A friend of mine was out on a run. He was on his usual route going down a narrow lane when he came across an ominously large puddle – it had been raining torrentially for the past few days. There was no way around it, he either had to turn back or go through it. Although the puddle was long, he assumed it would be shallow, so forged ahead. It was deeper than he expected, the icy water quickly covered his shoes. Thinking that would be the worst of it he carried on. But it kept getting deeper. The water went past his ankles and he wasn’t quite halfway through. As he was already cold and wet there was no point turning back, so he checked to see if anyone was watching and continued his increasingly slow paddle.  As he persevered and the water splashed up to his knees he wondered how long he would keep going if the puddle got deeper still. He had visions of just his head bobbing above the water. Fortunately, knee-height was as deep as the puddle got and he didn’t get to test quite how far his prior commitment would take him.

This must have been a bizarre sight for any onlooker.  Why would someone try to run through a puddle that deep? No rational human would consider that to be a sensible idea. Yet, of course, my friend would have agreed with this, right up until the point that he decided to put his foot in the puddle. As soon as he made that decision, everything changed.

It is easy to think of the choices we face as discrete, one-off decisions with a set of specific consequences (good and bad), but they are not. Each time we make a decision it impacts the choices we will be able to make in the future – it might commit us to a certain direction or close off other potential routes. There is a huge amount of path dependency in the decisions we make. This means that we should not consider only the immediate implications of any option we pursue but also its consequences for our subsequent behaviour.

Why did my friend continue running through a ridiculously deep puddle? Because he had already committed to the action. Not only had he incurred the cost of being wet, but he also didn’t want to feel or look stupid for choosing to do it in the first place. If he persevered it might look intentional.

He had set a new path.

There are three aspects to a decision that tend to influence how influential it might be over our future choices:

1) Does it impact our identity?

2) Does it change our incentives?

3) What costs will it incur?

Although these are inter-related, we can consider them separately:

Identity:

Whether a decision serves to shape our identity can be critical to our future choices. How we see ourselves or how we wish other people to see us will have profound implications for the choices we make or even the opinions we express. Once we make the implicit or explicit choice to create a particular identity, every subsequent judgement we make is framed by a desire to manage and bolster that it. We strive to make decisions that are consistent with our desired image.  

We see this behaviour clearly in politics – once we make a choice to align with a particular party or doctrine, everything we see is through that lens. Investors are also frequently guilty of allowing views and opinions to morph into an identity, through which all subsequent judgements are filtered. Often irrespective of evidence.

Incentives:

Incentives drive behaviour, so we must be particularly wary of any decision that materially shifts our incentive structure. We are likely to significantly understate how influential varying incentives will be on our future choices. The most painful and damaging scenarios are where there is a dissonance between what we believe and the direction that our incentives are pointed – “I believe that financial markets are highly uncertain over the short-term, but I make money if my clients trade more”. To resolve such friction, we will tell ourselves all sorts of stories to provide psychological comfort. In the end it is likely that our incentives will re-shape our beliefs.

Costs:

Sunk costs wreak havoc with future decisions. Whenever we expended significant time, effort or money on a choice, we find it incredibly difficult to change course. The idea of the sunk cost fallacy is now ubiquitous but it does not make it any easier to overcome.  Admitting we were wrong, moving backwards, or accepting ‘wasted money’ are too often deemed unpalatable. When we think about sunk costs we shouldn’t consider them as historic mistakes, instead they are very much recurring costs that are impairing the choices we are making right now.   

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When my friend was considering whether to run through the puddle, he was judging how likely it was to be deep, whether he minded soaking his feet and if it would ruin his running shoes.  What he should have been assessing is what he would do if he decided to go ahead and the water was too deep – how could he turn back? The consequences for his future decisions were just as important. 

If a choice has implications for our identity, the incentives we face or the costs we incur, we should be especially careful when making it. This is not just about the difficulty of quitting or the problem of commitment escalation, but how decisions made today can change everything about the decisions we will make tomorrow.

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

There are still too many people investing in active funds. Not because they are unnecessary, but because owning them comes with a unique set of behavioural challenges that we are often unprepared for. If we are to have any hope of benefitting from holding them, we must accept and embrace these. The worst – and all too common – scenario is investing in active funds whilst holding entirely unrealistic expectations about the realities of doing so. This dooms us to almost inevitable failure and disappointment. Before investing in active funds there are three questions we need to answer:

– Am I willing to own a fund for the long-term?

– Can I discount short-term performance?

– Can I withstand long periods of underperformance?

Let’s take these in turn:

Am I investing for the long-term?

As the investment industry has become increasingly myopic, I have had to moderate my view on what the long-term is because it seems too outlandish. I have heard people discuss the long-term as three years or more, but this is far too short  – it is much closer to 10 years. The longer our time horizon, the greater the odds of investment success.  Why is an extended time horizon so important? Because the shorter it is, the more our results are beholden to randomness and fickle swings in market sentiment. If we believe there is a strategy with an edge, we must give it time to play out, for fundamentals to exert themselves over noise. This does not mean that we must persist with an active fund whatever happens or that simply increasing our time horizon guarantees better results, but it at least gives us a fighting chance.

