What are the 10 Biggest Mistakes Made by Fund Investors?

Based on years of observation and bitter, painful experience; here are my thoughts on the ten most significant mistakes made by fund investors:

1) Searching for performance consistency 

There is perhaps no more damaging feature of the fund selection industry than the quest for performance consistency. By this, I mean the reverence for funds / managers that deliver outperformance compared to their benchmark over a variety of short time periods (consecutive months, consecutive quarters, consecutive calendar years). The problem is not that it is a bad outcome (it is clearly an incredibly positive one), but that it is used as a shorthand for skill or an indication that such patterns will persist into the future. Both notions are false. 

For performance consistency to tell us something meaningful about future fund returns or the presence of active management skill, we need to believe one of two things: 

a) That the manager or team have the foresight to predict short-term market movements: Most investors would surely accept that market returns over the short-term (at the very minimum) are highly unpredictable and variable, yet by using fund performance consistency as an indicator of skill or quality we are suggesting that the manager responsible can indeed predict market movements over the next month, quarter or year. If they couldn’t then their fund would not deliver consistent excess returns. 

b) The tailwind a fund is enjoying from style or market conditions will persist indefinitely: If we reject the notion that any individual or team can accurately and regularly forecast future market conditions, then performance consistency must arise from some style or bias inherent in a fund that has been in-vogue for a sustained period. Whilst style and factor performance can persist for prolonged spells (often much longer than we think), they will not be maintained forever. So often fund investors mistake factor and style momentum for skill. There is nothing wrong with using fund performance consistency / momentum to make investment decisions, provided we are clear about our intentions and set appropriate rules. We shouldn’t pick a fund because it has outperformed for six consecutive years and then carry out four manager meetings and hours of due diligence to justify a decision based on performance momentum.  

The only consistency fund investors should worry about is consistency of expectations -is a fund behaving in a manner that is consistent with reasonable expectations about its approach? It is critical to remember that if the returns of active funds were all entirely random, there would still be those that produced a remarkable consistency of returns by sheer chance. 

Not only does the search for performance consistency lead us to misattribute skill and luck, but it encourages some of our worst behaviours – most notably lurching between outperforming and underperforming funds. If we buy a fund based on performance consistency, what happens when it inevitably falters? We sell and move on to the next name at the top of the performance tables.

The problem is that the notion of performance consistency is incredibly compelling and has captured all market participants from regulators to private investors. Unrealistic expectations abound. The simple fact is that if we cannot accept inconsistency and maybe years of underperformance, then we should take as little active risk as possible. 

2) Neglecting the circle of competence 

If we are investing in an active fund, we are assuming that the manager or team possess some form of skill that allows them to outperform, but we are often vague about what the particular skill is. The worst form of this to classify someone as a ‘good investor’ (what does that mean?) Even when we attempt to be more specific – ‘macro’, ‘picking cheap companies’ or ‘selecting companies that beat the fade’, they don’t go anywhere near far enough. If we are not clear about exactly what skill(s) are evident then we are liable to allow managers to stray well outside of their circle of competence and into dangerous waters.  

When a fund manager develops a strong track record, we often seem to be comfortable watching them creep or leap outside of their circle of competence into areas where they have no credible history or expertise. The failure of the UK’s leading fund manager was a circle of competence issue. Neil Woodford’s shift into small and unquoted, often speculative, companies was not hidden, he was (for the most part) very transparent about what he owned. His shift was accepted* because of his past performance; even though this was produced doing something entirely different. 

If we are invested in active funds where skill is an expected feature, we need to be precise and explicit about what it is. If a fund manager shifts away from their core competency, we should start to worry. 

3) Seeking smooth returns 

Investment frauds are often not about stratospheric returns, but instead something that might be even more desirable – smooth performance. The attraction of funds that move on an unperturbed path upwards is entirely understandable – drawdowns and volatility are painful and bring about poor behaviours – but it is an entirely unrealistic expectation. If we are to invest with even a modicum of risk then we will witness variability in returns. Fund investors need to accept this rather than find ways to avoid it. That doesn’t mean we cannot make the journey smoother by implementing sensible investment principles such as diversification, but volatility is inevitable and indeed it is a reason why long-term equity returns are so high. 

Even away from frauds we can easily be tempted into funds that provide apparent diversification and smooth returns, simply because they are priced on a different basis to more liquid assets. The idea that certain private equity strategies, for example, are diversifying and lowly correlated to public equities because their assets are marked to model is nonsense. This type of situation is worsened by employing mean variance portfolio optimisation approaches that compare volatilities across asset classes with different pricing methodologies.

We should never let the attraction of smooth performance leave us blind to what assets a fund is actually investing in. 

4) Ignoring the odds of the game 

The first question we should ask about a fund selection decision is – what are the odds of success? But it is one that is rarely posed. It is possible to argue that it is too difficult to make a reasonable estimate of the chances of a good outcome, but this is not credible. If we want to know whether to participate in a game, then we should at least try to understand the odds. There is no precisely right answer, but there are critical questions we should always ask. If we are investing in an active strategy in a particular asset class, what is the history of success for active managers? Do the underlying returns within the market tend to be highly dispersed? We can easily build a picture that gives us a sense of how difficult or easy our task might be. So why don’t we do it? 

Aside from the difficulty of making an accurate probability assessment, there are two additional issues: 1) We tend to think that our case is special and falls outside of the odds of the normal game, 2) We are overconfident. We don’t care about the odds of the game, because we are that good they don’t apply to us. 

To make informed judgements about fund selection decisions, we need to seek to understand whether an investor has skill and if they are operating in an environment where their skill gives them a material opportunity for success. How difficult is the game being played likely to be and who are they playing against? 

5) Being complacent on capacity 

Capacity is a perennial problem for fund investors. Issues around fund size are only likely to occur in funds that are performing well (making us reluctant sellers) and the asset manager is unlikely to acknowledge that a key revenue generator should be closed to new business. 

Despite a disinclination to act on capacity from either fund buyer or seller, it is inescapable that asset growth serves to constrain a fund (when above a minimum viable threshold). A rising fund size limits the investable opportunity set, restricts flexibility, and fosters liquidity risks. 

We are often warned that we should not expect a fund to repeat historic excess returns because the environment is likely to be entirely different in the future. When capacity problems arise, it means a fund could not replicate past successes even if the environment were identical because it is encumbered by the size of assets managed. 

Fund investors need to take ownership of the capacity question, not rely on assurances from asset managers or wait until performance deteriorates. 

