to have adopted for his own investments.

Why would such a seemingly naïve approach work when dealing with such a complex problem?

Gigerenzer argues that simple heuristics are effective when the environment meets three key criteria: [iv]

 i) A high level of uncertainty.

ii) Many options.

iii) Short sample.

It is incredibly difficult to make optimal decisions in complicated, unpredictable environments where there is a broad assortment of choices and insufficient historical evidence. Optimizing for the past does not mean optimizing for the future.

Investing meets Gigerenzer’s three criteria. Yet rather than aiming for simplicity investors often layer complexity upon complexity. Not only is there the baffling variety of potential securities, funds and asset classes to assess; the markets in which we invest are adaptive and unpredictable.

Given this, why do investors often seem to prefer complexity over simplicity?   

There are four major drivers:

–  It can feel incongruous or even naïve to address a complex environment with a simple solution. To solve an intricate multi-faceted problem we must adopt an equally elaborate approach.  

– When we are presented with a complex situation with a huge range of variables and potential outcomes, the opportunity to over-engineer answers can prove irresistible. The torrent of noise makes us believe that there is always a better way.

– Complexity sells and sells for a higher price than simplicity. It is hard to differentiate ourselves, our product or our business by providing simple options.

– After the event, simplicity often won’t look like the best route to have taken as there will always be something more sophisticated that has delivered better results.

A simple approach is no panacea; an ill-judged decision rule or heuristic can lead to very bad outcomes. Simplicity does not equal efficacy. We should not, however, be in thrall to complexity. Investors should start with simplicity and make things no more complex than they need to be.


[ii] Serwe, S., & Frings, C. (2006). Who will win Wimbledon? The recognition heuristic in predicting sports events. Journal of Behavioral Decision Making19(4), 321-332.

[iii] DeMiguel, V., Garlappi, L., & Uppal, R. (2009). Optimal versus naive diversification: How inefficient is the 1/N portfolio strategy?. The review of Financial studies22(5), 1915-1953.

[iv] G.Gigerenzer, Rationality for Mortals: How People Cope with Uncertainty (Oxford University Press, 2008)

Mark Twain, Framing and Scarcity

In the second chapter of Mark Twain’s The Adventures of Tom Sawyer the protagonist is in a spot of bother. He has been involved in another scrap and as punishment is tasked by Aunt Polly to spend his precious Saturday whitewashing ‘thirty yards of board-fence nine feet high’. It seemed that a bleak day lay ahead for poor Tom, yet in a matter of hours boys from the town were queuing up to take a turn with the brush. Not only that, but they were paying Tom for the privilege.

How did he manage such a feat?

He applied some behavioural tricks to transform the situation, using the power of framing and scarcity.

Tom Sawyer has some lessons for investors.

As he was beginning his work on the fence, Tom was approached by Ben Rogers, a boy from the town.

Ben began to ridicule Tom’s predicament:

‘Say, I’m going in a-swimming, I am. Don’t you wish you could? But of course you’d druther work, wouldn’t you?’

Tom desperately wished he could stop painting and go swimming but he didn’t let on. Instead, he changed the frame:

‘What do you call work?’

‘Why, ain’t that work?’

‘Well, maybe it is, and maybe it ain’t. All I
know is that it suits Tom Sawyer.’

Tom re-frames the situation. Painting isn’t a chore; it is what he wants to be doing. He would rather be whitewashing than swimming.

As Tom lovingly returns to his meticulous task, Ben’s perspective is changed entirely. He stops mocking Tom, instead he asks for a turn.

Tom reframes the situation by evoking a key driver of our behaviour – the notion of scarcity.

Painting the fence is not arduous graft, it is a rare privilege that is not available to everyone.   

‘Does a boy get a chance to whitewash a fence every day?’

‘I reckon there ain’t one boy in a thousand, maybe two thousand, that can do it in the way it’s got to be done’.

Tom was able to spend the day relaxing and ponder how he had managed to get three coats of whitewash on the fencing, whilst almost bankrupting all the boys in the town.

Why do the actions of Tom Sawyer matter? Because framing and scarcity are critical to how we make decisions and are vital concepts for investors to understand.

