At its heart, the shift towards sustainable investing is driven by the disconnect between the attempt of companies to maximise short-term shareholder value and the impact their activities have on other stakeholders and wider society. The doctrine of shareholder value maximisation is best expressed by Milton Friedman’s assertion that the “social responsibility of business is to increase its profits”.  It is hard to dispute the notion that this philosophy has defined the motivations and actions of most companies and shareholders in recent decades.

Listed companies have an obligation to their shareholders.  This requirement is typically viewed as generating the highest possible returns on capital in its business activities and producing a rising stream of profits. Until recently these ideas were uncontroversial and rarely disputed, but is this still the case? Has the rise of sustainable investing changed the entire notion of shareholder value maximisation?

This is a question investors must answer, and one that is rarely addressed.  We currently exist in an environment where there appears to be a perception (or at least a sales message) that an improved focus on sustainability and responsible investing will inevitably improve financial returns. Yet this cannot always be the case. The notion that capital can flood into certain in-vogue areas driving down the cost of capital whilst returns remain high seems fanciful at best.   

It is not a conversation that anyone is keen to have, but what if, in certain companies and industries, the move towards sustainability (and other ESG goals) depresses returns to shareholders at the expense of other stakeholders, society and the environment? Are investors willing to accept this?

Let’s take a hypothetical example. A large oil company is considering investing in a sizeable offshore windfarm project. The investment would help the business transition away from fossil fuels, but the torrent of new capital into renewable energy means that the expected returns from the windfarms are low in all but the most optimistic scenarios; significantly lower than the returns that they enjoy on their existing business. Should they make the investment?

From Friedman’s perspective the answer is clearly no, companies should not be making decisions that are likely to diminish the value of a business, and, if they do, they are failing to act in the best interests of their shareholders. But presently investors seem to be supportive of this type of activity. Why are investors encouraging developments that may reduce the returns they make? There are four potential explanations:

1. They do not see such projects as low return and believe they are a superior use of capital even from a traditional, shareholder profit maximisation perspective.
   
   
2. They believe that moves into fashionable, growth industries will create positive share price momentum, (they are not interested in fundamentals).
   
   
3. Over the very long-run, fossil fuel activities will become obsolete, whereas returns from renewable energy will persist. If you stretch your time horizon into the distance, the latter activity may be more valuable.  
   
   
4. They are willing to accept lower returns because of the greater stakeholder good delivered by the move to renewable energy.  In essence, the argument here is that shareholder returns are a much broader concept than the cash flow we receive from our investment.

Different investors will have different perspectives on the scenario presented, but to navigate the field of sustainable investing as it develops, we must be able to answer it.  It is naïve to believe that sustainable investing automatically leads to higher returns for shareholders, or to ignore the fact that it threatens to change the common definition of shareholder value.

Sustainable investing is about returns we may never notice

Investing sustainably means we must consider what we want our investments to achieve away from the narrow lens of headline performance, and decide whether we are willing to potentially sacrifice returns to achieve it.  

For sustainable investing to change the asset management industry profoundly and permanently there needs to be an appreciation that the returns it generates are far broader than that which we typically associate with our investments. It is not only about profits and losses, or performance relative to a particular benchmark. Instead, it is about a form of returns that we may never notice.

These returns can occur in two ways. First, the widespread adoption of sustainable investing should force and encourage companies to improve behaviour and focus on a wider group of stakeholders over a longer time horizon. The benefits of such a transition could be incalculable.  If it aids in limiting the rise in global temperatures, such activity is worth far more than any relative outperformance against a benchmark, but it is an improvement we may never perceive because there is no counterfactual.  No parallel universe where these changes did not occur.  

Second, our long-term investment returns – in the broadest terms – may be higher because of the shift towards sustainable investing.  The disastrous impact of a failure to keep climate change in check – for example – would almost inevitably depress returns across many asset classes; thus, the aggregate influence of increased sustainable investing may help boost long run performance of most risky assets. Again, we will never observe this or experience what would have happened in alternative scenarios.  

If we treat sustainable investing as merely a theme to boost stock or fund performance the movement will fail to have a lasting impact. Inescapable periods of poor returns will lead to capital being withdrawn and behaviours changing. Despite the current fervour around sustainability and ESG factors we really don’t know how dedicated asset managers and investors are.  What happens after three years of underperformance? Do investment committees start sacking managers and abandoning previous commitments?