6) Buying thematic funds for the wrong reasons 

The continued growth of thematic funds – particularly in ETF structures – is a problem masquerading as an opportunity for fund investors. The potent combination of strong (often hypothetical) past performance and a compelling narrative can be behaviourally irresistible, but frequently leads to disappointment. Thematic funds are often little more than price momentum strategies with a story attached and absent any of the rules that define traditional momentum approaches.  

There is nothing intrinsically wrong with investing in a thematic fund, provided that the reason for doing so is sound. It is a pure way to benefit from the price appreciation brought about by pronounced flows into fashionable areas and we might profit in a second order fashion by predicting how other investors will behave. The major danger in such an activity is knowing when to exit.

The less credible argument is a fundamental one – that the securities captured by a theme are somehow unknown or undervalued. If a theme has performed so strongly and is sufficiently well known to have funds launched based on it, it is probably already in the price.

Thematic funds need little marketing because its sales pitch is embedded in investment philosophy. Tread carefully.

7) Forgetting we are all active investors 

The binary distinction between active and passive investing is simple and effective, but it is not strictly true. All fund investors exist somewhere on a spectrum between the two extremes, no portfolio or fund decision can be considered purely passive. Even in the most basic 60/40 construct there are decisions to make: Is just developed market equities, or should emerging market equities be included? What is the neutral duration position? Should high yield be incorporated? What about gold? 

The critical point is that investors who believe they are passive are not immune to many of the behavioural issues that more active investors face. In my time running passive only multi-asset funds, most of the questions I received were about why we were underperforming other passive funds with different asset allocations.

The prolonged success of long US and long duration portfolios has led to the assumption that people can simply invest and forget, this is great in theory, but unrealistic in practice. What happens if US equities underperform for five years? How strong will the temptation be to shift to the passive manager with a greater exposure to emerging market equities or a significant non-US developed market bias? 

We are all taking some level of active risk, fund investors need to acknowledge what that is and be aware of the behavioural temptations that come with it. 

8) Getting lost in complexity

We should avoid investing in things that we do not understand or cannot explain.  Owning complex funds is incredibly tempting – it makes us look good (see how smart we are!) and offers the prospect for a stream of returns different from traditional funds (uncorrelated, non-directional, through all market environments etc…) Yet mixing complexity (funds) with complexity (markets) often compounds risks rather than reduces them and in ways that can be impossible to foresee. Returns from simple investment strategies have been incredibly strong in recent years and will almost certainly be lower in the years ahead, despite this we should remain circumspect about complex funds.  

9) Starting with the assumption that a fund manager will outperform 

Selection effects such as survivorship bias can run amok when carrying out fund research. When seeking to identify a fund in a particular asset class the opportunity set will already be biased towards funds have had some solid spells of performance by virtue of the fact that they still exist.  In addition to this, we will probably have filtered the universe further through some form of quantitative performance screen.  As the funds we are researching will likely have been strong performers, we typically seek to discover how they have managed to outperform and why they might continue to do so. This is the wrong starting point. Our default position should be that every active strategy is destined to fail even if they have performed well in the past (maybe because they have). There must be exceptional evidence to the contrary to take a different view.

Framing our shortlist of candidate funds as a group of skilful managers who are likely to outperform in the future sets the bar far too low.  We need to begin by assuming everything will underperform.

10) Having time horizons that are far too short

If there was one thing that could be done to improve the decision making of fund investors it would be to extend our time horizons. The shorter our timescale the more we are captured by chance; consistently making judgements based on random and unpredictable market movements.

The irony is that as we try to become more sophisticated and diligent investors our time horizons inevitably contract making us worse investors. We check our funds too frequently, make confident inferences based on little but noise and overtrade. Unfortunately, it never feels or looks like this at the time. We have so much ‘information’ available to us that every choice appears reasonable and well-informed in the moment. Each switch from an underperformer to an outperformer feels good whilst we are doing it. It is only when we reflect that we are likely to observe the long-term costs.

This is an issue that is getting worse.  Our time horizons are becoming ever shorter. More observation points, more near-term scrutiny, and more unnecessary activity. What is good for preserving our careers or getting us through that next difficult meeting is probably to the detriment of our long-term returns.

* Private investors can not reasonably have been expected to know this; professional investors should.

Why Do Fund Investors Neglect Base Rates?

Given the vast amount of time, effort and resource dedicated to fund research it would seem absurd to suggest that the most critical pieces of information are ignored or neglected, but it often seems that they are.  Fund research can be defined as an inside view activity; one where the precise details of a particular case can dominate our decision making. This might be the pedigree of an active manager, an impressive track record or the attractions of an in-vogue investment theme. The allure of these specific features leaves us prone to ignore the general lessons from similar situations (the outside view). This means we make decisions without even knowing where the ballpark is[i].

The most effective form of outside view is the formulation of a base rate.  Although popularised in recent years, the idea of employing a base rate in decision making can still seem a somewhat arcane activity.  But a base rate is simply an observation derived from an appropriate reference class of similar examples[ii]. If we knew nothing about the specifics, then the base rate would be our only guide.  Let’s say we wanted to estimate the operating margin of a certain airline. The inside view would be derived from the specific features and operations of that company, whereas the outside view / base rate would be based on the operating margins of all airlines.

For fund investors, we can think of the base rate as answering two questions:

What do similar scenarios tell us about the likely outcome?

and

What do similar scenarios tell us about the odds / probabilities attached to our decision?

Fishing for a base rate

Imagine we are asked to make a forecast of how many fish a fisherman will catch on a single day. We speak to the fisherman and find that they are incredibly skilful and experienced and utilise the most sophisticated equipment.  They are supremely confident that they can catch more than 10 fish. We have our inside view. Is that sufficient to make a robust prediction? No. We need an outside view.  On further investigation we find that over the past year fisherman at the lake catch on average only one fish per visit. This is our base rate.

We might refine our reference class and look at the average catch of fisherman at different times of year or in certain weather conditions, but a good base rate needs to balance sample size and specificity.  Once we have a base rate, we understand the history of similar scenarios and have an idea of the odds of certain predictions being correct (the chances of catching more than 10 fish seems low). We are now much better placed to decide.

The base rate is a vital piece of information. Imagine attempting to forecast the number of fish caught without it.  It does not provide us with the answer, but it does offer a starting point.  We can still make a decision that is contrary to what the base rate tells us.  For example, we might argue that fishing is an activity heavily influenced by skill, and therefore the skill of the chosen fisherman will render the base rate less relevant – but at least we are clear in the assumptions we are making. Underweighting the base rate in a transparent fashion is far better than ignoring it.

