Although it feels like painful events such as bear markets are an unpleasant reality best quickly forgotten, they are incredibly important for investors.  Our decision making during such difficult periods can easily define our long-term outcomes.  Whilst our present inclination might be to focus on the specifics of the coronavirus we should instead consider how we can learn the right lessons about both our investments and our own behaviour during periods of severe market stress.  We can then be better prepared for the next bear market, whenever it may arrive.

Here are some lessons I think are important.

In a low interest rate environment we will have a love / hate relationship with cash: When rates are on the floor, very few people are comfortable holding cash.  For most investors it generates a low nominal return and often a negative real return, plus a fee is levied for the pleasure of owning it.  These paltry or negative returns become even more painful when all other assets are delivering strong performance.  In times of true market stress however, cash can become the only asset that investors want to hold.  This will make us start to question why we and others weren’t holding more of it.

This presents something of a conundrum.  In a low rate world, cash is likely to prove a material drag on returns, and the longer a bull market persists the more unpalatable holding it will become.  Yet it is incredibly valuable in times of extreme market dislocation.  So what is the answer? Well, we could just hold low cash when the market is rising and then increase our exposure before the market falls (this is a joke).  The only option is to have a sensible long-term view on its role in a portfolio (given its risk profile) and be content with that.  If we want to own a meaningful level of cash permanently, then we can’t complain when our portfolio lags in a bull market. Conversely, if we believe it will be of long-term detriment to own exposure to an asset that may produce a negative real return then that is likely to leave our investments more vulnerable in markets like those we have seen for spells of 2020.

Investment returns are not normally distributed, and prolonged periods of subdued volatility do not mean it is a good idea to increase your exposure to risk assets: These seem like obvious points to make but they are often ignored during a bull market.  Investment results come with more periods of sharply negative observations than one would assume from a normally distributed set of returns.  Irrespective of how low realised volatility has been there will always be wretched bouts of performance, which render any ‘information’ gleaned from periods of below average volatility meaningless.

The related issue regarding volatility (I have written about its use as a measure of risk here) is that during sustained spells of depressed realised volatility, there is often an overwhelming temptation to hold more risky assets.  Whilst a low volatility backdrop persists this can be an effective means of increasing returns and also looks fine when run through a backward-looking risk model; but can suddenly become incredibly problematic when volatility erupts.

Drawdowns are an inevitable feature of long-term investing:  Investing in any form of risky asset (above cash) involves drawdown risk. An extended period with few material drawdowns does not mean that this risk has been extinguished.  As a rule of thumb, I would say that for a diversified portfolio of liquid traditional assets the absolute minimum expected drawdown over a market cycle should be 2x the expected long-term volatility.  This is a base level because, as mentioned earlier, returns are not normally distributed – there is a negative skew – 3x volatility is probably a more reasonable expectation, depending on the assets / strategies involved.  My sense is that we tend to underestimate the potential for drawdowns in our portfolios so it is crucial to be realistic about this from the outset.  To generate strong long-term returns and enjoy the benefits of compounding we need to be financially and behaviourally disposed to bearing such risks.

Illiquidity is not diversification:  Just because something doesn’t price, does not mean it is providing diversification to a portfolio.  As I (and others) have mentioned before, the major advantage of illiquid assets is that the inability to trade limits our propensity to make bad short-term decisions. This is a behavioural premium created by structurally compelling us to be long-term investors (obviously with the caveat that a bad investment is still a bad investment).  Ignore anyone saying that their private equity holdings have ‘held up well’ during a market sell-off. 

Some alternatives are not that alternative: Low bond yields have pushed more investors into ‘alternative’ asset classes and strategies in order to ‘enhance’ portfolio diversification.  The market downturn has highlighted three crucial aspects around this for investors to consider: i) Some apparent diversification is just a different pricing methodology.  ii) Some strategies appear diversifying until a severe bout of market / economic weakness arrives and diversification disappears just when you need it. iii) Even if assets are genuinely distinctive from other traditional assets, when there is a stampede for cash, everything can get trampled. 

We need to have a plan:  Making plans for torrid market conditions is a crucial element of prudent long-term investing.  It is probably the only thing that will protect us from the confluence of newsflow, negativity, anxiety and stress, which lures us toward poor choices.  Of course, we cannot prepare for specific eventualities – here is what I will do in a global pandemic – but we do know that severe declines in asset prices will occur at some unpredictable juncture.  Even acknowledging this (and writing it down) can help.

