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.


Vaccines, Emotions and Investment Decisions

Vaccines have a behavioural problem. If they are effective then they can eradicate a risk from our lives. The successful development of vaccines means that we are no longer exposed to a variety of illnesses that were debilitating and devastating. Yet because we don’t experience these traumas, it is easy to overlook the incredible benefits this scientific progress has brought society.  Forgetting the risks that vaccines have removed means we are prone to understate their worth and give more weight to the other issues and concerns held about them.

But why does a problem concerning vaccines matter for investors? Because it is a vivid example of how the way we perceive and react to risks is about their prominence and how they make us feel.  We worry about and respond to risks that are present and emotive, whilst disregarding those that are remote or removed. 

This has profound implications for how we make investment decisions. The ‘risk as feelings’ hypothesis states that our emotions can dominate our behaviour[i].  Similarly, the affect heuristic is a decision making shortcut where our judgement is led by our emotional response to a situation[ii].

The risks that we are likely to consider as pronounced are those which are salient and we have recent experience of.  When there is a severe market calamity (the Global Financial Crisis, for example) we spend the following years worrying if it will happen again and making sure our risk models now account for it.  We are typically unprepared for the next crisis (a global pandemic, for example).

This is one of the reasons that tail risks are so problematic. They are risks that we have forgotten or never experienced. It is not simply that they are perceived to have a low likelihood of occurrence, but that they have no emotional resonance. The relationship is also circular –  the less emotional significance something has the more we are likely to understate its probability (and vice-versa). That we are more likely to take out flood insurance after our house has been flooded is not because the probability of us being flooded in the future has changed but because we now perceive the risk differently[iii].

That our treatment of risk is driven by our emotions and feelings is likely to lead to odd and contradictory behaviours by investors. Some of us will entirely fail to protect ourselves from certain risks because we have never seen or felt them (inflation might be a good example of this).

By contrast, the capricious nature of financial markets means that some of us might be lurching from quarter to quarter attempting to manage the latest salient market risk we perceive. How many investors have been scrambling to restore at least some value exposure in portfolios as the price moves / stories around vaccines and Biden hint at a recovery? 

Of course, the market is always hinting at certain outcomes prompting us to worry and fret; usually extrapolating randomness into concrete narratives. One of the largest behavioural problems investors face is how emotionally stimulating financial markets and all that comes with them are.  So many of our investment decisions – from performance chasing to cashing out at the bottom of the market – are those which make us feel better right now.  Short-term emotional benefits creating long-term financial costs.

The notion that it is the risks we see and feel that dominate our choices also ties into Bernartzi and Thaler’s behavioural explanation for the existence of an equity risk premium[iv]. It is the painful, short-term losses that provoke an emotional response and drive our behaviour; overwhelming the distant and sober long-term benefits.

The incentive structures for most professional investors also exacerbates the tendency to make short-term, emotional decisions. The more myopic the industry, the more stress, worry and emotion felt by decision makers. The more we judge investment decisions in binary terms as right or wrong, the less investors can protect against risks that never come to fruition.

Understanding how an investor is feeling when they make a decision is absolutely critical to judging the full rationale, but this is rarely even attempted. We want to hear about science and stories, not emotion. Even for the decision maker – unless it is a unmistakable moment of rashness – it is incredibly difficult to recognise the role of emotions in shaping a judgement.

When we consider how emotions influence our investment decisions, we often think only of ‘hot states’ and ‘in the moment’ decisions. These are important to protect against, but the issue is far greater than this.  Changes in emotions and feelings can be the creeping growth of pressure and stress, or a slow shift in how we perceive certain risks.  Even the absence of emotion can be problematic. How we feel matters much more than we like to think. 

[i] Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin127(2), 267.

[ii] Slovic, P., Finucane, M. L., Peters, E., & MacGregor, D. G. (2007). The affect heuristic. European journal of operational research177(3), 1333-1352.

[iii] Kunreuther, H., & Pauly, M. (2015). Insurance decision-making for rare events: the role of emotions (No. w20886). National Bureau of Economic Research.

[iv] Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The quarterly journal of Economics110(1), 73-92.

What is the Attraction of Star Fund Managers?

In sport, when an individual has a spell of sustained success and dominance they tend to enjoy widespread support; think of the likes of Roger Federer, Tiger Woods or Usain Bolt.  Although there are exceptions, people tend to want their runs of glory to continue.  But when it comes to a team, the reverse is often true.  Rarely does anybody but  the fans of the New England Patriots or Manchester United want them to win. This contrast has been highlighted in a recent paper by Jesse Walker and Thomas Gilovich[i], and they call this preference for continued strong performance from individuals over teams ‘the streaking star effect’.  It is a phenomenon we can also observe in the investment industry, where we are often in thrall to the successes of a star fund manager.