Fund investing and base rates

Unfortunately, there is no single base rate that we can take from the shelf to apply to our decision making. We need to define and identify an appropriate reference class. There also might be multiple angles around which we wish to apply a base rate to a decision.  There are a range of base rates fund investors might adopt. Here are some hypothetical examples:

Over the past 10 years X% of active managers have outperformed the benchmark. 

This is a relatively straightforward and easy to source base rate with a clearly representative reference class. We don’t have to be beholden to it, but we should be explicitly aware of it as a measure of the odds of success in selecting an active manager. Again, we might argue that the figure is unrepresentative of the future because, for example, the dominance of a select group of large companies made it unusually difficult to improve on the benchmark over the past decade. However we use such a base rate, we should be clear on what it is and how it impacts our choices.  

On average, funds that outperform by more than 10% annualised over 3 years, return X% over the subsequent three years.  

This is a different type of base rate more attuned to the tendency of fund investors to chase past performance and for fund excess returns to mean revert. If we are buying a fund with a stellar track record it is critical to understand how likely it is that this will continue; particularly as the inside view at the point of maximum performance will be incredibly compelling. A good example of this type of thinking is an article by Morningstar observing the performance of funds after they had risen by more than 100% in a single calendar year.[iii]    

Equity markets that have outperformed over the last decade and are relatively expensive, underperform by X% over the subsequent decade.

Base rates for fund investors are not simply about the classic, binary active versus passive debate. All investors are active in some form. Even if the underlying funds we use are trackers, the asset allocation involves active decision making – nothing is purely neutral. If we have benefitted from being heavily invested in US equities for the last decade by virtue of the construction of a particular index, we still need to apply base rate thinking to the implicit views we are expressing.

Why are base rates ignored?

Given how valuable base rates are to effective decision making, it is somewhat puzzling that they are not more widely and obviously used by fund investors. There are several factors that limit their employment:

Overconfidence: An exaggerated belief in our own abilities means that the base rate or average does not apply.  Odds of 10/1 against are meaningless to us.

Exceptionalism: Overconfidence means that we think that we are exceptional; in addition to this we tend to think that our specific case is the exception. This time / this one is different, so the base rate again does not apply. 

Salience and Stories: The inside view is far more interesting and persuasive than the outside view / base rate, therefore it tends to overwhelm it. The backstory to a specific manager or market is so much more diverting than looking at historic experience and averages.

Time: As with all incidents of (poor) investment judgments time has a central role to play.  Base rates often exert their influence over time but can be of little use over shorter time horizons. Without the right level of patience or appropriate environment the importance of base rates will diminish.

Difficulty: Although the concept of base rates is relatively simple, its application for fund investors is not easy. Aside from having access to the required data, it is not always obvious which element of a decision we wish to apply a base rate to and what the appropriate reference class is. There is no perfect answer here but doing something is a dramatic improvement on doing nothing.

Incentives: At times base rates will tell us information that we don’t want to hear, so we consciously or unconsciously ignore them.  



An attempt to incorporate an outside view and ascertain appropriate base rates should be integral to any fund investment we make.  Establishing a base rate not only improves our judgement, but it brings clarity as to why we have made a particular decision.  We need to allocate time away from the specific to better understand the general.


[i] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/daniel-kahneman-beware-the-inside-view#

[ii] https://plus.credit-suisse.com/rpc4/ravDocView?docid=gIamqy

[iii] https://www.morningstar.com/articles/1017292/what-to-expect-from-funds-after-they-gain-100-or-more-in-a-year-trouble-mostly

Why Should Equities Be Fairly Valued?

Investors spend a great deal of time thinking, writing and talking about the fair or intrinsic value of equities, whether it be an entire market or individual company. This is a critical issue. There is probably no greater determinant of the long-run returns we make than the price that we pay. The obvious challenge is ascertaining what fair value is – how do we estimate the current worth of cash flows we expect to receive in the future?  If this task is not difficult enough, there is another problem. Even if we knew the fair value, what would we do about it?  There is no reason to expect that equities should be fairly valued today or tomorrow.

When we discuss equities being cheap or expensive the underlying view often seems to be that at some point ‘the market’ will identify this anomaly, creating the opportunity to profit from a revaluation. The glaring assumption here is that the majority of participants are interested in the same thing. It presumes that most investors are engaged in an effort to calculate the fair value of an asset, they are just coming up with different answers. This is some distance from reality. Investors have a multitude of motives, approaches, and philosophies, many of them with a time horizon far shorter than one which would make defining fair value relevant.   

Wisdom of Crowds

It is easy to think about equity market pricing as a wisdom of crowds model, but it is not. In the classic example, individuals guess the weight of an ox, and the average of these are superior to most individual estimates. This idea can be used to claim that equity markets have a similar form of efficiency. Yet this wisdom only emerges if everyone is trying to guess the same thing. If, instead, some participants guess the weight of a pig, some a sheep and others a cow, the average would not be that useful in gauging the weight of an ox.  

This is the situation for equities. It is not that investors are using identical information but coming up with different answers; it is that they are using information for entirely different purposes. If investors are making decisions based on price momentum, multiple expansion, monetary policy, fiscal stimulus or simply adopting a passive approach, why should the assets in question be priced at their fair value?

The same applies to time. If we are focused on outcomes over one week, one month or one year, what is the relevance of the long-run valuation? If investors are investing for different reasons and with varied horizons, why should equities be fairly valued?

When Valuation Matters

This is not an argument that valuations do not matter, but rather there is no reason to believe that they will matter on any given day, nor is there a constant search by the market to discover fair value. It is best to think of valuations as having a weak gravitational pull over asset prices. Prices will fluctuate through time as cycles evolve and investors extrapolate. They will happen to pass through fair value at various unpredictable points.  

Considering valuations in this fashion leads to two critical observations. First, is the trite but true point that valuations are not useful in timing investment decisions. Second, is that extremes matter. A weak gravitational pull means that prices can diverge materially from fair value, but not become entirely disconnected.

If most investors are not investing because of fair value considerations, why would valuation exert any influence at all?  Because at extreme prices behaviour will change – for example, at dramatic levels of cheapness in an asset class or security the near-term cash flows will be high enough to attract an increasing number of investors.  Similarly, investors will eventually move away from a staggeringly expensive asset, in favour of competing assets with a more attractive cash flow profile.  