Can I discount short-term performance?

It is one thing to say that we are willing to own a fund for the long-term, doing it is another thing entirely. The biggest impediment to long-term investing is obsessing over short-term performance. Not only is it an entirely fruitless activity that sees us attempt to read patterns in the chaotic fluctuations of financial markets, but we persistently make poor decisions based on such fleeting observations. Each time we check performance, write a report or hold a meeting we are creating a decision point; another opportunity to make a near-sighted judgment. We need to be realistic about our situation – if the short-term matters (whether we want it to or not) active funds really should not be for us – it will simply mean constant anxiety and frequently poor choices.

Can I withstand long periods of underperformance?

Although incredibly damaging, the hardest part of active fund investing is not the senseless fascination with short-term performance, but the prolonged and painful periods of underperformance that are an inevitable feature of any active strategy. All skilful (and unskilful) active fund managers will go through years of underperformance – this is inescapable. Living though this on a day-by-day basis is exhausting and exacting. The doubts about the strategy – whether the manager has lost her edge, whether the process is broken or the market environment irrecoverably changed – will often be overwhelming. Yet if we want to successfully invest in active funds then we need to find a way to withstand them.  The alternative is believing that we can time our investment into active funds so that we capture the good times and avoid the bad (we can’t).

The problem with this required fortitude is that it is music to the ears of the unskilled active fund manager who will be delighted if we persist in investing with them despite their lack of ability, but this is the job of the active fund investor – to identify skill without relying on past performance.  If we cannot tolerate lengthy spells of poor relative returns, we should not be investing in active funds.

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If we answer these three questions in the affirmative, it does not mean that we should invest in active funds; these are simply the minimum entry requirements before we even consider attempting it. If we answer any of them negatively, we really should not be doing it at all.

None of these features are easy to deal with or manage, in fact the behavioural aspects of active fund investing are just as tough as finding a manager or strategy with an edge. Far too many investors neglect this and leave themselves in a position where the odds of success become vanishingly small. 

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My first book has just been published! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can order a copy here.

The moment has finally arrived. The Intelligent Fund Investor is published today!

Most of us invest in funds and the choices we make will have a profound impact on our financial futures. The problem is that fund investing is a decision-making nightmare. We are faced with a bewildering assortment of options and are constantly buffeted by market noise and narratives. Against this backdrop practising good investing behaviours is incredibly difficult. 

Despite these challenges there are surprisingly few books available to help us with the unique set of problems fund investing poses. The aim of The Intelligent Fund Investor is to fill this gap. I hope it can help all types of investors avoid costly mistakes and make better decisions.

You can buy a copy here right now.

If you enjoy the book, I would be incredibly grateful if you could leave a review. If you don’t like it, please don’t tell anyone!

2022 has been an incredibly difficult year for investors. Not only have we seen steep declines in equity markets, but this has been coupled with sharply rising bond yields. The negative correlation between equities and high-quality bonds that has served investors well in times of stress has broken down, leaving many investors holding cautious and defensive funds nursing losses similar to those seen in far higher risk portfolios. Does this shift in asset class behaviour mean that cautious investors need to rethink their approach?

An Unusual Environment for Cautious Funds

First, it is important to consider how rare the returns delivered in 2022 are for conservatively allocated investors. If we go back to 1999 – before the bursting of the tech bubble – and look at the one-year returns of a simple, hypothetical cautious portfolio (70% global bonds / 30% equities) ^* we can see how extreme the environment has been:

Losses are comparable with 2008 but have been generated in a very different manner. During the Global Financial Crisis equity returns were far worse, but some protection was provided by falling bond yields. In 2022, equity losses have not (yet) been comparable, but bond exposure has compounded investor problems, not mitigated them:

This is incredibly painful for cautious investors and has led to some results that are at the extreme end of reasonable expectations for this type of risk appetite. In such situations it is easy to make rash decisions, but it is crucial to reflect on what has happened and what the long-term implications may be.

A Valuation Windfall

Over recent years a combination of falling bond yields and rising equity valuations has meant that cautious investors earnt returns that were higher than might have been reasonably anticipated from the cash flow prospects of their investments. We can visualise this by looking at a simple yield-based expected return for the hypothetical cautious portfolio (calculated by combining the earnings yield on equities with the yield to worst on bonds)^** with the subsequent five year return delivered:

The blue line is what we might have realistically anticipated our return to be, given the yield of equities and bonds, while the orange line is the realised five year performance from that point. The realised return is five years out (on the chart the orange line ends in 2017/18, as it is the return five years from that point until today). The gap between the two shows that returns have been consistently above a reasonable projection of what such an asset allocation might deliver. This has been caused – at least in part – by what Antti Ilmanen of AQR refers to as a valuation ‘windfall’ – a one-off return that occurs when asset class valuations become significantly more expensive over a certain holding period. This type of performance tailwind does not persist forever and can move in the opposite direction if assets become considerably cheaper – as we have seen with bonds this year.

Periods of unusually high returns are often a prelude to weaker returns in the future. Although the human tendency is to extrapolate strong past performance, we should instead be moderating our expectations.   