Walker and Gilovich carried out a number of tests to observe people’s preference for the continued success of an individual rather than a team.  In a study, participants were told about awards given by the National Association of Police Organizations. In one scenario an individual won ‘Best Homicide Detective’ four years in a row; in another Kansas City or LAPD won ‘Best Homicide Department’ in four consecutive years.  Participants had a significant partiality for the individual detective continuing his success over the departments. They also felt more ‘wonder’ and positivity regarding their achievements.

Even when Walker and Gilovich tested their hypothesis using trivial or arcane events – such as the British Quizzing Championship or the Italian game Calcio Fiorentino – participants continued to prefer individual success to that of a team.

In another study, people also felt that companies were ‘deserving’ of a greater market share if their success was framed as being as a result of individual brilliance of a CEO as opposed to a group effort.  This feels intuitive, and it is easy to think of a number of contemporary examples of this.  

What is driving this phenomenon? Walker and Gilovich acknowledge that is could be a variant of the ‘Identifiable Victim Effect’, where we are more likely to identify with and offer assistance to a specific individual, rather than a generic group. They label this ‘Identifiable Victor Effect’.  Yet they suggest another driver – that we experience a greater sense of awe when witnessing individual achievements.

When we see persistent, individual success the responsibility and credit is clear – it belongs to them – and we enjoy seeing exceptional people pushing the boundaries of possibility.  Furthermore, individual brilliance is fleeting and rare.  When we attribute glory to the talent and ability of an individual by definition it cannot persist indefinitely.  When it is a team or a group the success could be perpetual, and it is far more opaque and difficult to define.  The story is harder to write.

Individual success is clear, comes with just rewards and is deserving of wonder. Group success can be overbearing, unfair and with no natural end.

Our fascination with star fund managers is inevitably linked to some of the issues raised by Walker and Gilovich.  We laud and participate in the success of such managers (while it lasts), but seem far more likely to view the achievements of teams or firms with some level of scepticism and mistrust.

This creates something of a quandary for asset management firms.  Star fund managers can do an incredible job of raising assets and are perhaps the most effective single marketing tool used to draw in investors. Team or firm-based approaches don’t have the same appeal, but do insulate a business against the loss or failure of any particular individual. 

Being attracted to individual success stories also leaves investors vulnerable. Whilst we know that Rafael Nadal’s success  is largely a result of application and skill; there is too much randomness in financial markets for us to unequivocally know that a streak is not just a run of good fortune. Even if a fund manager is skilful, the power of the narrative around them often leads us to make imprudent decisions.   It is never a sensible idea to make investment decisions based on our admiration of an individual or our desire to participate in their story.

The lesson for investors is to be aware of the strong lure of streaking star fund managers, who catch the eye but so often burn out.  We need to spend less time thinking about any given ‘exceptional’ individual, and instead concentrate on our own objectives and the overall outcomes we want to achieve.

[i] Walker, J., & Gilovich, T. (2020). The streaking star effect: Why people want superior performance by individuals to continue more than identical performance by groups. Journal of Personality and Social Psychology.

A Fund Manager’s Time Horizon is the Shortest Common Denominator

For most fund managers there is nothing more important than adopting a long-term approach.  This enables them to insulate themselves from the noise and random fluctuations of financial markets, and hopefully exploit them.  Yet for many this is simply not possible. Perverse and misaligned incentives, the desire to measure everything over meaningless time periods and the ascendancy of outcomes over process mean that the long-term is nothing more than a collection of reporting months and quarters.  Even when a fund manager’s express intention is to operate with a long time horizon, often they cannot because it is decided by the behaviour of other people. They don’t get to choose.

Every investment strategy or fund has a chain of involvement.  This will range from the underlying clients, to the fund managers, risk teams, CIOs and even CEOs.  All have differing objectives, incentives and levels of influence.  Unless all parties involved are aligned, the actual investment time horizon may not be what is stated in the investment philosophy, but be set by the shortest common denominator.  That is the shortest time horizon of someone involved who holds influence. 

If investors have the ability to freely withdraw money from a fund and are focused on monthly performance figures, then the fact that the investment approach is designed to take a five year view becomes almost an irrelevance.  Short-term numbers matter. Equally, if the CEO of a listed asset manager is worried about near term outflows then performance over the next quarter is everything.  In both of these cases the power lies away from the fund manager.  The client has the ability to sell their fund; the CEO has the ability to sack them.

When short-termism arises in the chain it becomes highly infectious. It affects the behaviour of everyone involved, most importantly the fund manager.  Their behaviour will either consciously or subconsciously change to stave off career risk.  The typical route to this is by chasing momentum.  Buying what has worked recently is an easy way to please everyone in the chain, for that moment at least.

It is not that investors (whose money it is) and senior managers should not have influence or choice, but it is crucial to acknowledge the impact that this may have on the ability of a fund manager to stick with their investing disciplines. It is not easy making long-term decisions when everyone will be poring over the next set of performance figures.  As soon as all involved in the chain have defaulted to a short-term view the investment outcomes become captured by randomness. Success or failure is no longer about the validity of an investment approach, it is about the toss of a coin.