To take an absurd example, if an equity market is trading on 100x earnings and paying a 0.1% dividend yield whereas high quality bonds in the same market yield 4%; this will impact the decision making of investors and companies. This is a gross simplification to make the point that there is an unidentifiable juncture where some form of valuation consideration will start to matter more to more people.

The problem with this idea is that we know neither what fair value is nor what extreme means. We can make an estimate of fair value for any asset, but the range would have to be broad, and we might still be wrong. We can even build a framework for defining an extreme divergence, but this will not help us with timing. If we believe that asset prices are extreme then we are paid to wait for when the price again moves through fair value, but we will have no idea when this might occur. 

Extreme dislocations are meaningful because they account for the noise and uncertainty inherent in estimating a fair value for an asset class. If prices are a great distance even from a fair value assumption with a wide range, we can be more confident of the anomaly. Furthermore, extremes matter because they change the probability of suffering from disappointment and disaster. Very expensive assets are likely to carry a greater risk of the long-run disappointment of low returns, and the short-term disaster of a dramatic, permanent reset in price. 

The Valuation Dilemma

Valuations are vital for long-run investment returns, but there is no reason for an asset class to be fairly valued on or by any specific point. We should be aware of extreme dislocations between price and valuation, but these are not easy to define or time. This presents something of a quandary, so how should investors think about these issues?

– Any notion that the pricing of equity markets is efficient because it represents our best collective guess at its fair value based on the information available is unlikely to be true. Investors are using the information in a multitude of ways often unrelated to any approximation of fair value. That the market is not efficient in this form, does not mean it can be easily exploited however.

– Even if we knew the fair value of equities, there is no reason to believe that they will be priced at that level at any given time.  The market is not ‘attempting’ to find fair value.  We should not wait for other investors to ‘realise’ what fair value is.

– Because we operate with such short time horizons, perceived over or under valuations of an asset class or security are often viewed as an opportunity to participate from mean reversion, but we cannot hope to predict this. The more important element of valuation discrepancies is the ability to secure higher cash flows and reinvest at a higher rate of return and avoid the opposite – low cash flows with lower rates of return. This requires time.

– Buying assets that appear extremely cheap based on some view of fair value should be beneficial (on average) because the rates of return should be high, and we should be confident that prices will not become entirely detached from valuation (but can get pretty close to it).  Taking aggressive and concentrated views, however, based on this belief is always a bad idea.

– The longer our real time horizon the more likely it is that we might benefit from extreme scenarios. If our time horizons are short, notions of fair value are close to meaningless. Not only can we not predict when an asset class might become fairly valued (as there is no reason for it to be), but the higher cash flows that we might benefit from over the long-term, are likely to be overwhelmed by short-term factors such as price performance, momentum, and stories.  The premium for long-term investing exists because it is so difficult to do.



There is no reason for equities to be fairly valued at any specific moment. Over time they will pass through some fair value range for unpredictable reasons, at unpredictable instances.  Despite this, for long-term investors, valuations are likely to define our outcomes and periods of extremes will create the greatest opportunities and threats.  

Does Sustainable Investing Change What Shareholders Want?

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.

The Inflation Story

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.

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.

It is Difficult Being a Skilful Investor

If I am a skilful tennis player, it is obvious. I win more points, games, sets and matches. There will be the occasional dose of bad fortune and the waxing and waning of form, but it is easy to tell if I have skill. In many activities results alone are sufficient to gauge ability. Investment is not one such activity. Skilful investors will often appear incompetent, amateurs can outstrip professionals and idleness can better action.  This is what we would expect in any environment where randomness has a prominent influence on outcomes. It is not, however, just bad luck that talented investors must contend with; in a dynamic system, they must always question whether their perceived skill remains effective.

We can think of skill as there being a consistent link between process and (desired) outcome. Hitting a forehand in tennis 70mph onto the baseline 95 times out of 100 is a skill. It is specific, deliberate and repeated. The ease in identifying skill depends, however, on the task in question. If luck has a meaningful involvement, then skill becomes incredibly challenging to locate with any level of confidence. 

The effect of randomness is the most obvious problem faced by skilful investors. It means that they can attempt to apply a skill in a consistent fashion but achieve disappointing outcomes. They will also lose to others who have less skill and may come to be perceived as having no skill. The notion that skilful investors are often thwarted by misfortune, however, is based upon a significant and precarious assumption – that investing skill is stable.

An oft-used analogy for the luck and skill dichotomy in investing is that of poker. A game that clearly mixes elements of both. The problem with this comparison is that financial markets and poker are different types of system. Poker is a system with a fixed set of rules attached; although player behaviour may alter, we can understand and model potential outcomes. Financial markets are a complex adaptive system; akin to a game where we don’t know all of the rules and some are likely to change through time.

Defining skill in an activity with amorphous rules is not an easy task. Even if an investor possessed evident skill that delivered strong results in the past, we cannot be certain that it will work in future. It is not sufficient to know whether skill exists, we need to judge whether it can persist. Such doubts are exacerbated by the randomness of markets, which mean the skilful often appear as if they are not. Even skilful investors do not receive continually positive rewards and feedback. When struggling, they must constantly wrestle with the quandary of whether to persevere because poor results are just noise or adapt because the requirements of the game are no longer the same. 

To better understand investment skill, it is critical to disabuse the notion that there is such a thing as a ‘skilful investor’.  Skilful at what exactly? Using skill in such a broad sense renders it entirely devoid of meaning. It is one of the reasons that people often appear so willing to follow a previously successful fund manager when they stray outside of their narrow circle of competence, with inevitably grim consequences. 

The more that chance influences the outcomes of an activity the more important it is to separate skill into its component parts because headline results alone can be incredibly misleading.  It is far better to think of investing as a vast array of specific and distinct activities – varying by instrument, market, time horizon and discipline. If there is any hope of identifying and monitoring skill, then it is critical to be precise about what it is and how it may change.

Defining a specific investment skill is just the beginning.  We also need to understand why the skill is likely to deliver some benefit or advantage and whether the skill is still relevant – how sure are we about the rules of the game?  It is difficult becoming a skilful investor and difficult remaining one.


How Do You Identify Skill?

The Three Elements of an Investment Time Horizon

The most influential aspect of investment decision making is our time horizon. By understanding the period over which we hope to invest we can better frame what we are trying to accomplish and how we might achieve it.  If we are not certain about what the potential duration of our investment is, then we cannot hope to have a clear rationale for making it. Owning equities for three months bears little relationship with doing so over thirty years. Time is the defining feature.