If Not Long Duration Bonds, Then What?

The cautious and defensive funds that have been most susceptible to losses in 2022 have been those using long duration bonds as a significant portion of their low-risk asset allocation – particularly those with a passive or quasi-passive approach. This strategy has been incredibly successful and effective for several years but did lead to many portfolios increasing their duration sensitivity as yields continued to fall (higher risk and lower returns, the so-called ‘return free risk’ trade).

Given the environment the results from many cautious funds this year should not be surprising – it is entirely consistent with their design – but does the recent experience mean that the approach adopted requires a rethink?

Not necessarily. No investment approach works in every situation, and we must be realistic about the drawbacks of any strategy in which we invest.  

Much of the pain this year has been caused by being exposed to long duration bonds in an uncommon environment of sharply rising bond yields and declining equity markets. What options do cautious investors have if they wish to avoid this type of scenario?

Market timing: They could attempt to adjust exposures based on an assessment of the prevailing market environment. The problem is such tactical approaches are incredibly difficult to do well. The track record of investors making consistently successful interest rate and bond yield forecasts is poor.  

Valuation-led approach: Rather than predict when things will occur as in a market timing strategy, they could adjust duration sensitivity based on the risk-reward characteristics of fixed income. For example, holding a short duration position when the yield available relative to the interest rate sensitivity is unattractive. The challenge here is that they must wait for valuations to normalise, and that can be a long wait.

Short duration: One option, particularly considering higher cash rates, is to run with a far shorter level of duration in their fixed income exposure, leaving them less sensitive to a more prolonged change in the relationship between movements in equities and bonds. Although this is a prudent approach, there are two potential drawbacks. First, if investors are comparing the performance of their cautious fund with a simple passive alternative there will be a large duration mismatch – are they willing to accept the underperformance that might stem from that? Second, in a recessionary bear market for equities we might again see significant declines in bond yields and their short duration approach may well offer us less protection in such a scenario.

Non-bond diversification: When bonds are failing to diversify our portfolios, particularly in difficult market conditions, there is always a great temptation to look for other sources of diversification. While this is a great option in theory there are dangers. There is often a temptation to invest in complex strategies that we do not truly understand, or asset classes that are not genuinely diversifying but simply look it because they are illiquid and have stale, mark to model pricing. Both scenarios lead to the assumption of a whole new host of risks.

As our tendency is to compare the (short-term) results of our cautious fund to a simple passive (equity / bond) comparator, adopting any of these approaches would have in all likelihood come with a prolonged and considerable performance cost in recent years. This does not mean all these methods are inferior, but investors need to be willing to bear the periods of underperformance that will inevitably occur.

There is a real danger that as investors we extol the virtues of a particular fund when it is delivering (often ignoring the inherent risks) and then abandon it when we are surprised by a period of poor performance. We are prone to adjust our fund holdings to deal with the risk that has just been realised, rather than those that may come to pass in the future. Consistently repeating this behaviour is likely to erode returns through time.

Deteriorating Performance and Improving Valuations

Given recent market performance there is a great deal of speculation about the negative correlation between equites and bonds that we have witnessed in recent decades being broken and becoming an artefact of an era defined by persistently falling bond yields. Whilst this is possible, it is extraordinarily difficult to predict with any level of conviction.

Rather than attempt to make such heroic forecasts, it is more prudent to look at areas where we can have greater confidence. The weakness in bonds and equities through 2022 means that our expected long-term returns for a typical cautious portfolio have improved significantly:

Unfortunately such valuation measures provide very little guide to the short-term outlook for cautious investors, but higher bond yields and lower equity prices do increase the probability of improved returns as we extend our time horizon.

Whichever approach to cautious investing we adopt, we need to understand both its benefits and limitations, and then decide whether we are behaviourally disposed to sticking with those for the long-term.

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* The hypothetical cautious portfolio is comprised of a 70% allocation to a global aggregate bond index (USD hedged) and a 30% allocation to a global equity index. All returns in USD.

** This is a very simple model combining the earnings yields of equities and the yield to worst on bonds. It is meant to be instructive rather than a precise forecast.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Expensive investor mistakes come in two forms. We can either lose money slowly or quickly. Slow losses are small and compound over time – largely unnoticed – growing into a major cost; these can be through high fees or persistent performance chasing. Rapid losses are far more dramatic and are often a result of us having our investments unnecessarily concentrated in an asset class, fund or scheme that suffers a savage and irrecoverable decline. The most damaging sudden loss scenarios are typically investment bubbles and outright frauds. Although these two phenomena appear distinct, they exploit the same behavioural vulnerabilities. 

An investment fraud is a situation where an individual (or group) makes a deliberate and nefarious attempt to mislead people about the characteristics of an investment for their own benefit. Contrastingly, an investment bubble occurs when there is a crowd delusion about the prospects for a particular security that sees its price detach from its underlying value by a dramatic margin; there may be disreputable individuals seeking to profit from a bubble, but no one person creates it.