We need to have a plan we can stick to:  Investment plans are incredibly important, but also fiendishly difficult to follow.  In a bull market it is easy to say: “when valuations become more attractive (markets fall) I will increase my exposure to equities”.  The problem is that when we make such commitments we neglect to consider how it will actually feel at the time it happens.  Markets will be declining for a reason.  News will be uniformly terrible. Are we sure that our plan was sensible? Hasn’t everything changed? Sticking to our plan will be the last thing we want to do. Plans need to be clear, specific, realistic and, as far as possible, systematic.  Make the decision before it happens. 

Base rates are ignored even more than usual in periods of stress:  During the recent market turbulence high yield spreads moved to 1000 over.  Historically, this has been a good time to own lower quality credit for the long-term, and on a five year view has typically led to strong returns.  We can call this the base rate or our outside view.  Despite the importance of this information we are prone to ignore it, particularly in times of stress.  Rather than consider the relationship between starting valuations and future long-term returns; we focus on specific, salient issues (the inside view) – the virus, the default rate, the energy sector travails.  It is not that this information is irrelevant, but that we weigh it too heavily in our long-term considerations. 

We should always start with the base rate / outside view (spreads being wide is good for long-term returns) and make any adjustments we feel are prudent based on the prevailing backdrop.  Instead, we start with the inside view – the particulars of the current scenario – and the salience and availability of that tends to overwhelm any consideration of base rates, or the things that are likely to matter more over the long-term.

It is hard to make good long-term decisions:  Our obsession with the present makes it close to impossible to implement sensible long-term decisions.  Time horizons contract dramatically and savagely during market declines.  The quality of the choices that we make will be judged over the next week or month (rather than the usual quarter).

People will want action!  As uncertainty increases and markets fall there will be an inevitable clamour for activity.  Things are happening – what are we doing about it?  Whether or not what we are doing is likely to be beneficial in the long-term or is even part of our investment process is likely to fade into insignificance.

For the vast majority of investors sitting on our hands, or making very modest adjustments based on pre-existing plans is the right thing to do.  The problem is nobody else thinks it is, and it might see you out of a job. 

Some people will look stupid, some will look smart:  Most of it is luck and randomness.  When recessions and bear markets arrive there are always heroes and villains.  Some will be lauded for their foresight (and perhaps have books and movies produced about them) others will be castigated for their folly.  Outcome bias grips us hard.  There will always be a few skilful exceptions, but even then we don’t know if the individuals involved will repeat such feats (history would suggest not).  If you work on the assumption that most investor results during such periods are the result of luck and sheer chance, you will have the odds on your side.

Recessions will happen, and for reasons we have not predicted:  There are plenty of things that people ‘know’ are a waste of time in the investment industry but keep on doing anyway – one is speculating about recessions.  Experts cannot predict when they will develop or what the cause will be.  We shouldn’t waste our time trying to forecast the next one. (I am assuming that nobody leaving their homes for months means that we are in one now, but I am no economist). 

It is difficult to tell whether changing market structure, or the nature of the pandemic caused the pace and severity of the asset price decline:  The speed and severity of decline in risky assets was likely in part due to changes in market structure, but not all arguments are equally valid.  A reduced willingness for investment banks to warehouse risk seems likely to be a contributory factor; the growth in low cost index investing wasn’t.

Whilst the structural arguments have some merit, the nature of the market drop was also due to an unprecedented economic stop and huge uncertainty around a global pandemic.  There were (are) some deeply negative economic consequences from the coronavirus outbreak and nobody had (has) any confidence about what probability to ascribe to them.  Does the recent decline provide information about how market bear markets may occur in the future?  Yes.  Will they all look like this one? No.

We are not epidemiologists. Even if we were, we still wouldn’t be able to time markets:  Let’s be clear about short-term market calls in this environment.  It means taking a view on the progression of the virus, the fiscal / monetary response, the economic impact of that response, the prospects for businesses, the reaction of individuals, and, crucially, the behaviour of other investors.  Good luck.

The virus and its consequences will be used to support everyone’s pre-existing beliefs:  The virus will change the beliefs and behaviours of very few people.  When I say ‘very few’, I really mean nobody.  Growth investors will tell you that societal changes following the virus will bolster the prospects of tech companies.  Value investors will say the fiscal response means that inflation and rate rises are inevitable providing a catalyst for the long awaited resurgence.  MMT advocates will say their ideas have been validated, naysayers will forecast the coming inflationary reckoning.  Active investors will say dispersion is high and the time is right; passive investors will say they held up just fine in a bear market.  Everyone has an angle and everyone will use the same information to bolster their own contradictory views. 

Decisions we make in periods of stress will have profound implications for our long-term results:  If an investment decision makes you feel good immediately, it will probably make you feel bad in the long-term.  In periods of market weakness, the temptation to do what will make you feel better now can be overwhelming.

Things will happen that we had never seriously considered:  An economic shutdown / negative oil prices. These weren’t in forecasts or captured in risk models. 