Understanding our time horizon is far more difficult than it seems. It is not simply about a discrete start and end point.  What comes in-between can be far more important.  To recognise our true time horizon, we need to consider three elements: Our objective, our interactions, and our activity.

Our Objective: This seems like the easy part. I can gauge my time horizon by simply understanding the main goal of my investment. If it is for my pension it might be my retirement in 30 years. If I am a portfolio manager, it might be the five years stated in my fund’s prospectus. If I am taking a punt on a stock it might be a month.  

Unfortunately, it is not quite so simple. There can be a sharp disconnect between our explicit and implicit investment objectives. Let’s take the fund manager. Their formal fund objective states a time horizon of five years, but their remuneration is based on returns over one year.  They have also been going through a difficult period of performance and both their manager and clients are focused on the next quarter’s results.  Over what time horizon are they now making decisions? 

Even in the case of the personal pension, the 30-year goal creates a theoretical time horizon, but not necessarily a practical one. If I fill my pension with the latest flavour of the month thematic funds; I am not thinking about three decades hence, I am trying to turn a healthy profit over the next year. Our ability to assume more investment risk when we have a long-term investment objective can easily be used as a licence to make a succession of ill-judged, shorter-term decisions.  Assuming exactly the wrong sort of risks.

The time horizon that stems from our investment objectives is about the specific incentives and pressures driving our decision.  Can we identify the major motivating factors? 

Our Interactions:  Another critical aspect of our time horizon is the way in which we interact with our investments.  How frequently do we check performance?  How regularly do we review our decision? We can think of our time horizon as a start and end punctuated with a mini horizon whenever we interact.  At each moment we do it we are generating a decision point. A situation where we will consciously or sub-consciously be making a judgement about whether to persist. Every interaction we have with our investments is creating the potential for us to obstruct the power of compounding. 

Whenever we make changes to our investments it is because we think we are wrong about something.  There is a better stock, a better fund, a better opportunity, a better time.  Irrespective of how good our decisions are, the market will persistently lure us away from charting a sensible course.  The more we engage, the more likely we are to succumb to its siren song.

Minimizing interactions is probably the sternest challenge faced by investors. Rather than being viewed as behaviourally prudent, restricting the amount we check our investments and markets is more likely to be seen as negligent.  This is the curse of professional investors who are required to persistently evaluate and take action irrespective of whether it is likely to beneficial.  Fixing short-term problems by incurring long-term costs. 

Restricting interactions with our investments is not about making one decision and then closing our eyes and ears; nor does it mean failing to review and reassess the choices we have made.  It is simply about understanding the behavioural reality that the more we interact, the shorter our time horizons are likely to become. We need to engage in a measured and deliberate fashion over time horizons that matter to us.       

Our Activity: Frequent interaction with our investments raises the probability of increased trading and turnover, but it is not a certainty. The final element to consider is our activity. We can only act if we are able to. Worrying about quarterly performance and checking our investments everyday is irrelevant if it is impossible or difficult for us to trade. Our time horizon is also shaped by our ability to act.  If we are locked into an investment for ten years, then that is our time horizon (the real illiquidity premium)!

Most of our investments are not fixed term; they are second-by-second, day-by day-liquid. We can, however, extend our horizons by adding friction. Slowing the decision-making process to extend our horizons or dulling the temptations fostered by our frequent interactions with markets. Professional investors might do this by using (dreaded) committees or creating specific hurdles to clear before a decision can be implemented. For private investors, the challenge is to marry the accessibility provided by technology with realism about our behaviour. Nudges that encourage long-term investing by making it more difficult to trade should be considered. It is an unfortunate truth that the best chance of long-term compounding in our investments might come with that forgotten pension that we had with a company we worked for ten years ago, rather than the current one which we are poring over each day.

If our horizons are short then having a constant option to quit or change course is invaluable, if we are long-term investors then it is an impediment. Our ability to act can frame and influence our time horizon.

Our investment time horizon is not a choice but an aspiration. If we don’t understand and align our objectives, interactions and activity then our behaviour is likely to be wildly inconsistent with what we are hoping to achieve.

When and How Should Investors Make Forecasts?

It is easy to criticise investment forecasting. I do it myself on a regular basis. As enjoyable a pastime as this is, there is a problem. All investors are consistently making forecasts. Consciously and unconsciously. Even the biggest sceptic of the folly of market and economic predictions is inevitably expressing views about the future when they make an investment decision. If we are all forecasters, then we need to be careful about denouncing it in a broad and unequivocal fashion. Some nuance is required. If we must make forecasts, when and how should we make them?

If a twenty-year-old has forty years until retirement, most people would agree that investing all or nearly all of their pension across global equity markets is likely to be a sensible decision. Although it doesn’t automatically feel like one, this is a forecast. We are predicting that equity returns are likely to outstrip other major asset classes over the long-run horizon. I don’t like making forecasts about financial markets, but I feel comfortable with this one.

To understand why this is, we need to distinguish between the characteristics of different types of forecasts. Below are four forecasts and next to them is my level of confidence in each:

– Global equity returns positive over next forty years: 99%

– Lower returns from 60/40 portfolio over next decade than the previous decade: 90%

– Non-US equity returns higher than US equity returns over next decade: 65%

– Non-US equity returns higher than US equity returns over next 12 months: 50%

These are all forecasts but my conviction in them varies wildly, from being as close to certain as I would be comfortable, to the toss of a coin. What are the features that differentiate them?

Time horizon:  Although it instinctively feels easier to make a forecast about tomorrow than the distant future (much more will have changed in the case of the latter) this is not true for certain types of investment forecasts. Would you rather take a bet about whether equities were higher or lower tomorrow, or over the next twenty years? In many cases extending the time horizon means that the outcomes are less driven by noise and randomness, and more by the fundamentally important variables.  For equity markets over the long run this is real earnings growth, inflation, and dividends (to varying degrees) rather than sentiment or flow. Extending the time horizon is only helpful if we are confident what the critical variables are, however.

Critical variables:  When we are making an investment forecast; we are usually predicting the behaviour of a host of other variables. We need to correctly gauge what these are and what will happen to them over the forecast period. This is why most investment forecasts are so difficult and pointless. Even if we identify what the meaningful variables are (a huge feat in itself) we might not accurately judge how they will change or influence other variables. The reason I have no idea about whether non-US equity returns will be higher than US equity returns over the next 12 months is because over such a short period I don’t know what the determining factors will be and, even if I did, I still would not be able to anticipate how they might behave. What matters to equity markets over short time periods can vary wildly from year to year; it might be elections, central bank activity or an event I don’t expect to occur, such as a pandemic. Yet even if I knew what mattered in advance in most cases I would still need to foresee the outcome and (if I am predicting price movements) how other investors would react to it. In most cases, it is just too difficult.