If we are adopting a sustainable approach to investing it is critical to reframe how we think about returns. Our rationale cannot be founded solely on a desire to outperform traditional strategies – we might, but there are no guarantees and no robust evidence. Rather we do so because we care about more than simply the narrow financial returns of our investments, and because we believe that the widespread acceptance of sustainable investing will improve everyone’s outcomes in the long run, in a multitude of ways. That is an exceptionally different type of shareholder value creation.

This is not another piece about inflation. Well, it is a little, but it is really about stories. Just as most things in investment are. The market narrative of the moment is inflation. The possibility of long dormant consumer prices rising, perhaps substantially, as a recovery from the pandemic (in some parts of the world) meets substantial fiscal and monetary stimulus. The potential implications for interest rates, asset classes and future returns are undoubtedly significant. But what should we do about it?  As investors we lurch from one diverting story to the next, usually forgetting what we were obsessing about in the previous quarter. How do we know how much we should really care?

Financial markets are narrative generating machines. Creating stories is the only way we can deal with the discomfort caused by their complexity and unpredictability. Some can be long-running undercurrents (secular stagnation, for example), others can flare up and come to dominate but only for fleeting periods. The current fascination with inflation is in the latter group, it might morph into something more enduring, but nobody really knows.

We spend most of our time obsessing over these short-term narratives. They spread and bloom with incredible speed. This is both due to their salience (they quickly become incredibly prominent) and their transmissibility – even if you regard an issue as short-term noise, if a client or colleague is aware and asks you a question, you need to respond. A particular story can rapidly become an issue that everyone must address and have an opinion on. It comes to be the focus of every meeting. It is remiss not to mention it. This is where inflation is now. That is not to say it doesn’t matter, but rather because we cannot predict it, we don’t know how much it matters or what to do about it.

Asset prices movements are frequently used as validation for these types of flourishing stories, but that is getting the order in reverse. Often it is the movement in asset prices that creates and fuels the story. Price gyrations must be explained, so a narrative is forged, and its persuasiveness creates increased momentum in prices.  Either a vicious or virtuous circle depending on your positioning.

Most macro investors are playing this momentum / story dynamic (save for a few contrarians). Although they may make bold proclamations about the forthcoming economic environment and its impact on markets, it is typically just momentum trades with a narrative attached. The alternative is to believe that people can accurately predict staggeringly complex systems like economies and markets, but nobody really thinks this, do they?

Inflation is the story today, but there is always something. These often ephemeral, self-reinforcing stories that investors fixate upon have a range of consistent features:

1) Everything is amplified: The implications of a major story are usually greatly exaggerated. We don’t have a mild rise in inflation from unusually low levels, we have an inflation problem. Bonds are not returning to yields of a year ago, it is a rout.  Unfortunately, the power of a narrative is not often related to its credibility or importance.

2) Temporary experts: We will hear most from people whose views have been long aligned with the story that comes into the spotlight. In that moment, they will be considered an expert, even if they have been wrong for the previous decade.

3) Everyone has an angle: People will talk their book on any given story. Don’t ask a bond investor or a commodity investor for their opinions on inflation. We know them already.

4) Stories are often transitory: In the moment, certain stories will feel overwhelming and all-encompassing. What we see is all there is. It is hard to believe that we might well be focusing on something else in a few months’ time. But so often we are.

5) Stories sell: Prominent narratives provide a perfect opportunity to sell products. Stories are how we understand financial markets, they dominate how we feel and behave. Asset managers will inevitably shape their offerings to match the story that – for the moment – has our rapt attention.

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Investors are constantly battered by a torrent of stories. These are used to explain or predict market behaviour, from daily price changes to long-term trends and themes. The sheer volume of shifting and often contradictory tales make it impossible to ascertain which are valid and what we might do about them.

Inflation is an important risk that investors must be aware of over the long-run, we should prepare our portfolios for its lasting impact and be appropriately diversified in order that we are reasonably insulated irrespective of the outcome. We should not, however, make rash decisions based on short-term narratives about things we cannot predict.