We can consider framing to be the lens through which we interpret the world. The mental models that we apply to inform our view on a particular situation. The frames we apply can be intransigent and all-encompassing, such as a strident political view which influences how we understand almost everything. They can also be or more focused and potentially malleable – like Ben’s view on the joys of whitewashing a fence.

Some frames can be easily shifted, others cannot.

We spend a great deal of time trying to change the mind of people we disagree with by to them explaining how we see things – this is likely to be fruitless. We need to understand that they are viewing the evidence through an entirely different frame. Our starting point in the face of differing opinions should be to try and view the situation through the other person’s frame.

Many intractable investment debates are a faming problem. Take the inherent friction between a strong advocate of ESG-focused investing and a proponent of the idea that shareholder returns are paramount above all else. No amount of discussion and deliberation about the specific evidence is likely transform any side’s viewpoint, it is a framing problem. Understanding the model each side is applying is likely to be far more productive than exchanging different studies with contrary evidence.

Some of our most significant investment mistakes are also likely to be a problem of framing. It is not that we made a wrong call on a particular market or macro-economic event, it is that we were viewing the world through an entirely incorrect frame. An investor whose initial experience was in the 1970’s is likely to have an entirely different model for thinking about interest rates and equity markets, than someone who has only experienced the most recent decade.

The major challenge for investors is that markets are complex adaptive systems – how they function through time will evolve. Applying one overarching frame is unlikely to be a successful approach. We need to understand the frames that we use which are likely to prove robust through time (short-term market movements are unpredictable noise) and those which are subject to change (bond yields always fall if equities are weak).

It is important for investors to think more explicitly about framing – why we see the world or the situation as we do. There are three key benefits:

1) It allows us to better challenge our own views. Our beliefs about a subject are likely the result of the specific frame we are using. We need to worry less about the information we are observing and more about the lens through which we are looking upon it.

2) It enables us to understand the perspectives of others. It is easy to disregard the viewpoints of people we disagree with, without ever attempting to understand the frame they are using.

3) It can assist us in encouraging good investment behaviour. How can we influence people to become long-term investors? Think about the frames they are applying and try to shift them.

Tom Sawyer did not just change the framing of his task by highlighting how much he enjoyed it, he applied the scarcity principle. We desire things more and ascribe them a higher value if we believe they are scarce.

The perception of low or restricted supply increases the demand and price.

The concept of scarcity and how it influences our behaviour is critical to how we consider the value of different assets or investments. It is an idea that has seemingly become increasingly relevant in recent years.

In simple terms we can think of an asset or object as possessing value for three reasons:

1) It has some use or utility.

2) It provides us with a cash flow (often related to its utility).

3) It is scarce.

If something has no or little utility and does not generate a cash flow, then its value is likely to come from scarcity. It seems unlikely that something that is abundant and has no use will be of value.

To create value without utility, we need scarcity.

Of the three drivers of value, scarcity is the exception. This is because its perceived worth is not driven by the asset itself but entirely by the perceptions others hold about it. Whilst the value of all assets are impacted by the beliefs of others, most are underpinned by utility or cash flows.

Why can scarcity create value, or at least the perception of value? Social proof is perhaps the critical element – our view is informed by the behaviour of others. It must be valuable because everybody else thinks it is.

The information we take from the actions of others is compounded by the fear that we are being excluded – limitations in supply make us view the situation through the frame of loss. What is it we are missing out on?

The more boys from the town turned up to help paint Aunt Polly’s fence, the more other boys wanted to join the queue.

As much as scarcity value is about other people, it is also about us. Scarcity is deeply intertwined with signalling – the decisions we make to manage how we are perceived. Items that are rare or difficult to attain are attractive because they say something about us, about the group we belong to. Nobody buys an expensive, branded t-shirt because it has significantly more utility than a simple option, they do it because they want to signal something. Here there is a circular relationship between scarcity and price. The higher the price of something the more scarce or difficult it is to obtain, which makes it worth more as a signalling tool.