Prior knowledge:
The investment forecasts that we should be most comfortable making are those where we understand the variables that will drive the outcomes (often by extending the time horizon), and where we don’t also have to predict the level of those variables, because we already know them.  Why do I have a high level of confidence that a 60/40 portfolio will produce lower returns in the next decade than the last? Because over a ten-year period, the critical driver of the performance of a 60/40 portfolio is likely to be the starting valuations. I know that yields are far lower and equites more expensive (I can observe this, I don’t need to foretell it) so my conviction in this can be strong. That doesn’t mean I am certain, there are scenarios where this forecast doesn’t come to pass but the chances of these seem remote.  

Conviction:  In most cases our investment forecasts will reside somewhere between the near certainty of equities producing a positive return over the very long-run and the near-randomness of what they will do over the next quarter. Our views therefore need to reflect this. My 65% confidence that non-US equities will outperform US equites over the next decade is because over such a time horizon there is a strong relationship between starting valuations and subsequent returns. The conviction I hold in this view, however, is tempered by three factors: 1) Although the relationship between valuations and ten-year returns has tended to work historically it has not always – it is not an unimpeachable association. 2) Other factors may also matter over this time horizon (earnings growth / return on equity / sector composition); therefore, I cannot be confident that other variables won’t be more influential. 3) The relationship between starting valuations and subsequent ten-year returns may be an artefact of history, perhaps it no longer holds.  



When we are making a forecast it pays to have a checklist to ensure we know exactly what we are forecasting and whether we should be:

– Do I know what I am forecasting?

Although the headline forecast is obvious, the result will be driven by other factors. We must be clear about what these variables are and what we are really predicting.  When we are forecasting the performance of asset classes or securities over the short-term, we are attempting to anticipate investor behaviour.

– Am I also predicting the level of the influential variables, or do I know them already?

If I am making a prediction about where ten-year government bond yields will be in a year’s time, I might be making assumptions about inflation expectations and the elements that influence this.  It is rarely just a single forecast. Forecasts are more robust if the variables are known (valuations) or easier to foresee (economies will grow).

– How much will randomness and noise impact the outcome?

The more randomness and noise there is in an outcome the less sensible it is to make forecasts. Have forecasts in this area worked in this past for us or others?

– How does the time horizon impact the forecast?

Time horizon is critical and materially impacts the amount of luck involved and what variables might be at play.  For financial markets, short-term forecasts are usually incredibly problematic.

– Is there a historically strong relationship between those variables and the outcomes I am predicting?

Although not a failsafe, having some evidence of a robust relationship between the thing we are forecasting and the variables that impact it is critical.

– Have we considered what breaks the relationship?

If we are basing a forecast on historical relationships between different variables, we must assess what might break them.   

– Have I expressed a level of conviction?

We should always express a level of confidence about any forecast or prediction we make.  Not only does it force us to be explicit about the uncertainty in the opinion we hold, but it makes it far easier to change our mind or adjust our view.

– Have I stated what will make me change my mind?

To make changing our mind less painful in the future it pays to state at the outset what developments might cause us to alter our perspective.

– How much specific risk am I taking?

The more idiosyncratic risk in a forecast, the more dangerous it is because the number of potentially impactful variables expands dramatically.  I am extremely confident that equity markets will make positive returns over forty years, I would not be confident about making such a claim for any single company over this period.



Investors should make as few forecasts as possible and avoid at all costs making narrow, specific or short-term forecasts, where our success rate will be miserably low. As much as we might like to, however, we cannot avoid making a certain number of forecasts. When we do, we must understand exactly what it is we are predicting and ensure that the evidence is firmly on our side.

Behavioural Lessons from 2020

2020 has been a year to forget, but for investors there have been some lessons to remember:

Most predictions are pointless

As we finalise our predictions for 2021, it would be prudent to consider what our expectations were for 2020 and how those played out. Markets, economies and people are far too complex to foresee with any level of confidence or accuracy.  Making predictions about financial markets is one of those activities that we perform in an indefatigable fashion in the face of overwhelming evidence that it is a hopeless endeavour; perhaps because it is in none of our interests to state that we just don’t know. We should never make our investment outcomes reliant on heroic forecasts.

Making predictions is more difficult than we think

It is not simply that we did not predict a global pandemic that evidences our limited abilities in the art of divination; it is that even if we had known about coronavirus in advance, there is a very good chance we would have made some very poor and costly investment decisions.

Imagine if – at the close of 2019 – we were told that there would be a global pandemic in 2020 with an impact so severe most of the charts we use to track economic data would fall so precipitously that we wouldn’t be able to use them meaningfully in the future.  Would we have gone long global equities? Financial markets are complex, adaptive systems; even knowing certain pieces of information does not mean we can predict related outcomes. 

Recession and bear markets will happen

Although we cannot anticipate their shape or form, we should treat recessions and bear markets as an inevitable feature of investing.  Rather than worrying about when they will happen; we need to make sure we are appropriately prepared for when they do.   

Our tolerance for losses is behavioural as well as financial

Our capacity to withstand drawdowns and financial loss is often framed in purely financial terms – what is our ability to bear such risks?  Although this is crucial, equally important is our behavioural tolerance; are we able to withstand difficult periods without making poor decisions?  We need to understand how we will feel and how we might react. 

Bear markets are as much about how we feel, as how we think

Bear markets are a test of temperament, not intelligence.  Success through torrid periods is about having the disposition or processes that enable us to make clear-headed and rational decisions in the face of huge emotional stimulus.  If we don’t prepare then the chances are that we will be overwhelmed.

Investment intentions are not always easy to follow

The problem with investment intentions is that it is impossible to appreciate in the present how we will feel in the future when we actually have to implement the decision.  Saying that we will buy equities when they are 30% lower is easy to say and hard to do.   When they are 30% lower it will be for a reason, and there will inevitably be a host of negative narratives as to why they have fallen.  In the midst of that that noise, sticking to a plan is anything but straightforward. We should not make a decision about the future in a cold state and then try to carry it out in a hot one.

The best option is to make such choices systematic. This is why rebalancing is so effective – it systematises sensible decisions that we probably would not make consistently if left to our own capricious devices.