Although these appear to be entirely separate episodes, they are deeply entwined. The life of an investment bubble or fraud is predicated on three critical aspects. The story, the performance and the social proof. These operate as a virtuous and vicious circle through the emergence and death of both bubbles and frauds:

Let’s take each element in turn:

Story: The narrative supporting an investment bubble or fraud is the critical underpinning. Stories not only provide a simple and compelling tale about why an investment opportunity is so attractive, they are also an incredibly effective means of disguising complexities and unpleasant realities. Successful stories make us blind to the risks and shortcomings. Tell us a gripping and believable story – one that ends with us making a lot of money – and that is often all we need to hear.

The influence of stories is intensified by the involvement of individuals with charisma. In frauds, they are often the person at the forefront telling the enthralling yarn, while in an investment bubble they are the main protagonists – the people that have already made a fortune and who we want to follow. Powerful storytellers and compelling characters make us even more susceptible to a story.

Performance: Strong past returns are also a vital feature of the most dangerous bubbles and frauds. This works in three ways:

1) It provides validation – we are so biased towards past outcomes that stellar recent performance is taken as a sign that something is being done right – otherwise why would it be working so well?

2) It allows us to extrapolate – we seem ingrained to believe that high returns from the past will continue unabated into the future.

3) It fosters greed – we are attracted to the high, often stratospheric, profits that have been delivered in the past and don’t want to miss out. The performance is far better than we are achieving in our own boring investments.

Social Proof:  The behaviour of other people is also essential in the emergence and persistence of bubbles and frauds. It provokes both confidence and envy. Confidence stems from the idea that there is wisdom in the choices made by other people – this can be particularly true if institutions are involved – it must be okay because those smart people would have done the work. Envy arrives because we see other people making more money than us and cannot help but find it painful.

These three elements feed on each other. A captivating story both boosts performance and corroborates it (the story must be true, haven’t you seen the returns?); while strong performance increases the power of social proof (my friends are making even more money), and new investors becoming involved supports performance. This virtuous circle can be incredibly powerful and self-sustaining. The longer it persists, the more people are drawn in.

The failure of frauds and bubbles occurs when this circle reverts from virtuous to vicious and this can happen suddenly. The catalyst for this shift is impossible to predict. It can be a piece of news or information that punctures the story, or simply a period of poor performance that leads to doubt, scrutiny and, eventually, distress.

Bubbles and frauds not only prey on similar human behaviours, at times they can become one and the same thing. The most perilous situation is when a fraud morphs into a bubble. Here the euphoria that arises around an investment doesn’t lead to the price being detached from reality, but the price being attached to a fantasy.    

For investors this is the worst of all worlds.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

If you work in the investment industry then you must have a view. Always. About everything. When will inflation peak? Will the Fed pivot? How will Japanese equities fare over the next six months? Is Amazon expensive? Does this fund manager have skill? If we don’t have an opinion then we either lack knowledge or conviction, perhaps both. As professional investors this is what we are being paid for, isn’t it?

No, it isn’t. Quite the contrary. The ability to not have a view on most subjects is a major advantage, just one that is incredibly difficult to exploit.

There is a stigma attached to saying “I don’t know”, not just in the investment industry but in many walks of life. Nobody wants to sit on the fence or stand in the middle of the road, but for investors this is absolutely the correct place to be most of the time. We are operating in a highly complex, uncertain environment where most predictions are either difficult or impossible. Being well-calibrated means spending a lot of time not having an opinion.

The majority of investors have all sorts of views. Does this mean we are poorly calibrated? In many cases, yes. There are two reasons why investors are so keen to predict everything. The first is simple overconfidence – we think we are better than we are.  The second is because it is expected of us – our clients want us to have a view, so we must form one.

Why is there an expectation for investors to have views on everything? Because it gives a sense of control. Financial markets are messy, chaotic, and anxiety-inducing; when an investor makes predictions and trades on them it feels like there is a steady hand on the tiller, rather than our portfolios being a hostage to fortune.

This is the enduring appeal of tactical asset allocation despite the compelling evidence that people cannot time markets successfully and consistently. Things are happening so investors need to be seen to be doing something about it.

But having wide-ranging and ever-changing views on markets is not harmless, it is damaging. Not only are investors constantly forecasting things when we cannot reasonably expect to have any skill in the task; it also means that we will be trading far more than is necessary – destroying value through transaction costs and the losses that stem from predicting the unpredictable.

The erroneous views that investors hold come in two forms. We can be operating far outside of our circle of competence – it is not feasible to have credible expertise in UK mid cap companies, the Chinese real estate sector, and the implications of the latest US non-farm payrolls report. Most common, however, is simply to have views on subjects that are not reasonably inside anybody’s circle of competence – typically these are short-term market perspectives: how is the Russell 2000 going to fare relative to the S&P 500 over the next six months? Who knows?

The vacillations of deep and intricate financial markets are endlessly fascinating but being intrigued by them does not mean we need to take a position or trade.

When Should Investors Take a View?

So if investors should avoid taking views most of the time, when should they do it?

The critical questions to ask are whether it is reasonable to have a view at all (is it something we or anyone can predict) and are the odds on our side in getting it right?

Let’s take an example.