How much influence other people possess in a chain relative to a fund manager will be heavily dependent on past performance. A fund manager with strong historic results will have more influence – they have pedigree and a track record. They are at little risk of outflows or redundancy so can set the terms. As performance deteriorates this changes.  The manager becomes more vulnerable and the influence shifts. Without a track record to fall back on they are at the mercy of others, often with interests and incentives that are based on a horizon very different to what appears in a due diligence document. 

When we consider a fund manager’s investment time horizon we often focus on how they apply their philosophy and process; with maybe some consideration as to whether their incentive package is aligned with this, But that is not sufficient. The crucial issue is whether a fund manager operates in an environment where they are able to invest with a sufficiently long time horizon.  Who are the other people with potential influence over the strategy and what are their incentives? This is difficult to answer and will evolve, but is vital for understanding on what basis investment decisions are actually being made. 

Investment strategies with fixed capital or fixed terms partially overcome this problem as their illiquidity forces a level of alignment; but the real benefit is for private investors.  Private investors don’t have a chain of involvement; they have one time horizon and one objective – their own. They can make decisions free of competing interests and conflicted incentives. It is easy to underestimate the incredible advantage this offers in reaping the benefits of making genuinely long-term decisions. 

So many professional fund managers extol the virtues of adopting a long-term approach, but how many are in a position or environment  that allows their words to be validated by their actions?  The structure of influence and incentives within the industry make it increasingly difficult to achieve.

Good Investors Make Decisions They Hope Will Cost Money

We tend to judge the outcomes of our investments in binary terms.  We make money or lose money. We outperform or underperform. Our judgement was good or it was bad.  This type of thinking is flawed because of the role of luck in financial markets.  If I make a decision when the odds and evidence are heavily in my favour and it doesn’t work out; that doesn’t make it a poor decision. A small dose of randomness can heavily dilute the information provided by outcomes alone. But there is something else. A prudent investment approach means making certain decisions that you expect and hope to disappoint.

The need for investors to diversify is often framed as a means of smoothing investment performance or tailoring a portfolio to a specific appetite for risk.  Whilst this is true, it is not enough. Diversifying across a range of assets or securities is an acceptance that we cannot predict the future and that we will be wrong about many things. 

The more confident we are, the more concentrated our investments.  With perfect foresight we would only invest in one security.  If we want to understand an investor’s confidence, check their portfolio concentration.

Appropriate diversification means always holding some assets and securities that appear to be laggards. This is the intended result.  We can think of such positions as failures or costs. Alternatively, we can consider them to be holdings that would have fared better in a different scenario to the one which transpired*.

As investors we all have opinions on markets, stocks and funds.  Diversifying our risks appropriately is challenging because it forces us to make decisions not only that we think are likely to be wrong and costly, but that we want to be wrong and costly. This is difficult to justify to ourselves, let alone others.  It is tough to tell a confident story about our view of the world, and then make investments that seem contrary to it. 

So, you have just told us there might be an inflationary problem around the corner, why are you holding nominal government bonds?”

“Well, I might be wrong and there could be a deflationary problem around the corner”.

That’s a hard sell.

Let’s make a bet. There is $100,000 on offer. You have to decide what will produce the highest return over the next decade. Emerging market equities or US equities. You have to allocate the $100k between the two options. You will receive the amount you stake on the strongest market.  If you are supremely confident, you can put it on a single outcome and risk losing the entire amount. If you are ambivalent you can split it equally and guarantee $50k.

Most investors will have a view on this choice. Some more forthright than others.  If you had a strong disposition towards US equities, how aggressive would your stake be?  Given the huge uncertainty surrounding the result it makes little sense to go all in.  You need to diversify and put money on both. This means allocating money to something that you think is wrong and want to be wrong.  It is sensible and prudent, but uncomfortable.

If you wager $70k on US equities and they outstrip emerging market equities, how do you feel? You are likely to curse your conservatism, rather than think about the other possible paths taken. You were right, why didn’t you back yourself more?

After the event, diversification only feels gratifying if we were wrong.  If we were right it feels like a cost. If I bet each-way on a horse that wins a race, I will rue the fact that I didn’t bet solely on a victory.

As always, the most challenging aspects of these types of decisions are when it involves changing our mind.  Let’s expand on the emerging market versus US equities bet. Five years in and the returns from both markets are identical.  You are asked if you want to adjust your stakes.  As you have some new information, you still favour US equities but now have less confidence in your view. So you alter your bet to $60k US equities / $40k emerging markets.

You have made a decision that you explicitly want to be incorrect.  At the end of the ten year period, it is in your interests if you were to look back and regret making this choice.  The level of cognitive dissonance here is pronounced.  I prefer US equities but I am reducing my bet. I am making a decision and I want it to cost me money. 