The next crisis will be different to the last

A host of behavioural factors – such as recency and availability – make us worry about yesterday’s crisis.  There will be misfortunes and turmoil in the future, but the causes will probably be different to the ones we are currently experiencing.  We should not let 2020 entirely define how we think about markets and future risks for the next decade. 

Market timing can be painful

The severity and speed of market movements in the first half of 2020 was a perfect example of the challenges and dangers of attempting to time short-term volatility. One wrong call during this period could have resulted in an arduous road back.

 In times of crisis, our time horizons contract

The most crucial discipline for the majority of investors is the adoption of a long-term approach when making decisions. The central problem of periods of crisis is that our time horizons contract dramatically. Our attention and concern is inexorably drawn to what is happening in the current moment. This risk of making reactive, emotion-laden judgements that make us feel better (and safer) in the present is never greater.

Events that feel seismic at the time will probably be a blip in the long-run

Events such as the pandemic feel profound for investors and it is hard to accept that they will probably appear to be an insignificance over the long-term (from a returns perspective).  Most things matter far less than investors think they will when we are living through them. 

The urge to action can be overwhelming.

The case for investors doing less has again been bolstered through a tumultuous 2020.  The impulse and encouragement to act during a period of such high volatility and extreme change was incredibly powerful. The hardest thing to do is the thing that nobody wants us to do. Sit on our hands, follow our processes.

We deal with risks which are current and salient

The political will to take such dramatic action to stem the spread of the virus provided a wonderful contrast with the trudging (in)action and apathy around the climate crisis.  The consequences of climate change for humanity are likely to be far more devastating, so why the indifference?  Coronavirus is present and salient; climate change is a future risk that feels removed and abstract.  The risk is stark that we don’t take enough action on the climate until its most severe implications are as close as the pandemics. Too late.

The outside view is easily ignored in periods of stress

In all our investment decisions we tend to focus on the issues specific to the particular case (the inside view) rather than general lessons or similar incidents (outside view).  When high yield spreads went to 1000 over in 2020, it was far easier to think about the disastrous consequences of the pandemic on default rates; than to focus on the historic attractions of investing at such widespread levels.  The outside view is even more important during tempestuous spells in financial markets. 

It is not the bear market that matters, but what we do during it

As investors we worry a great deal about drawdowns and losses. The potential damage wrought by bear markets and severe market losses always looms on the horizon, but we think about this risk in the wrong way. If we are appropriately diversified and have a long-term approach; it is not the short-term declines in markets that matter, but what we do in those periods. The consequences of rash behaviour and injudicious decisions made in difficult periods will likely have far greater long-run consequences than the near-term losses themselves.

It is difficult to think of a more challenging year to navigate for investors. The list of unprecedented events is long and distinguished. The potential to make classic behavioural mistakes driven by emotion, short-termism, and skewed risk perceptions never greater.  Yet the year is also testament to the benefits of being aware of our most damaging behavioural tendencies. 2020 was a behavioural stress test for investors. It is important to check how we fared.

10 (More) Questions ESG Investors Must Consider

The sheer pace of the move toward ESG and sustainable investment approaches means that it is often difficult to take time to reflect on some of the most pressing questions. I previously discussed 10 critical issues ESG investors must consider and, such is the scale and importance of the shift taking place, I now have ten more:

1) Does short-term performance validate the long-term prospects of investing in companies with strong ESG characteristics?

The answer is no. The relative performance of stocks with positive ESG credentials or those playing into the sustainability thematic through 2020 tells us nothing about the long-term return potential of such companies. Particularly dangerous are claims around their ability to prove resilient through a market downturn, which are often based on a sample of one.

Even longer-term suggestions about there being a return premium attached to ESG as a ‘factor’ cannot be disentangled from a decade of underperformance of value stocks, declining yields, and the corresponding outperformance of quality and growth.

Small samples, inconsistent definitions and post-hoc rationalisations are not a strong foundation to make claims about future returns.

2) Should high scoring ESG companies produce lower returns?

Amidst the strong performance and momentum of ESG investing, it is sometimes difficult to assess the landscape in a measured fashion. One important, but rarely posed, question is whether the best quality companies from an ESG perspective should produce lower returns for investors.  Although this sounds heretical in the current climate, the logic is simple.  From a financial perspective ESG investing is about how companies manage the environmental, social and governance risks that may impact their profitability and long-term viability. The companies that manage these risks well should enjoy a lower cost of capital, because the risk to their business is reduced (other things being equal).  Can we really have lower risks and higher returns?

This is admittedly an over-simplification. One could argue that high quality businesses have proven their ability to deliver strong returns for a prolonged period and mitigate a host of potentially material risks. Perhaps investors are still underpricing the ‘value’ inherent in such attributes. In a related fashion, it could be contended that the main mispricing investors are making is not applying a high enough cost of capital to poor actors from an ESG perspective.

Whatever your perspective, it is too simple to draw a straight line between ESG scores and future returns.

3) How do high scoring ESG companies or sustainable / thematic stocks generate excess returns?

Whilst we are not short of claims being made about the return potential of ESG, sustainable or impact investing; there is a lack of consideration about how such companies can deliver superior returns. There are several potential paths:

  • Momentum: Stocks in this sweet spot may continue to outperform simply because of the weight of money and price momentum in this area. Such trends can persist for far longer than fundamentals might suggest. 

  • Starting valuations: The price paid now may be sufficiently attractive to deliver outperformance through the cash flow yield provided by current valuation levels. 

  • Cost of capital reduction: A company might be re-priced based on a change in the return required by investors. This seems more likely to be the case when investing in companies that have poor / average ESG credentials now but are improving, rather than investing in those currently regarded as leaders.

  • Growth: The market might be underappreciating the long-term growth prospects of a business. This is probably the most common investment rationale in this area, particularly in the impact space.

If claims are being made about excess returns from an industry or specific company, it is important to be clear about how this is going to happen.

4) Are carbon intensity measurements a solution or a limitation?

There is no more important element in the movement towards ESG focused investing than the transition away from carbon and the need to slow the rise in global temperatures. A feature of this shift is the measurement of portfolio carbon intensity and often targeted reductions versus benchmark. Whilst this move should be generally applauded, this is an incredibly complex issue and one that is not fully captured by simple metrics alone. There is a danger that the desire of asset managers to ‘prove’ their ESG / carbon credentials means they focus simply on the numbers and measures that can be most easily produced, even if they may be of detriment to the overall goals.  What is measured is what matters.