I am asked to predict whether global equities will generate positive returns over the next six months. I have no idea. Over short run horizons markets are noisy and unpredictable, and I would simply be guessing with little confidence in my outlook.

But what if I am asked to predict whether global equities will generate positive returns over the next ten years. Here I have a view. Over the longer term the performance of equities will likely be driven by the cash flows they generate. History also tells me the odds are in my favour in having a confident (though not certain) perspective.

We should only express forthright views and take positions where we have a long-time horizon and a robust evidence base that suggests the likelihood of our view coming to pass is strong. This will often only occur when markets are priced at extremes, everything else we can think of as noise.

Wilful Ignorance

Not having an investment view on every imponderable in financial markets can seem like ignorance, but it actually shows an acute awareness of the environment in which we operate. It is far more ignorant to believe that we can accurately predict all manner of complex and unfathomable things.

Rather than have an ever-evolving set of views and positions, we would be far better off allowing others to pontificate and trade, and instead wait until there are opportunities where the probability of good outcomes are firmly on our side.

Investors would be far happier (and better off) not having a view on most things most of the time.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

It has been a bruising spell for ESG investing. Not only has the war in Ukraine brought into sharp contrast some of the potential trade-offs involved (fairly and unfairly), but it has faced numerous stinging criticisms. Tariq Fancy – formerly CIO of Sustainable Investing at BlackRock – labelled it a ‘dangerous placebo’, Stuart Kirk made his now infamous ‘Miami underwater’ speech and Aswath Damodaran – probably the pre-eminent scholar of business valuation – suggested people working in ESG were either ‘useful idiots’ or ‘feckless knaves’. As is symptomatic of the world today, ESG investing has become another polarised debate. It is either unimpeachable and essential, or little more than an asset management confidence trick. This lack of nuance is incredibly unhelpful and makes a complex topic even more problematic. How can investors successfully navigate these issues?

Why Has Criticism of ESG Investing Increased?

There are two central factors that have driven the increasing level of criticism faced by ESG investing. First is some of the unsubstantiated claims that arose from the asset management industry. When companies in the ESG sweet spot were enjoying prodigious performance tailwinds, it was easy to make naïve yet compelling assertions about how we can ‘do good’ and outperform. This was a potent marketing cocktail – not backed by robust evidence – that created entirely fanciful expectations. It was just a matter of time before the backlash arrived.

The second catalyst was the pronounced style rotation in markets, which has seen high-growth companies (including many ESG darlings) fall back down to earth, whilst much-maligned resource stocks have surged. In financial markets it is performance that creates narratives (not the other way round). When something is underperforming it becomes open season for disapproval.

And much of the opprobrium has been warranted. Greenwashing is rife, trades-offs and difficult questions about fiduciary duty are roundly ignored and the industry is in danger of measuring everything and achieving nothing. Yet valid criticisms do not render the entire endeavour meaningless or defunct. It just means we need to step back from the noise and think clearly about what ESG investing is and why it matters.

How Should We Think about ESG Investing?

One of the central problems with ESG investing is its sheer complexity. Investors of all guises are inevitably discombobulated by a seemingly endless array of measures, metrics, initiatives, regulations, acronyms, initiatives, bodies, reporting requirements, pathways, targets and even genuine issues.  Amidst all this, it is easy to lose sight of its underlying purpose.

At its core, ESG investing is about three elements – values, value and valuations. Any ESG-based decision we make should consider these aspects:

Values: These are issues that we care about. What matters to us outside of pure financial considerations?

Value: These are factors that we believe impact the worth of a company. Do they create or destroy long-term business value? *

Valuation: This is how an ESG related factor or business is priced. Is it expensive or cheap?

With any ESG based judgment or decision, an investor should be asking – is this about values, value or valuation?

Let’s take each element in turn:

Values

Values are the ESG-related choices that we make because of our beliefs on the issues or subjects we care about. The most obvious example of a values-based ESG decision is a portfolio exclusion. For example, we decide that we do not wish to invest in tobacco stocks because of the harmful and addictive nature of the product.

The flip side of exclusions is investing in thematic ‘impact’ strategies – here we might wish to invest in companies that are engaged in activities that we believe are positive for society or the environment. Investing in such a way makes us feel good or at least better.

The distinguishing feature of a values-based choice is that we are agnostic about the return effect of such decisions. We are willing to accept a financial cost. Green bonds are a good example of where there is some evidence of investors accepting inferior returns (in the form of a lower spread / yield) to ‘directly’ fund certain types of activity with an expected positive environmental impact. Investing due to our personal values will not always result in a loss but we have to accept the possibility that it might.

The problems arise when investors are unclear about what is driving a decision. Most investors in heavily thematically tilted sustainable or ESG funds are not doing so under the apprehension that performance will be poor (despite the historic evidence of thematic fund performance). Asset managers also frequently muddy the water by applying minor exclusions at the margins of a fund (such as controversial weapons), but without being transparent about whether this is an investment view or values-based choice.

This is a messy and highly subjective area. Not only because of the personal and somewhat opaque nature of values, but also the different ways we might be willing to express them. Two investors with a similar set of values might behave in an entirely different way – one might exclude a certain industry; another might believe that engagement is a far more effective approach.