The central problem here is that when we are making an investment decision there are a huge range of potential, unknowable paths. After the event, only one route has been taken and a binary judgement will be made – were you right, or wrong?  To make matters worse,  everyone now feels that the result was obvious at the time you made your decision. 

Sensible investment is not about predicting a single path and trying to maximise your returns if it comes to pass.  It is about ensuring that you are appropriately positioned for a reasonable range of outcomes.  By all means have a view, but it needs to be heavily tempered with an acknowledgement that the future is inherently unpredictable.  

How often do you hear this phrase?

“Based on the information you had at the time, that seemed a sensible decision – even if it didn’t work out”.

In life? Rarely, In financial markets? Never. 

The best investors are those that are well-calibrated. They understand what they don’t and cannot know. Their decisions reflect this.  In simpler language they are comfortable making choices that they feel are wrong and that they hope come with a cost.

*This doesn’t absolve us from investing mistakes.

A Little Bit of Friction Can Make Us Better Long-Term Investors

One of the most effective methods for changing our behaviour is to alter the level of friction we face when making a decision. If we want to encourage an action, make it simple. If we want to restrict it, put up obstacles. We use this method intuitively in our everyday life – when we are trying to eat healthily we know it’s best not to have chocolate readily accessible in the fridge – but we tend to understate how the introduction of small amounts of friction can have profound consequences for the choices we make.

Take the case of paracetamol.  It is estimated that after the UK introduced limits on the number of tablets contained in a single packet, overdose deaths fell by 43%[i]*.  It seems absurd to believe that the implementation of a seemingly slight change could materially influence a decision of unparalleled consequence, but it can.  When behaviours are driven by emotion and moments, even minor amounts of friction can exhibit incredible leverage. This is a concept that matters a great deal for investors.

Technological developments have profoundly changed the decision-making experience of both professional and private investors in recent decades.  We are awash with information (noise) and stimulus; and have the freedom to transact at any given moment. Technology has made investing seamless.  It has removed the friction.

The greater transparency and control investors enjoy is regularly lauded, and it has brought us a wave of benefits; but it also comes with a major shortcoming.  The absence of friction allows us to easily take decisions based on how we feel at a given point in time.  It makes the most pernicious investing behaviours – performance chasing / market timing / panic selling – easy, and the most important – adopting a long-term approach – more difficult.

Friction in investment has a bad image.  We tend to think of it slowing our decision making.  Rendering us unable to access opportunities as they arise and suppressing our best instincts.  This view is illogical.  For most investors, the ability to exploit near-term opportunities or react rapidly to changing market dynamics is a danger not an advantage.  Whilst a very select group will attempt such activity for most of us it is a damaging distraction or at best an irrelevance.  We tend to perceive friction as a hindrance, but it can quell some of our worst dispositions and promote long-term investing.

It is important to differentiate friction in decision making from outright prohibition.  Friction does not prevent us from taking a particular path entirely, it simply slows the process.  It introduces time and reflection.  Although there may be some investing activities where a complete block might be prudent; in most cases the simple introduction of some level of difficulty or delay is likely to have significant ramifications for our decision making.

For private investors, the notion of friction is often allied to being trapped in poorly performing, expensive funds where extricating yourself from them is seen as too painful, costly or complicated to be worthwhile.  This is an undoubted negative friction. Freedom and ease of movement here is essential.  Yet a consequence of removing such friction is the ability it gives us to lurch between in-vogue investments and make judgements based on ever-dwindling time horizons.   

To counter this, we can introduce our own inhibitors.  Part of our long-term investment plan should be specifying limits on how frequently we check our investments (the most effective way to reduce volatility is to review your portfolio less) or put restrictions on the amounts of trades we place.  Setting the password for your account to something you are unlikely to remember might have an even greater impact.

It would also be helpful if the investment platforms that we use allowed us to apply our own restrictions when setting-up an account – creating frictions in a cold state that will prevent us making poor decisions in a hot one.  For example, there could be a feature where your ability to place trades online is switched off, unless you make a request (which might take 7 days to be approved).  Not removing the choice, but introducing a pause.

Even for professional investors, the use of friction can be beneficial.  It is typical to pour scorn on ‘committee-led’ decision making and any element of an investment process that seems to undermine the unadulterated views of a fund manager.  But they are not immune to short-term thinking or the pressure to react to the prevailing market narrative.  Frictions in the process can allow them to be more faithful to their investment objectives, rather than act as an impediment. 

Long-term investing has never been more difficult. The freedom, transparency and choice now available to investors which has brought many benefits, also increases the opportunity to make poor decisions.  Doing less and enjoying the power of compounding sounds simple but it is far from easy.  The more we engage with markets, the greater the temptation is to make choices that feel good now, that we later come to regret.