Because of availability and clarity most carbon metrics encompass Scope 1 and Scope 2 data, this is limited because it misses the carbon emissions in the value chain. It is also important to acknowledge that reducing your portfolio’s carbon intensity on Scope 1 and 2 basis, does not alter the situation in and of itself – someone is still owning those emissions, just not you. This does not mean such behaviour is ineffective – the increasing attention on this aspect should encourage and incentivize all businesses to reduce their carbon intensity – but it is not the complete answer. We should not focus just on this element because Scope 3 data is messy and difficult.

There is nothing wrong with using Scope 1 and 2 data alone provided you are clear about what it is and is not telling you.  But the limitations of measurement here mean that it is dangerous to restrict and define yourself solely by a narrow and incomplete set of metrics. For example, if you set a restriction on the carbon intensity of your portfolio using Scope 1 and 2 data, you might prevent yourself from investing in transformational companies that are transitioning away from intensive carbon use because owning them is penal when making Scope 1 and 2 comparisons.

When an area is evolving rapidly the desire to measure and prove can be an impediment to progress rather than evidence that progress is occurring. It is important to be aware of what the numbers are telling us and how aligned they are with what we are trying to achieve.

5) What would be the impact of a prolonged period of value outperformance?

This is the great unknown. Although – despite recent events – it is difficult to envisage years of outperformance from value stocks*, it is important to consider whether such a scenario would dampen the enthusiasm for ESG investing. It seems almost certain that the movement has been accelerated by strong performance, but this is about more than return chasing. It is intertwined with a much needed realisation of the misalignment between the focus on short-term shareholder returns and the long-term needs of people and the planet. The shift would likely have happened anyway, but perhaps at a slower pace. 

The real challenge will arise when in favour ESG leaders begin to underperform – how will our behaviour alter?  It is crucial to acknowledge that our investment decisions around ESG and sustainability must encompass broader considerations than a purely financial return. There is a not inconceivable scenario where the transition towards ESG investing has dramatic benefits for the environment and society but produces underwhelming long-term returns in terms of narrow, relative investment performance of the funds focused on this area.

Aside from the potential non-financial benefits, the move towards ESG investing might also increase the long-run returns of most financial assets because of some of the major environmental and social risks it helps to obviate. This, however, is not an outcome we will notice when comparing the relative performance of our ESG-focused strategy to a benchmark.  This type of investing requires a broader lens when thinking of returns.  

6) How should investors be voting and engaging?

Another area where a desire to measure and provide evidence is running ahead of a clear set of principles is in voting and engagement. Being active rather than sedentary shareholders or lenders seems an unequivocal positive but when pro-active voting and engagement is encouraged it is sometimes unclear as to what outcomes should be targeted.

Let’s take a simple scenario. A major oil company is about to embark on a huge CAPEX program to move into renewable energy but given the amount of capital flowing into this area the returns on invested capital are likely to be exceptionally low. Significantly below that being generated in their existing business. Should a shareholder be supportive of this transition despite it likely being of detriment to their financial interests? There is no right answer here, but these are the sort of questions that need to be posed to understand what we mean when we talk about voting and engagement. Where do our priorities reside and what sort of sacrifices might we be willing to make?

7) Who should be defining what good ESG credentials are?

It is somewhat tired and trite to talk about the low correlation between different ESG ratings and scores, but the broader point is important.  Who should decide what ESG criteria are significant? Should it be asset managers, companies, ratings agencies or regulators? At some point judgements are being made about what is important and how important it is. The motives behind assessments will also differ markedly. An asset manager will likely be trained on how ESG issues will impact the success of a business (in particular the risks it might face), whereas a regulator will have a far broader perspective and be focused on the issues that most impact people and planet. These are not necessarily the same things.

8) How do we assess the trade-offs?

One of the most difficult elements of developing an ESG assessment framework is thinking about trade-offs. Judgements are persistently being made about the value (financial or otherwise) of one factor against another. How do we think about the green bond issued by a polluting but transforming utility company? How do we assess a company at the forefront of plastics recycling but with objectively weak governance? How do we compare the profound privacy, competition and societal issues stemming from big technology / media firms with the environmental impact of extractive resource companies? These are all incredibly difficult questions, and to suggest there are any easy answers is naïve or conceited.

9) What if all companies get better?

One consequence of ESG investing becoming ubiquitous is that we are likely to see an increase in overall ESG standards across most or all firms. The incentives for companies to address pertinent ESG issues is strong. If this occurs, then the ability to differentiate between good and bad actors will likely diminish, and distinctions will become increasingly marginal. This would represent a major success for ESG investing but will see it become much more difficult to apply. A positive endgame may even be that it becomes a redundant term because it is the norm. Not a problem for today.

10) Should a fund manager be able to say that they don’t do ESG?

Very few, if any, fund managers will say that they don’t incorporate ESG. Indeed, most will say that they have always been doing it, but just forgot to mention it. But is it a pre-requisite? Is it reasonable to say that they do not consider ESG factors? Yes and no.

All fundamental investors should analyse ESG factors to the extent that they believe that they will or could have a material impact on the operations of a business. To not do so would be remiss. It does not follow, however, that their portfolios should have positive relative ESG scores, or have any concerns wider than how these issues impact the returns made by the businesses in which they invest.

If a fund manager’s clear goal is to produce index outperformance and nothing else, it is perfectly reasonable (and implicitly expected) that they could ignore the best scoring ESG stocks if they believe they are expensive. They could also favour the ESG laggards if they believe that the ESG risks of the business are more than reflected in the valuation.

Incorporating ESG does not necessarily mean being long ESG leaders. If a fund manager is required to take more than pure financial returns into account, this should be made clear.



The dramatic pace of the shift to ESG investing belies many of the complexities and uncertainties that exist.  The tendency to suggest a strong relationship between ESG characteristics and future performance is a particular concern, both because there is not sufficient evidence to make such a claim and the unrealistic expectations it might set.  Furthermore, the desire of asset managers to prove their ESG credentials is leading them to use simple metrics to measure intricate and multi-faceted issues. The perils of Goodhart’s law mean that we need to be vigilant of the unintended consequences of such behaviour.  

The vital and wide-ranging objectives of ESG investing will be much better served by having open conversations about such issues and broadening the way we think about the returns and outcomes of ESG-focused investments.
 


*I am painting with an overly broad and short-term brush here – value stocks and ESG laggard companies are not synonymous; but as currently constituted the underperformance of value has been a tailwind for ESG leaders.

https://behaviouralinvestment.com/2020/04/07/10-questions-esg-investors-must-consider/