There are few right answers when it comes to values, but if we are making a values-based decision it is critical that we admit we are doing so and understand the potential implications.

The question that investors need to ask to ascertain whether an ESG-related decision is values based is – am I willing to accept a financial cost to make a decision that is consistent with my values?

If the answer is no, then we need to provide a coherent, evidence-based explanation as to why the decision is instead about value or valuation.

Value

Value is about the ESG issues that impact the value of a business. These will be specific to companies and industries, and should be considered alongside other relevant factors that impact the long-term worth of a business.**

The crucial point here – as Alex Edmans’ highlights in his excellent recent paper – is that if there are ESG issues that are vital to the value of a company then it should be a focus of all investors, not simply those running ESG or sustainability orientated strategies.[i] ESG factors and risks that are central to a business and will impact shareholder returns should be considered alongside a host of other aspects. The job of any fund manager or analyst is to understand the factors within a business that are likely to create or impair long-term shareholder value.

The logical extension to this idea is that there is no need for sustainable or ESG-orientated funds because all competent investors should be doing it anyway. There is some truth to this, and this is hopefully the direction in which the industry moves. There are, however, two caveats:

First, ESG funds may cater to certain investor values (as previously covered), but if this is the case then we should be willing to incur a potential cost. Second, ESG funds are likely to believe that these issues are more material than others and therefore weight them more highly in their analysis of a company’s worth. In such a scenario we need to be transparent that this is a stark investment view that will have meaningful implications – we are stating that most mainstream funds are neglecting the importance of ESG factors and underweighting them in their investment decisions. There is nothing wrong with holding this perspective – although it would be helpful to understand the evidence supporting it – but we need to be clear that it is a position that will have performance implications.

Even if we correctly identify the ESG issues that are relevant to a company and can assess their materiality, there is one other aspect to consider – valuation.

Valuation

Identifying the long-term drivers of value within a business is imperative for making sound investment decisions, but we cannot ignore how that business is priced. What we pay for a security or asset matters greatly to the returns that we receive.

Let’s assume we have identified an ESG factor that has a material impact on the creation of shareholder value and a company that scores particularly well on this metric (amongst many other non-ESG characteristics). Is it a good investment? It depends on the price. Positive ESG or non-ESG characteristics do not result in good investment outcomes if they are more than reflected in the price that we must pay for it. ***

There will almost inevitably be times when stocks with a particular set of ESG credentials become very expensive. What do we do in that situation? 1) Hold them for so long that the price paid pales into insignificance relative to cash flows and growth (few people have a time horizon of this length). 2) Become a values-based investor and say that we are willing to endure a lower return because of the positive ESG traits. 3) Not hold the companies because they are not attractively or even fairly priced. The third option seems the obvious one but becomes problematic if we had made commitments about the ESG metrics of our fund, which limits our flexibility. If we hold expensive assets to maintain some score or meet an ESG threshold – we become implicit values-based investors.

In the future we may see strategies that are explicitly willing to sacrifice potential returns by investing in companies with positive ESG characteristics irrespective of the price. But for most existing funds this creates question marks around fiduciary duty – this is a discussion that not many people want to have but will have to happen at some juncture.

For any ESG orientated investment decision we should be able to ask whether it is driven by values or value.  If the latter, there should be a significant evidence base supporting why it impacts the long-term value of the business. We can then consider how that company is priced relative to those attributes and all the many other facets that feed into an assessment of its valuation.

What about externalities?

If we think about ESG investing through a values, value and valuation lens, where does that leave negative externalities? Where and how do we incorporate a cost created by a company that is not fully borne by them? Let’s take an example.

Imagine there is a large social media company that we believe creates a profound societal cost due to its negative impact on the mental health of teenagers. How do we integrate that into a values, value and valuation framework?

If we believe that costs of this are not currently incurred by the company but may be in the future, we can absorb this into our valuation. Even though it is currently an externality we can price for its future internalisation. It is in such situations that engagement is likely to prove particularly powerful and can combine values and value effectively. (I care about the issue deeply and think the company value will increase if it alters its behaviour).

If we believe that either costs are unlikely to ever be fairly levied on the company, or that we simply find the activity of the company unpalatable then our decision (perhaps to exclude the company from our portfolio) will be a values-based choice.

The major difficulty with externalities is when we think from a portfolio perspective rather than how they impact an individual business. We may suffer the cost of the negative externalities of a company we hold because it has broader consequences on, for example, economic growth or asset class performance. A polluting company we own may benefit financially (particularly in the near term) from avoiding the full internalisation of external costs, but it could still be to the detriment of our overall, long-run returns (amongst other things).

If we make decisions based on the potential ‘universal’ impact on our investment returns it can still be considered value-led, just through a different lens. The critical aspect is to be open about how we arrive at such judgements.    

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Trying to simplify how we think about ESG by using a values, value and valuation framework doesn’t make a complex and subjective area easy. Being clear about the drivers of our ESG-influenced decisions will, however, help in both setting realistic expectations and allow for reasoned debate about the quality of our choices.   

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* This could also apply at a portfolio or market level.