Taking a long-term approach takes effort and requires assistance.  A little bit of friction can go a long way.


* Not all of these will be suicides, and there are several confounding variables that mean that there is significant uncertainty around the 43% figure.  There is general agreement, however, that there has been a meaningful impact.

[i] https://www.nhs.uk/news/medication/smaller-paracetamol-packs-may-have-reduced-deaths/

How Much Conviction Do You Hold in Your Investment Views?

I recently read War and Chance by Jeffrey A. Friedman, which considers how foreign policy specialists deal with the uncertainty that surrounds their high stakes decisions.  Friedman focuses on an historic reticence to explicitly discuss either probabilities or confidence levels when making subjective judgements.  Whilst the impact of decisions made around the whereabouts of Osama bin Laden or the presence of WMD in Iraq have consequences that are far more profound, it struck me that the challenges and concerns highlighted by Friedman are also relevant to how we make investment decisions. In particular, the struggle we have in articulating how much conviction we hold in a position or opinion. 

The conviction that we express in any investment view reflects our expectations around the likelihood of certain outcomes.  We are constantly making judgements that are founded on our subjective belief about probabilities and our confidence in the available evidence. Despite this we seem unwilling to talk in these terms.  Instead, there is a tendency to frame investment positions in a definitive fashion – I believe X will happen because of Y.  The absence of nuance entirely belies both our own fallibility and the sheer uncertainty of the environment in which we operate. Ignoring these factors not only impacts the type and size of risks we take, but materially inhibits our ability to change our mind and learn from past decisions.

Why don’t we talk about probabilities?

In a similar fashion to foreign policy, the reluctance to address uncertainty and be specific around our probability judgements is driven by several factors.  Many people recoil at the spurious accuracy that appears to exist when numeric probabilities are expressed – how can you be 67% sure of something?  But this misses the point.  We are making this judgement whether we are transparent about it or not.  It is better to offer some level of clarity rather than not mention it at all or cloak it in vague language that will be interpreted differently by everyone who sees it.

The even greater impediment to being clear about probabilities when expressing an investment view is the value that the investment industry places on confidence. The conclusion we reach will either be right or wrong, and therefore there is a desire for our rationale to be consistent with that. It is all or nothing.  This is a meaningful decision and therefore we want it to appear as if it is an objective one (even though we know that this is an impossibility). 

When we discuss uncertainty and probability, we are admitting how much we do not and cannot know.  This jars with the fact that we are being paid for our investment acumen, and it is rarely a prudent marketing strategy to highlight your limitations. Particularly as everyone else seems more certain than we do.   

The value placed on (illusory) certainty and (over) confidence is vividly apparent in the categorical fashion in which we discuss our investment views. For example,  if I take the position that the dominant, large tech / consumer stocks in the US are overvalued and will underperform over the next five years, most of my time will be spent justifying why this perspective is correct and other theories are false.  If presented with a counter argument – such as certain names in this space becoming virtual monopolies that will not see their excess returns competed away as quickly as in ‘traditional’ industries – my instinct is to debunk this point to validate my own position. Yet if I accept uncertainty and a range of potential outcomes, I should not be discrediting all other scenarios, but rather acknowledging that there are other plausible paths. Albeit ones I ascribe a lower probability to than my central view. 

Disentangling confidence and probability

A crucial distinction that Friedman makes is between probability and confidence, which are often conflated.  Probability is based on the likelihood that something is true, whilst confidence is based on our belief in the robustness of the evidence supporting that view.  I believe that the chances of a single fair coin flip coming up tails is 50%; I also consider the chances of value stocks outperforming growth over the next 12 months to be 50%.  The probability I have ascribed to both outcomes is identical, but my confidence in my coin flip view is far greater than in the value versus growth call.  In the first case my 50% forecast is based on what I do know, the second case is based on what I do not know.  Expressing conviction is about both probabilities and confidence.  

Friedman states that the confidence we hold in our own analysis has three distinct components: i) The reliability of the evidence, ii) the breadth of reasonable views around a judgement, and iii) the extent to which fresh information could alter our perspective. 

Overtly utilising such a framework is crucial for a robust decision-making process and for understanding the level of conviction we should hold.  A cynic might suggest that financial markets are too noisy to distil confidence in this fashion, but if that is the case then it simply means we do not have sufficient confidence to take a view – which is perfectly reasonable. Also, when making an investment decision these three aspects are always implicit in the conviction we possess; it is far better to be open about these assumptions, particularly if we want to encourage consistency in our decision making and have the ability to learn from mistakes.

The benefits of probabilistic thinking 

Being clear about the probabilities we ascribe to potential outcomes and our own confidence in our views can be incredibly important to our investment decision making; especially when informing our level of conviction.  There are at least five clear benefits: 

1) Clarity of view:  Investment views tend to be either absolute or obscured (sometimes deliberately) by vague and ambiguous language. This means that they are either negligent of uncertainty or useless.  Addressing this by being more specific – by using numeric probabilities, for example – provides far more transparency around what we believe.     