Depending on the progression of the virus and its market / economic impact, there may or may not be a part 2 of this post (hopefully not). 

The coronavirus outbreak has diverted attention away from the drive towards ESG-focused investing that had become the dominant narrative in the asset management industry.  Yet whilst its prominence may have temporarily dimmed; it will almost certainly be one of the defining issues for investors over the next decade.

Although I am supportive of the determination to make ESG factors critical to investment decision making; I worry that professional investors have become focused on the outcome (achieving some form of ESG badge) rather than the process required to get there.  Asset managers frequently proclaim that ESG is ‘in their DNA’ whilst keeping a straight face and fail to acknowledge that it is one of the only routes they have to maintain high margin active management business (alongside private markets).  Every investment process now ‘integrates’ ESG because they have to, even if it is unclear what influence these factors really have.  In many cases ESG has become a tick box or a label. This is a disservice to the complexity of the subject and what the core principles of ESG investing are designed to achieve.

 Whilst the issues to consider are myriad, below are some of the most important questions around ESG investment philosophy that need to be considered by all involved:

Are you willing to sacrifice investment returns? Although it is wonderful to work on the assumption that you can ‘do good’ and improve your financial returns this should not be the founding principle of any ESG-focused investment.  When applying portfolio restrictions that constrain choice you must be reducing your ex-ante return expectations – otherwise they would not be a constraint (of course it might turn out that they improved returns after the event).  Whilst ESG investment is about far more than limits and restrictions; even if we move towards ‘Sustainable’ and ‘Impact’ strategies there is not an insignificant probability that investing in a manner that has material environmental and societal benefits may diminish your investment return.

Every investor in this area needs to ask how they would feel if their investment strategy underperformed a broad market benchmark for a sustained period.  At its core making a decision to invest with an ESG mindset should be based on the notion that you care about more than simple financial results and understand the possible consequences of that from a return perspective.  Three years of underperformance from ESG factors should not lead you to recant your beliefs.  Part of accepting a broader definition of what ‘returns’ means is being able to understand the positive non-investment outcomes that your portfolio might deliver. 

Do any ESG elements constitute a risk premia? It is possible, but there is nowhere near sufficient evidence to prove it.  The strongest case to be made is that within the governance component there are elements that are intertwined with the quality factor, which can be considered a risk premia.  Broadly, however, it would seem a stretch to assume that ESG factors deliver excess return for their level of risk, and provide some form of external societal and environmental benefit in addition.  Of course, in specific cases this might be true, but it is unlikely to be broadly applicable.  Furthermore, as ESG factors become an increasingly vital element of investment decision making it is likely that investors will be willing to hold certain securities at higher valuations, and therefore with lower expected investment returns.

Should ESG assessments be absolute or relative? It is important to understand the heterogeneous nature of ESG scoring and assessment.  One of the most critical is the distinction between absolute and relative.  Are you comfortable investing in companies that are the best in their industry, even if the industry is poor in certain ESG aspects – the best airline, for example?  Or do you think about ESG in absolute terms – how strong is a potential company on ESG factors relative to everything else?  The latter option offers a level of ‘purity’ to an ESG philosophy but brings with it a cost in terms of a lack of diversification.

Should you worry about where a company is now, or where it is going? Another crucial consideration is around what could be referred to as ESG momentum.  Should you focus on companies that rate highly from an ESG perspective now; or also incorporate those companies that may fare poorly at present, but are showing signs of positive change?  If a key aim of ESG investing is to bring about a broader shift in corporate behaviour, then giving some reward to positive change seems prudent.

Should you divest or engage?  This requires careful thought. Of course, there are certain companies that you may wish to avoid from a pure values perspective – controversial weapons, for example – but is it always best to relinquish investments that are deeply questionable from an ESG perspective, and what do you achieve by doing so?  My initial thinking on this was that divestment could be an effective means of bringing about change, primarily on the basis that if carried out in significant magnitude it could materially increase the cost of capital to that business.  However, as Izabella Kaminska at FT Alphaville eloquently argued[i]by divesting you lose all influence and any chance of bringing about material change.  Furthermore, you allow other investors (perhaps those with purely financial motives) to invest with more attractive return prospects, and tacitly permit the company to continue absent any shareholder pressure to alter its activities.  The question therefore should not simply be to divest or not, but if I remain invested what influence can I exert (alongside others) and how might this change the business.?  Also, if I don’t invest, who does?  The problem with this last question is that it provides a get out of jail free card, which allows anyone to own anything.  Therefore it is crucial that you are able to justify and evidence your ability to influence a company. 