The other vital element of scarcity is the narrative. Not all items or assets that are scarce are deemed to be valuable, particularly if they are useless. So, the story matters. The story also becomes more powerful the more the perceived value increases. Price change begets story begets price change. And so, the cycle continues.

Assets with a value driven solely by scarcity can be dangerous for investors because there is no supporting worth or utility. We are beholden to the behaviour of others. Yet, we should not be too dismissive of a factor that can exert a huge influence on the behaviour of financial markets and asset prices.

Tom Sawyer elegantly uses the framing of scarcity to transform the perception of his situation and change the behaviour of others.

He had discovered a great law of human action, without knowing it – namely in order to make a boy covet a thing; it is only necessary to make the thing difficult to attain.

He changed the frame. What frame are you viewing the world through?

Twain, M. (19876). The Adventures of Tom Sawyer,

Betting Against Warren Buffett

Suspend your disbelief for a second. Imagine you have been gifted $1m, the only proviso is you must split the amount between an equally weighted 30-stock portfolio of US listed companies selected by Warren Buffett and a 30-stock portfolio of US listed companies selected by…me. You get to keep the amount staked on whichever portfolio produces the highest return.

Where would you put your money?

Of course, it is impossible to take any view on likely outcomes because we are missing a vital piece of information – the time horizon. When considering luck and skill in investing this is the most important thing. It changes everything.

Let’s say the time horizon was just a single day. The odds of my portfolio beating Buffett’s must be 50%. One day’s stock market movement is nothing but random noise. $500,000 each seems a prudent approach.

What if the length of the bet is increased to one year? The chances of my portfolio might be a little less than 50% but only modestly. Nobody can accurately and consistently predict in advance what will happen in equity markets over the next year. Fundamental company attributes are unlikely to matter that much compared to events, narratives and flows. The result would not be far from a coin toss.

How about three years? This is an important timespan because it is often the period over which fund investors hire and fire active managers. We should expect some advantage to arise from Buffett’s acumen and experience here, but the results would still be extremely variable and hugely influenced by sentiment, rather than the aspects of a business Buffett cares about.

We could use base rates to help us size the bet. Between 1988 and 2019 Berkshire Hathaway outperformed the market on c.60% of rolling 3-year periods.[i] A $600,000 stake towards Buffett would seem sensible.

The tangential point here is that on the time horizon adopted by most fund selectors, Warren Buffett would have been sacked on multiple occasions over his staggeringly successful investing career. Past performance can be a terrible decision-making tool.

Now, back to the bet. 

Finally, let’s try a 10-year time horizon. We are getting into the realms of long-term investing. Company fundamentals should matter more. Skill should start to exert a material influence. But how much?

Let’s go back to base rates. Over the same period as previously mentioned Berkshire Hathaway outperformed the market on close to 90% of rolling 10-year spells. We might now have more confidence placing $800,000 or $900,000 on Buffett’s side of the table.

Time horizons matter.

When thinking about the bet; don’t worry too much about my limited capabilities in stock picking, just assume that I design my 30-stock portfolio to look as much like the market as possible. Also, it doesn’t have to be Warren Buffett – just a highly skilled stock picking investor. The message will be the same.

So, what is the message?

1) Conversations about luck and skill in investing are irrelevant unless we specify a time horizon. For most styles of investing, the longer the time horizon the more skill will influence outcomes. Whatever the time horizon, however, the results will never be devoid of chance.

2) Investing is a bizarre activity. Over reasonably lengthy time horizons (one year, three years and more) people without any discernible skill will produce better results than the most skilful individuals in the field. There are very few activities that are structured in this way.

We hugely understate the role of luck in investment outcomes. Humility is a pre-requisite for good investing. Sensible decisions will appear mistaken – a lot.

3) Active fund investors have their time horizons all wrong. Attempting to identify skill and then worrying about one and three-year performance is entirely futile. We are doing little more than playing roulette (particularly if we acknowledge that we are unlikely to identify the greatest investor of their generation in advance). A focus on short run horizons will doom us to making persistently bad decisions based on the unpredictable movements of markets.

If there is any chance of success investing in active funds, we must extend our time horizon. If that is not possible, we should not be using them.