** This is obviously messier and more complicated than it sounds. There will be (many) scenarios where company executives are incentivised based on short-term profitability / share price performance and rational behaviour for them may be to maximise this, perhaps at the expense of long-term shareholder value. Engagement should play a crucial role in such situations.

*** The reverse of this situation is a company that scores poorly on the ESG metrics that are relevant to it but is incredibly cheap. Here we can decide not to invest (which becomes a values-based decision) or look to invest and engage.

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[i] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4221990

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Imagine a young active fund manager is presented with a choice; over a twenty-year investing career the fund they manage can take one of two paths. In path A it delivers annualised outperformance of 3%, but it is a bumpy ride – there will be numerous years of sustained and substantial underperformance. In path B their fund underperforms the market by only 0.3% a year, but it is a far smoother journey – in some years returns are a little better than the benchmark, in some slightly worse, but never too far away. Which path would they choose?

For a client investing with the fund manager the choice seems relatively straightforward – path A leaves them with substantially more wealth and justifies their use of an active fund. Yet for the fund manager it is not an obvious decision at all, in fact it is probably rational for them to choose path B, even though it would leave their clients worse off over the long run. Why? Because in path A there is a high probability that they will be fired and never be able to deliver the long-run results promised; contrastingly, path B is more likely to lead to a lucrative career.

There is a major incentive problem at the heart of the asset management industry, where the interests of clients and the professional investors who run money for them are often poorly aligned.

The key to a ‘successful’ career as a fund manager is not long-term outperformance, it is survival. Making sure from quarter to quarter that your results are adequate so that you don’t find yourself in the firing line. If you can survive long enough then you might get promoted to head of team or another executive role, so you are no longer even directly responsible for investment decisions. The most lucrative choices you can make are those that help you to stay in the game.

The power of the incentive to keep your job and progress your career increases through time. As you earn more money, you adapt your lifestyle, take on a bigger mortgage and send your children to private school. This means the risk of short-term failure becomes even more acute.

The development of this type of incentive structure means that the active fund management industry has evolved to a point where making high conviction, long-term decisions is irrational behaviour for many participants. Even though it should be one of its primary purposes.  

This is not the fault of fund managers. The entire industry is complicit in the game of enabling their own short-term survival. Asset management companies trying to meet quarterly inflow targets, board and committee members worried about the reputational impact of something going wrong, consultants concerned about losing disgruntled clients. Even regulators are now enforcing judgements on “value” based on performance time horizons over which every strategy (no matter how capable) will fail at some juncture. Nobody is incentivised to make long-term investment decisions because doing so exposes you to profound personal and corporate risks. 

Most people are left spending their time engaging with largely meaningless short-term market noise and ensuring that they are safely ensconced within the pack.

What does this cultural backdrop mean for the structure of the active asset management industry? We are left with an unnecessarily large and amorphous blob of uninspiring funds stuck in the middle and doing enough to survive. Strategies taking higher conviction, longer-term decisions frequently succumb to the endemic short-termism that defines the industry (irrespective of whether they are skillful or lucky).

For the active management sector to successfully evolve not only does it have to become smaller and cheaper, but it must ensure that it creates an incentive structure and clear purpose that is properly aligned with the long-term interests of its clients.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

Much of the focus on the dramatic and unprecedented sell-off in gilt markets this week has been centred on the technical factors that led to an intervention from the Bank of England, potentially worth £65bn. Whilst the tribulations of the Liability Driven Investment strategies used by pension schemes are both fascinating and concerning, these periods of extreme stress are not just about the technicalities – they also provide acute behavioural lessons:

Small sparks can lead to great damage in complex systems:

The catalyst for the dramatic rise in gilt yields was the new leadership’s ‘mini-budget’. Which precise part of Kwarteng’s proposal led investors in UK assets to panic? The removal of the highest rate of tax, the unfunded nature of the proposals or the lack of independent oversight from the Office for Budgetary Responsibility? Everything and nothing. It doesn’t matter. In deeply complex, interconnected systems small sparks can precipitate dramatic and destructive feedback loops.

Markets are about the behaviour of other investors:

Financial markets are about the decisions made by other people. Most investors do not assess new information about an asset based on how it impacts its cash flows and valuation, but how we believe other investors will respond to that same information. This creates vicious and virtuous circles. In periods of severe turbulence this feature of markets is taken to the extreme. Our decisions become driven by the fear and cost of being the wrong side of momentum shifts. We want to be in the herd during the stampede, not underneath it.

Predicting when things will happen is close to impossible:

The fact that complex systems can be compromised by small events doesn’t simply make them riskier than we might normally perceive. It makes them even more difficult to forecast than we realise. Even if a system has inherent fragilities, anticipating when these will be exposed (if ever) is an incredibly difficult, perhaps impossible, task. Investors should never try to predict when things will happen.

Both financial and mental models can break under stress:

It is inevitable that the scale and speed of the rise in gilt yields would have torn asunder many ‘worst case’ assumptions that have been made in financial models. Whether it be the stress tests or scenarios used to judge the appropriate collateral buffers in an LDI strategy or the predicted drawdown in cautious (but duration heavy) portfolios, some models will have been found wanting. This is to be expected – models are an abstraction, a simplified version of something too chaotic to replicate. Not only that, but the output of financial models is inexorably shaped by what has happened before. In a complex system, things tend to break in the future in a different way to how they broke in the past.