Is active or passive the best approach?  Although a perennial favourite for ESG deliberations, it is a false dichotomy.  The real question is about whether a rules-based decision making approach (such as an ESG index) is sufficient or do you require additional qualitative judgement to run an ESG oriented strategy?  Even this distinction is limited by the fact that ESG indices will involve qualitative assessments both in the construction of the benchmark and the underlying scores that inform it.  Unlike in broad asset class decisions a simple active versus passive choice doesn’t exist; it depends on your objectives and requirements.

Are the multiple ratings services a problem? We are likely all well-versed in the fact that the major firms in ESG ratings adopt significantly different approaches in their company assessments resulting in a worryingly low correlation between scores from different providers.  The same portfolio could have positive or negative ESG characteristics depending on the lens through which you choose to analyse them. The problems with this lack of consistency are often highlighted as a profound weakness of ESG investing; but we should also consider an alternative scenario where one firm held the ability to define what represented ‘good’ from an ESG ratings perspective.  The idea of being beholden to a single judge in this regard is equally unappealing. There is at least some benefit to the diversity of thought embedded in numerous ESG ratings services, and there is far more subjectivity in defining ESG quality than credit quality, for example, so this divergence is likely a feature rather than a bug.  Clearly it is important for investors to understand the different methodologies and assumptions, and also use their own.

The other issue with ESG ratings is the spectre of Goodhart’s law – when a measure becomes a target it ceases to be a good measure.  Whilst ESG scoring will likely encourage companies to improve and potentially lower their cost of capital there will inevitably be gaming.  Firms will look at what is being measured and almost certainly target specific areas to improve their ratings.  Although companies seeking to increase their ESG score is a positive; a close eye will need to be kept on loopholes in the ratings, and situations where optics supersede substance.  One indirect benefit of the aforementioned issue of multiple scoring approaches is that it reduces the ability to game or target specific metrics – because of the very inconsistency.  

Is ESG investing in a bubble? An investment bubble needs a compelling narrative, widespread participation and a complete disregard for valuation. ESG has momentum and a compelling story, but not the broad and complete disregard for valuation and future returns.  The danger for ESG investing is that because it is about more than financial returns there can be a tendency to make valuation subordinate to other issues.  Furthermore, flows into ESG can create a self-reinforcing problem, where strong appetite for positive ESG stocks encourages more investors to convert because past performance is appealing.

The fact, however, that ESG is such a nebulous term and the ratings highly subjective means that a widespread bubble is unlikely and actually very difficult to define – what would a bubble in ESG look like?  More possible is that there will be certain areas of the market captured in the drive towards ESG that will (and have already) moved to unsustainably lofty valuation levels.  The other potential ramification is an increasing valuation gap between positive ESG stocks and those that are uniformly excluded or commonly score poorly.  I did think for a time that things could not get much worse for value investing, but the move to ESG is another potential headwind*.

How do you balance principles and diversification? Your ESG philosophy will have a significant bearing on the level of diversification you are able to achieve in your portfolio, and it is important to be clear about the sacrifices you are willing to make.  For example, in a multi-asset fund are you willing to own sovereign bonds?  In an equity fund are you comfortable excluding swathes of the market and being narrowly exposed to certain styles, sectors and industries?  There are trade-offs to be made and you need to be acutely aware of the investment implications of these.

What matters and how much does it matter? Implicit in any ESG score or rating will be assumptions about what issues are important and how important they are.  An overall ESG score will incorporate a hugely disparate group of factors, from carbon intensity to board level gender diversity, which are almost impossible to compare in any reasonable fashion.  Furthermore, judgements are being made about the relative importance (or weighting) of each factor at an E, S and G level, and also regarding the underlying metrics that fuel the headline scores. 

The use of the ESG definition as a coverall term for such a diverse group of factors and issues is almost certainly a net positive as it brings focus and direction to a movement that could otherwise be unwieldy and disparate.  It also offers welcome simplicity to a horribly complex and subjective area that could leave many afflicted by decision paralysis.  Those benefits notwithstanding, we should be aware of the implicit assumptions and judgements we might be making. 

It is easy to be cynical and critical about aspects of the growth in ESG investing and the motives of some involved in it.  Yet whilst it should be held up to scrutiny, there is also the possibility that we allow perfect to become the enemy of the good.  For all of its faults and limitations the move towards ESG influenced investment decision making in recent years is very likely to be of long-term benefit to us all.  For it to continue to evolve and improve it is important that we are realistic about the investment implications of any ESG approaches we adopt, and ensure that we are willing to understand what underlies simple definitions, scores and labels.

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* Or opportunity, depending on your time horizon.

[i] https://ftalphaville.ft.com/2020/02/19/1582111795000/Climate-activists-would-be-better-off-buying-BP/