2) Realism:  All investment decisions are made amidst uncertainty, although most of us behave as if that is not the case.  As soon as we employ probabilities in a consistent manner, we open ourselves to alternate scenarios.  It is crucial to concede the uncertainty both of an event and our own ability to foresee it. 

3) Ability to change our mind:  Moving away from categorical views makes it far easier to change our mind and update our thinking.  If we predict something will happen, we invariably become committed to that position, and often defined by it. Utilising a more nuanced approach that acknowledges other possible outcomes affords us the freedom to adapt and update as we receive new information. 

4) Ability to learn: All investors will be wrong and wrong frequently.  We cannot hope to improve our decision making unless we are consistent in how we record and convey our views.  If we are clear about probabilities and our level confidence at the point a decision is made; it becomes possible to review this in the future and understand the flaws in our judgements when we err. It allows us to become better calibrated. 

5) Consistency and comparability:  Given that investors will be expressing numerous views at any given point in time (and through time) the ability to treat them consistently and compare them equitably is paramount to effective decision making.  If our conviction differs between views, what is causing that? Why are we happy to take more risk in position A than position B? We can only answer such questions if we have a clear framework to understand probabilities and confidence levels.  

Don’t forget the magnitude 

Whilst our conviction should be driven by probabilities and confidence, that is not all that is required. We must always consider the magnitude of potential outcomes. The most significant example being situations where there is something unpleasant lurking in the tail of the distribution.  A bet with a 99% chance of a favourable outcome, may be unappealing if there is a 1% risk of ruin.  In such a scenario we might have an incredibly high conviction in our view, but still decline the ‘bet’ or at least size it in a manner that seems optically inconsistent with the strength of our beliefs.  Being more open to considering probabilities offers some protection against being ignorant of such tail risks because we are explicitly incorporating other possible scenarios in our thinking. 

Embracing uncertainty

Uncertainty is uncomfortable and unappealing, but it is also the reality of financial markets. The unequivocal investment opinions that we so often hear, and offer, feel bold and informed but are incongruous with the environment in which we make decisions.

Whether we acknowledge it or not, the conviction or strength of belief we hold in our investment views must be based on assumptions around probabilities and confidence.  Yet we rarely discuss our investments in this manner.   This is a problem not simply because it is hard to understand how much weight to give to other peoples’ opinions, but it also impairs our own decision making.  If we are to formulate, compare, scale and adjust our investment views appropriately we need to be clear not only about what we believe and why, but how much we believe it.

Friedman, J. A. (2019). War and chance: Assessing uncertainty in international politics. Oxford University Press.


Active Management has Become a Game of Musical Chairs

An often heard lament in recent years has been how the torrent of flows into passive strategies is distorting financial markets.  Although this is an inevitable angle for much maligned active managers to take, it is also somewhat absurd.  What is a broad, market cap index if not a reflection of the decisions of other ‘active’ investors?  Passive investors will replicate the prevailing weights of the target index; active investors will move those weights*.  The opprobrium directed at the rise of passive investing is mostly misguided.  Indeed, it is a sharp irony that the major impact of increased indexing has been for active investors to become more benchmark aware and myopic.  Their attempts to insulate themselves from the threat actually weakens the case for using them.

In an ideal world a market capitalisation index should be a reflection of the behaviour of other investors – a simple derivative outcome.  Unfortunately,  the market cap index or benchmark is now far more than that .  It has become the lodestar for the majority of active managers.  Not only is it a yardstick to evaluate quality over increasingly short and meaningless time horizons, but it has become the foundation of many investment processes. This is not because there is a widespread, philosophical belief that this is the correct approach to adopt; but because of skewed incentives and the management of business and career risk.

Active managers are under severe competitive pressure.  If they don’t perform they will be removed and the money will go to a passive option, or at least an outperforming peer.  Therefore their desire to take significant risk away from the benchmark is low.  Active management has become like a game of musical chairs where it makes sense to hover close to the chairs at all times, rather than risk being at the other side of the room when one is pulled away. 

Allied to this defensive behaviour is the closely related problem of increased short-term thinking.  The threat that most active managers face of being fired tomorrow has profound implications for decision making, both for individual managers and their employers.  Is there any purpose in making a long-term investment decision if there is little chance you will be around to witness it come to fruition?  Indeed, making such farsighted decisions may well hasten your departure.  Investing is a long-term endeavour,  active management has become a short-term game.

Success in this game is based on the measurement of performance over increasingly contracted time horizons.  Investors in active funds and managers of them consistently talk about results in terms of days, weeks and months.  This is nonsense.  Financial markets are hugely unpredictable and chaotic, and discerning skill is incredibly difficult.  Over short-time horizons it is impossible. 