It is not just the limitations of financial models that leave us vulnerable, but the mental models that investors use. Inescapably, the mental models we apply to inform our investment decision making are framed by what we have experienced. For most that means years of tranquil market conditions, moribund inflation, and interest rates at close to zero. When the environment shifts it can leave us incredibly exposed.  

Short-term performance chasing sows the seeds of future pain:

One of the major casualties of the remarkable increase in yields has been defensive or cautious funds, some of which are nursing losses of more than 20% across the year. Many of these strategies have used a heavy allocation to long duration bonds to provide a ‘low volatility’ return stream and diversification alongside the growth assets held in a portfolio.

It is easy to now be critical of the unappealing ‘return free risk’ of owning long duration bonds with very low return prospects, but it is important to remember the context. Holding such assets had worked well for years (decades). Investors who came to find the combination of close to zero returns and (potentially) severe volatility unappealing likely found themselves underperforming their peers and benchmark. The more pressure investors feel about poor short-term performance – ‘being underweight duration led to underperformance again this quarter’ – the greater the temptation is to fold. Unfortunately, there is often a choice between keeping to our long-term investment principles or keeping our job and assets. We cannot always do both.

Market shocks leave scars:

The type of market shock we have witnessed in the past week will undoubtedly leave scars. Not simply in terms of unrealised and realised losses, but future behaviour. What will the consequences be? Changes to collateral buffer requirements for LDI strategies seems obvious (we have a new scenario to use in the risk model). What about cautious and defensive portfolios – are long duration assets now less palatable? (Ironically, they are far more attractive now than they have been in recent years). Will it now be more acceptable to hold high cash levels in a portfolio? The trend towards global bond and equity exposure at the expense of a domestic (UK) bias will almost certainly gain even further momentum.

The memories and consequences of stressful events unavoidably shape our future behaviour. Some changes will be an irrational reaction to an idiosyncratic occurrence, others might be more sensible. Some behaviour shifts will fade, others will prove long lasting.  

Our model for how things work has changed, and it will change again.

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.

In his new book on decision making, Ed Smith, who was responsible for the selection of the England Men’s cricket team between 2018 and 2021, discusses the challenges of innovative thinking.[i] He quotes poker player Caspar Berry:

“Whenever someone innovates in business or in life, they almost inevitably do so by accepting a negative metric that other people are unwilling to accept”.

Smith cites the dramatic increase in the number of 3-point shot attempts in the NBA in recent years – a revolution led by the then Houston Rockets General Manager Daryl Morey – as an example of pre-existing norms being broken because of a willingness to accept a negative metric (the increased failure rate when attempting the higher value shot).

It is not just in sport where this concept prevails. It matters for investors too. Whenever we attempt to make decisions with the aim of improving returns, we must also be willing to experience unpalatable negative metrics.

The simplest investing analogy that encapsulates the requirement to accept a negative metric is in active investing. Growth investors deviate from their benchmark because they have willingness to accept higher valuations; whilst (traditional) value investors may suffer from a portfolio with lower sales growth, weaker profitability, and potentially higher levels of debt.

Yet these simple figures miss the point. The critical aspect of a readiness to assume a negative metric is not the number itself, but the experience and consequences of deviating from what is expected. The cost to Daryl Morey of his team’s increasing propensity to take 3-point shots was not the lower successful shot percentage. It was the reputational risk, the anxiety of being the outlier, the threat of failure – all the stresses and pressures that come from diverging from the norm.

We can observe these trade-offs right across the investment landscape. Let’s take the equity risk premium, one compelling explanation for the long-run return advantage to equities is myopic loss aversion – higher returns are the compensation required for the pain of short-term losses. If we want to enjoy the benefits of long-term equity investing, we need to accept the behavioural pain and embrace the negative metrics.

On a more granular level, this is exactly the situation faced by active investors. Prolonged bouts of underperformance are inevitable – even if we happen to possess the ability to deliver long-run outperformance. It is pointless even having conversations about investor skill if we do not have the appetite or wherewithal to withstand the uncomfortable behavioural realities of active investing.

To make matters worse, negative metrics are not something that only appear on the road to success, it is also a feature of the path to failure. When we diverge from the crowd or consensus, we might accept negative metrics and still be wrong.

The most damaging situation for investors is where we take decisions with the intention of enhancing our performance, but don’t acknowledge or accept the negative aspects that we will have to endure to achieve it. If we invest in equities but don’t understand that gut wrenching bear markets are the price of admission, we will sell at the most inopportune time. If we invest in active funds and expect consistent outperformance over months, quarters and years we will pay the exorbitant tax of incessantly switching from near-term losers to yesterday’s winners.

Any investment decision comes with pain points and costs, failing to recognise and accept these will lead to consistently poor decisions.

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[i] Smith Ed (2022). Making Decisions: Putting the human back in the machine. William Collins

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I have a book coming out! The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can find out more here.