[i] Daily: Firing Warren Buffett | UBS Global

Long-Term Investors Must Make a Ulysses Pact

In Homer’s Odyssey, Ulysses and his crew must navigate their ship past the sirens. The sirens produce a beguiling and irresistible song, which if heard would lead the men to their deaths. To be the first person to hear their song and live, Ulysses applies some behavioural science. He creates a commitment device in the present to protect his future self. He instructs his crew to fill their ears with wax to avoid temptation and has himself tied to the mast to avoid action. If investors want to enjoy the benefits of long-term investing, we must adopt a similar approach.

Stephen Pinker discusses this type of behaviour management in his new book Rationality. He notes that Ulysses surrendered his ability to act and the sailors their option to know. This is puzzling because wilfully relinquishing information and agency seems deeply irrational. Yet if we are aware of the challenges and impulses that await us, it can be the most rational approach to achieving our goals.

As investors we find ourselves in a similar situation to Ulysses. Most of us have long-term objectives best facilitated by doing less, yet the constant noise and narratives of markets are there to lure us into frequent injudicious decisions.

Being a long-term, low action investor is the easiest approach to adopt in theory, but the hardest in practice. How do we make a commitment like Ulysses to protect us from our future investing selves?

Plugging our ears like the sailors means ignoring the chaotic vacillations of markets and the unpredictable path of the economy. Rarely checking our valuations, cutting off our subscriptions to financial news. Avoiding anything that will entice us away from our plan.  

Tying ourselves to the mast means making action far more difficult than inaction. Cancelling the brokerage account, losing the password for our portfolios, or adding elements of friction to slow an investment decision-making process.

Of course, we don’t do any of these things. It feels absurd to disregard ‘critical’ information and constrain ourselves from making ‘vital’ investment judgements. We also find it difficult to believe that we will make poor choices in the future – surely, we will behave in a perfectly rational manner no matter the environment?

As with so many things in investment, taking the right behavioural steps to achieve good outcomes can seem irrational and imprudent.  Saying ‘I don’t know what markets did yesterday, and I don’t really care’, probably increases the odds that our long-run outcomes will be good, it is just that everybody will think we are incompetent.

Professional investors naturally dislike this type of Ulysses pact.  We are paid to engage with markets and act, irrespective of whether that activity is beneficial.  We must listen to the siren song and probably erroneously believe we can avoid the rocks whilst enjoying the melody.  

Commitment devices do not have to be entirely restrictive, however. They can be designed so that our future self is more likely to exploit opportunities that arise. We might commit to acting only when certain extreme valuation levels are reached. This approach is obviously imperfect compared to an avoidance pact because we will still have to implement the decision when the time arrives (and will no doubt create excuses as to why it is no longer a good idea). Setting a high threshold for action, however, at least protects from the worst ravages of noise and overtrading.  

A critical part of managing our behaviour is understanding the challenges we will face and planning in advance how we will mitigate them. Good investment is primarily about making sensible decisions at the start and avoiding bad decisions on the journey. The problem is that the compulsion to veer off course is likely to be overwhelming.  

Most of us want to be long-term investors, but unless we make the right behavioural commitments at the outset the siren song of financial markets will make that an impossible aspiration.

Should Investors Care about an Asset Manager’s Culture and Brand?

Asset managers spend a great deal of time cultivating their brand and extolling the virtues of their culture. Although as an investor it is easy (and enjoyable) to be dismissive of these activities, they do matter. Investing in a firm with a toxic work environment and invectives wildly misaligned with our own is unlikely to lead to positive outcomes. If a firm or team’s culture is at odds with its investment philosophy, the culture will win out. Culture is critical but gauging it from the outside is incredibly difficult to do. The only way to better understand it is to ignore the words and instead focus on behaviours.

We should not think about culture without also considering the issue of brand. The two are deeply intertwined and can be considered different sides of the same coin. One external to a company and one internal. A brand is the perceptions held about the behaviours of a company by outsiders. A culture is the expected behaviour of insiders within a firm – what is permitted, enacted, and rewarded. Asset managers are unlikely to sustainably and successfully reset a brand without also addressing the underlying culture.