Although suggesting so is often met with derision, judging investment quality by performance alone is deeply flawed.  In a system where there can be profound randomness in outcomes, it is crucial to focus on decision quality rather than results.  Performance outcomes (particularly over short horizons) are incredibly noisy.  There will inevitably be periods where the skilful (or just sensible) will appear inept and the lucky will appear to be sagacious.

Judging decision quality in financial markets is fraught with difficulty, and it is far easier to use the shorthand of relative performance instead.  Replace a difficult question with an easy one.  More importantly, however, if everyone else cares about short-term performance outcomes, then you have to as well.  There is no point playing in a game where your idea of winning is different to the other players.

Our investment behaviours pose major agency problems for active management.  Listed asset manager share price performance is driven by asset flows, which are led by short-term performance .  Executives at these firms are incentivised to raise assets under management  and therefore become focused on near-term results.  Although underlying investors are unlikely to be well-served by such myopia, the structure of the system means that executives and fund managers have to play a different game where the pay-offs arrive at a different point in time.  What is rational for the manager or business, may not always be rational for the client. 

We therefore exist in an environment where underperforming active fund managers are sacked, lose assets, forced to collapse their unrewarded risks and review their processes.  Even if you are a talented long-term investor you might not make it through your inevitable barren spell in-tact.  The result of all of these aspects is more money flowing into areas that have been ‘working’, exacerbating any perceived market distortions . Passive strategies reflect this, active strategies cause it.

Frustrated active managers will often complain that fundamentals don’t matter any longer.  They do, they are just not important in the game being played.  The desperation of active managers to ward off the threat posed by passive investments is leading to less differentiation and more short-term performance chasing, which only makes the case for passives more compelling.  Time for a rethink.


*In this context we can think about passives as exposure to broad, market capitalisation indices. Of course, securities not captured in these can be more impacted by increasing flows into passive strategies.

Financial Markets Are No More Uncertain Today Than They Were Last Year

One of the most common statements since the outbreak of the coronavirus pandemic is that the economic and market outlook has become more uncertain.  Given that the future is inherently difficult to predict with any level of confidence and we are generally terrible forecasters can it really be true that the world is now more uncertain?

The environment unquestionably feels more unstable.  There are a range of imponderables around the development of the virus itself that none of us can hope to anticipate.  From the potential of a ‘second wave’ to the production of a viable vaccine.  We have also experienced an unprecedented economic ‘stop’, and credible cases can be made for an inflationary or deflationary future. 

Yet before accepting the ‘greater uncertainty’ idea at face value, it is worth deconstructing the meaning of such a claim.  What we are really saying is:

“I was much more confident in predicting the future of the economy and financial markets before that unexpected event occurred”.

Which can be expanded to:

“I was much more confident in predicting the future of the economy and financial markets before that unexpected event occurred, and showed that my level of certainty was exaggerated.”

It seems paradoxical to suggest that things were more certain before something we hadn’t expected happened and upended our prior beliefs. 

When we say things are now more uncertain we are usually implying that something has altered which has meant that the future has become increasingly difficult to predict.  It has not.  It was unpredictable before and it remains unpredictable now.  Rather than making the world more uncertain, unanticipated events serve to show us that we were understating how uncertain things were before. When claiming greater uncertainty in the future, we actually get it backwards.

Although we should not conflate greater uncertainty with changes in the forecastability of the world, this does not mean that the notion is meaningless; it just needs to be considered in a different way.  What we perceive to be an increase in uncertainty is really a change in the frame through which we view the world.  We have taken a particular path and now face a different distribution of possible outcomes. 

Let’s take a simple example.  My range of potential future personal outcomes involves me losing my job tomorrow.  This is (hopefully) a tail risk, yet it is a possibility.  If I am made redundant tomorrow then my life has taken that specific course.  My future is still unknowable, but the routes and their likelihood from this starting point have changed.  Although it feels like my life is more uncertain now I am without a job or salary, it is nonsensical to suggest that my life was more certain before it was struck by a remote risk that I failed to predict. 

If my life following a job loss hasn’t become more uncertain, then what has it become?  More fragile. When we discuss greater uncertainty following a particular event,  we often focus on how the shock has left us more vulnerable to future negative events.  Since losing my job I am now more susceptible to failing to pay my mortgage and losing my house.  There are a range of unpleasant scenarios that are now more likely.  This is the same for many businesses through the current recession.  The probability of ruin has changed.  Our certainty in predicting the future hasn’t.

The perception of greater uncertainty is not just about fragility, but how we make sense of the world.  When we perceive  a sharp rise in uncertainty it is a case of the narratives we use to explain the world becoming untethered.  The cause and effect stories we weave help give us some comfort navigating the randomness and chaotic nature of life.  If there is an occurrence that dramatically alters the environment then the threads that hold together our own explanatory narratives quickly break apart.  

