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.

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.