The cynicism that meets much of the talk around brand and culture within the asset management industry is entirely fair. It is so often vacuous nonsense – a superficial effort to manage perceptions. Establishing or transforming a brand is not about slogans, fonts or colour palettes, it is about changing the beliefs held about a company’s activities. If a company changes its name but its behaviour is consistent with the past, then existing opinions will simply transition to the new name.

If there is an effort to modify the brand and culture of a business, it is critical to ask – “what actions and behaviours are changing and why?” Not – “what is it you are calling yourself now?”

Given the industry’s focus on performance, it is possible that strong brands can exist when the team culture underlying it is poor. Investment returns can be impressive in a bullying, exclusive environment where client outcomes are subordinate to that of the business, but they are unlikely to be sustainable – the culture will lead to a reckoning at some juncture. Even if strong returns do persist against such a backdrop, we should ask ourselves whether it is the type of business with which we are happy to entrust our money.

Situations can also exist where a company has made material strides in improving its culture, but its brand remains tarnished because of past deeds. In such instances, shifting the optics (changing the name or logo) might help to allow the brand to reflect the evolving culture but will be insufficient. There needs to be consistent and meaningful evidence of what is changing. Skoda’s brand image would not have evolved had they not also improved the quality of their cars.

Assessing the culture at an asset management business is not easy. The starting point is to dismiss everything that you are told and anything that appears on a PowerPoint deck, and instead focus on tangible actions. It is easy to extoll the virtues of an inclusive environment in which the many different forms of diversity are paramount, but what is actually being done about it? Have concrete policies been put in place to facilitate this?

If the purported culture is based on putting the long-term interests of the clients first, how is that achieved? What remuneration structures are in-place to incentivise behaviours that are aligned with this mindset? How is the firm overcoming the pressure of meeting short-term financial objectives?

There is often a yawning gulf between what a firm says about its culture and what it actually does.

When assessing the culture of an asset management business, we should start by asking two questions: i) What are the cultural features (expected behaviours) we would expect to see at a high quality investment organisation? ii) What are the cultural elements that would support the application of the specific investment approach we are considering?

As an outsider there are a variety of ways to build a better understanding of culture within a firm or team. Those with privileged access can attend internal meetings and obtain details on incentive structures and historic staff turnover. It doesn’t have to be that difficult, however. Sites such as Glassdoor can be insightful, as can conversations with previous employees. We can also observe how the company engages with different stakeholders. The messages given by management to shareholders may well differ with those offered to potential investors in their funds – shareholders will hear about cost cutting and improving short-term flows, investors will hear of continued investment in the business and the paramount importance of adopting a long-term approach.

What we are seeking to understand is whether a firm’s behaviours and expected behaviours (its real culture) are consistent with what it says and what it is trying to achieve. There is no magic bullet to judging this, but we can easily build a framework or checklist, and reach our own conclusions.

Asset management firms should care about culture not because it sells or helps improve the brand, but because it leads to better outcomes for all stakeholders. Investors should care because our outcomes will be driven by the behaviour of the individuals in the firm with which we are investing.

It is so easy to poor scorn on culture and brand as amorphous and frivolous concepts, particularly when most asset managers play the game of saying the right things to best support and furnish their desired image. Culture is frequently discussed without anyone taking the time to explain it; but this doesn’t mean we should dismiss it. At its heart culture is about behaviour, and there should be few things as important to investors as that.

Investors Should Prefer Camels to Horses

There is a common decision-making adage that states: ‘a camel is a horse designed by a committee.’  Although there is some doubt over its origin it is thought to have been first uttered by Sir Alec Issigonis, designer of the iconic Mini car. The ungainly camel represents the flaws of committee-led design, which is often defined by indecision, competing interests and compromise. The sleek horse is the result of individuals or small teams operating with focus and a distinct purpose. Although it is a wonderfully salient maxim, it is deeply flawed. Camels are a design / adaption marvel and in areas such as investing they provide invaluable lessons about how best to deal with uncertainty.