The world has not become any harder to predict, but rather the stories we previously used to explain it are no longer valid.  If we cannot construct a coherent narrative things begin to feel distinctly uncomfortable.  To address this we will create new stories, or simply adjust our previous ones.  Restoring our prior (misplaced) sense of confidence and control

The very occurrence of the coronavirus pandemic means that any certainty we may have held before was unfounded.  We never know what will happen tomorrow.  We should act accordingly.

Do Fund Investors Prefer Lower Fees or Strong Past Performance?

Performance chasing is endemic in mutual fund selection.   Despite the randomness and luck involved,  the decisions that we make and narratives we weave are inextricably influenced by historic returns.  Although we may only spend a fraction of our time considering performance, it has an overwhelming impact on the judgements we make.

Supporting the results of previous studies in this area, a new piece of research by Leonardo Weiss-Cohen, Philip W.S. Newall and Peter Ayton shows individuals using  strong past performance to inform their fund choices rather than lower fees.

The researchers devised a task where investors had to select between one high fee (0.7%) and one low fee fund (0.1%) over 60 periods (months).  Both funds generated returns which were index plus random noise.  The mean of the random noise was set at zero, so the only long-term performance differential was the fee load.  For the first selection participants were shown a 12 month historic return for each fund and asked to make an initial choice.  At the end of each subsequent period they were shown the performance of both funds and again selected between the two options.  The compensation participants received for taking part in the study was in part based on the wealth they managed to accumulate through the game.

There were two separate experiments.  The first featured subjects (400) who had previous investment experience, and two conditions – one where they received a standard disclaimer: “Past performance does not guarantee future results” and one without this disclaimer.  The second experiment recruited subjects (596) without investing experience.  Here there was a third condition – a ‘social disclaimer’ stating:  “Some people invest based on past performance, but funds with low fees have the highest future results.”.  All participants also took a test to grade their level of financial literacy.

The were a number of informative results:

– Performance chasing behaviour was evident across all trials, in both initial and subsequent fund selections. The fund with the highest returns in the last trial was selected with greater regularity.  Recent performance was more influential than fees.

– The standard performance disclaimer had limited impact on reducing performance chasing behaviour and led to worse outcomes for those with low financial literacy and no experience.

– In the second experiment participants chose the low fee option more often when they had been shown the ‘social disclaimer’.

– Participants with lower financial literacy and no investment experience actually chose the expensive fund more frequently when they received the standard disclosure: “Past performance does not guarantee future returns”.

– Participants were more likely to choose the low fee option as the trials progressed, but the overall effect of this was modest.

Of course such ‘lab’ studies are imperfect and never a substitute for natural experiments. Furthermore, the paper does not provide full details on the exact scenarios faced by the participants or a granular breakdown of the results achieved .  These issues notwithstanding there are a range of insights that are worthy of greater research and consideration:

-It is fascinating that participants tended to favour highly uncertain (indeed random) future performance at the expense of the certain performance advantage of a cheaper fund.  Their decisions were made absent any information about the forthcoming returns of the funds meaning choices were guided only by fees or previous results.  This could be an example of our struggle to accept randomness and tendency to see information in noise (the outperforming fund must have some advantage).  Or, as the authors suggests, higher fees can be associated with quality.

– In the real world, performance chasing behaviour is typically intertwined by some form of narrative.  A story that validates why past performance will indeed be a prelude to future excess returns – it could be the exceptional skill of a certain fund manager or the wonderful prospects of a particular economy.  In this experiment there was no story to tell just the numbers, and individuals still tended to be led by them.

– As suggested by the authors, one of the potential issues with recurring fees is that because they can be small relative to the volatility in performance, investors may neglect to attend to them, or fail to understand the huge influence they can have when compounded over the long-term.

– Those with low financial literacy performed worse in the task, which goes to reaffirm that it is individuals in such groups who require the most protection and direction.

– Perhaps the most fascinating aspect of the study is the role of the disclaimers. The “Past performance does not guarantee future results” wording has always seemed a woefully ineffective message because if offers no meaningful guidance.  The social disclaimer provides a clear nudge by directly stating that lower fee funds achieve better outcomes than higher fee funds. Whilst this wording is not without its own problems – fees alone are not sufficient to make an investment decision –  it does suggest that such disclaimers could be re-worded in a manner which genuinely helps investors, particularly those with less experience and knowledge.

Although it is no surprise to observe performance chasing behaviour;  it is particularly interesting to see it play out in a sterile, artificial environment absent the narratives, newsflow and incentives that contribute greatly to performance chasing in the real world.  The structure of the research also allows for a clear distinction to be made between past performance and fee levels as a decision driver, which are otherwise impossible to isolate.  The study provides further support to the idea that past performance and neglect of costs are real problems for investors, and behavioural interventions – such as changing disclaimer wordings – might be part of a solution.