The idea that a camel is a poorly conceived horse does a huge disservice to a fantastically versatile creature. Adapted for desert living, camels must deal with dramatic temperature extremes from +50°c to -40°c. This means that they cannot use fat as insulation (as many animals living in cold climates do), but instead store fat in humps and have insulating fur. The energy stored in their humps mean they can go for sustained periods without food; whilst their technique for processing water allows them to survive for days in the severest droughts.

Although not as rapid as the fastest horse they are no slouches with certain species able to run up to 40mph. They are also ideally suited to long distance toil. Bactrian camels can carry 200kg (440lbs) for 50km (31 miles) per day. Camels have a range of other adaptions that allow them to survive and function in hostile environments such as wide padded feet, an extra-long intestine (to aid water absorption) and a fluctuating body temperature. They are creatures built for variability and uncertainty.

We are drawn to horses because of their appearance and speed, but their design is only superior to a camel if we are certain about the distance, environment and terrain. The less we know about our future path and the conditions we will encounter, the more valuable the resilience of the camel becomes.

The preference for the alluring features of a horse over the unwieldy camel is also suffered by investors. Most of us have long-term objectives requiring a portfolio that can withstand extreme variability in the environment and cope with material uncertainty. We are, however, so often tempted by options that have proved themselves ideally designed for the recent past and assume those conditions will persist. This leaves us sharply exposed to the realities of a complex and dynamic system.

Even when we acknowledge that the investment landscape will be changeable our tendency is to believe that we can foresee this and adapt our positioning accordingly. When we attempt to time markets or invest in funds that do, we are declaring that we can forecast the undulating path ahead and identify the investment ideally designed to navigate it. Although the promise of holding the perfectly tailored investment vehicle at the appropriate moment is an appealing aspiration, it is also an exercise in profound and costly overconfidence.

A prudently diversified portfolio is akin to a camel; it is not the most attractive choice and at any given time there will always be a superior option to deal with the current circumstances. It feels like we are always making concessions and carrying unnecessary burdens. Those fat storing humps on a camel seem superfluous when food is abundant, but much like the drag of holding anything but the most in-vogue asset class or fund, they are essential tools for an uncertain future.

If we are asked to undertake a long journey along an unpredictable path we should take lessons from the design of a camel, not a horse.

What is Your Investment Edge?

The idea of an investment edge is a simple one. It means that there are some features of an investment behaviour that improves the odds of better outcomes. Although the concept is straightforward, locating edges and creating an environment that fosters them is incredibly challenging. This is primarily due to the difficulty in specifying and evidencing them. Many established active fund managers – who are selling edges – struggle to articulate their own supposed advantages. Edges are, however, not the sole domain of active managers; whenever anyone is making an active investment decision they should understand the edge they have in doing so, otherwise they should not be doing it. 

Types of Investment Edge

The starting point for overcoming the problems of identifying an investment edge is defining the different types that might exist. I consider there to be three broad groups, which each include a range of more granular sub-groupings, these are: Analysis, Behaviour and Implementation:

Analysis – What information is used and how it is used

– Investors access more / unique information (insider trading is an edge, albeit an illegal one), or use different / new types of information.

TechnicalInvestors have specific technical skills that provide them with an advantage in assessing securities and markets. For example, a complex MBS strategy.

CriticalInvestors use information in a distinct fashion, which provide differentiated insights.

Behaviour – How an investor makes decisions

Decision Making I – Investors structure a decision-making process that mitigates the impact of our behavioural limitations.

Decision Making II – Investors structure a decision-making process that exploits the impact of our behavioural limitations. Most factor-based strategies are founded upon such an edge.

Emotional – Investors manage and control their emotions, so that their decisions are not overwhelmed by how they feel.

Environment Investors work in an environment that supports the objectives of their investment approach. The obvious example here being a high conviction active manager who is incentivised based on the long-term results of their strategy and supported through prolonged periods of underperformance.

Temporal – Investors make long-term investment decisions absent pressures of short-term performance or noise. This is the incredibly powerful edge that private investors hold over professionals.

Implementation – How an investor implements ideas

Trading Investors can skilfully trade in and out of positions.

Portfolio Shape
Investors have an advantage in how they construct their portfolio or how they weight conviction in certain ideas.

Not all edges are created equal. Given the abundance of information the potential for a credible analytical edge now seems far lower than has historically been the case. Edges are also not mutually exclusive, often they are dependent upon one another. For example, a temporal edge can only be credible within a supportive environment.

Although there are simple investment edges most (particularly those that are not easily commoditised) are a complex web of complementary or (sometimes) conflicting elements.

Key Questions About Investment Edge

The categories of investment edge are by no means exhaustive, but I would expect most to fall within these groupings. Critically, defining edges in these terms is only a starting point for more detailed analysis. There are three critical questions to ask about any purported investment edge:

1) What type of edge is it? It is not sufficient to state that an investor has an edge that sits within a certain category, we need to be clear about precisely what it is, otherwise it becomes close to impossible to evidence. Edges can be very general – buying companies that are cheaper than the market. They can also be specific – complex country models to assess the credit quality of an emerging market.    

2) Why does the edge improve the chances of better returns? It is important not to accept an investment edge at face value. We need to create a hypothesis as to why it might improve our results. We can never be certain, but unless we can make a plausible claim as to why an edge should lead to excess returns, then it probably isn’t an edge.

3) Can we evidence the edge?  Now comes the tricky part. If we have identified an edge and have created an argument as to why it may lead to better outcomes, we need some means of evidencing it. Obtaining confidence in edge (or skill) is all about drawing a consistent link between process and outcome. The typical and flawed approach to this is to discover an investor who has outperformed and then assume that their edge must therefore be effective. Markets are far too random and noisy to make such inferences. There are many investors with no credible edge that will appear as if they do when we focus on performance in isolation.  Instead, we need to ask what type of behaviours are likely to result from the edge and identify whether that is apparent in the decision making of the investor.

There are inevitably challenges with this approach. Sample sizes are often small and the evidence base lacking. Also, the more nuanced and intricate the edge, the more difficult it is to draw a causal link between it and outcomes. This means we must adjust our confidence in the existence of any supposed edge and should correct our investment conviction accordingly. Any view on an edge is a probabilistic judgement informed by the evidence available.

If we don’t attempt to evidence an edge then we cannot develop a reasonable level of confidence that it exists or observe when it has been compromised or competed away.

How to Identify an Investment Edge  

Generating convincing evidence about the existence of an investment edge is undoubtedly a challenge, but there is an even more fundamental problem. It is often difficult to decipher what the actual edge is. Even investors who should have one (because they charge for it) struggle to convey what precisely they believe their advantage to be. Fortunately, for most traditional, qualitative investment approaches there is a simple resolution. We just need to ask the fund manager one question:

“Could you effectively systematise your investment approach?”

Inevitably most active fund managers would baulk at the notion that their nuanced investment process can be transformed into an algorithm; for a start it does not augur well for their career prospects if the answer is yes. More importantly, if the answer is no the reasons they give as to why it cannot be made systematic should provide a clear view of their purported investment edge. By definition, they must believe that there are distinct elements of their investment process that cannot be easily or consistently replicated. Whatever is supposedly lost through systematisation, is likely to be some form of supposed edge.

Identifying a possible edge does not mean that an investor possesses a genuine one – most of the time it will not be – but it gives us a clearer sight of what that edge might be. We can then test it.

Most active investment strategies will feature two levels of potential edge – a base level ‘risk premia’ that can be easily systematised and then a more nuanced secondary level which reflects the specific features of their approach.  For example, the manager of a value equity strategy will have a base level edge of buying cheaper companies than the market (easy to replicate, but still with historic efficacy) and the second level that is the distinct elements of their process that allows them to produce better outcomes than the cheap, simple version of the base level edge. The second level is what investors are paying for, but it is much harder to evidence credibly, and we should have less belief in it.

This post might read as if it is solely about how we perceive the investment edges of other investors, but it is not. We must always view ourselves through the same lens that we judge other investors.

When we make an investment decision, do we know what our edge is?