The paradigm shift to sustainable investing has led to increasing recognition that investment objectives should be dual-based: a traditional return/risk objective combined with a sustainability objective. Current consensus is that the two objectives are more likely to trade off in risk space than in return space.
That consensus – that sustainable investing won’t cost asset owners in terms of return – has been helpful for sustainable strategies in gaining a foothold in mainstream asset management. The more aggressive stance – that sustainable investing can actually enhance returns – is a stance increasingly being taken by asset owners and asset managers who have adopted sustainability as a pillar of their corporate and investment strategy.
Even amongst these investors, however, the notion is that, since sustainability-related factors typically play out over the long term, any uplift to return will come from favourable strategic (i.e. long term) portfolio positioning, and hence will accrue over the long term.
Active investors are fuelled by information
Financial markets are merely information-discounting mechanisms. Volatility of asset prices reflects market participants’ attempts at trying to understand the unknown. As new information is released for public consumption, investors collectively express their fears and seek opportunities, causing asset prices to change accordingly. Markets inevitably oscillate around conceivable risk scenarios based on their changing probabilities.
However, investors are human, too. The translation of information into asset prices is a flawed and exaggerated process. Prices over- and under-shoot their ‘fair’ values, as investors try to make sense of what the information means. Not only that, but ‘fair’ means different things to different investors. In fact, if there were enough of a consensus on what ‘fair value’ really meant, then active investing would be a fruitless task. But it isn’t so; the ‘madness of the crowd’ will always give active investors opportunities to profit on the basis of informational – and information-processing – advantages. As a result, short-term tactical opportunities for active investors will in fact arise as sustainability-related information makes its way into the collective market pricing mechanism.
Ultimately, the fundamental impacts of sustainability-related factors don’t have to actually play out in order for financial markets to attempt to incorporate them into asset prices. So, there are two ways in which sustainable investing and tactical asset allocation can co-exist.
– The inevitable mispricing of this currently poorly understood source of information
– The inevitable series of policy responses, creating a stream of reasons to misprice
The inevitable mispricing
We don’t have to know what the fundamental value of an asset is in order to illustrate mispricing. On route to it’s ultimate destination (known only with hindsight), an asset price will take a winding path as investors attempt to understand the latest releases of information and express their views by buying and selling the asset. Despite over 100 years of practice with the S&P 500 index, investors remain uncertain amidst the persistent ambiguity of information.
Unless there is clarity about sustainability-related factors and their impact on asset prices in the future, markets are likely to respond to new information as they have always done – with uncertainty. Given the scope of sustainability as an information source, it is likely that there will never be clarity, and so there will always be ambiguity, mispricing, and overshooting. On that basis, sustainability is an active short-term investment problem like any other.
The inevitable series of policy responses
As the world falls behind the rate of progress required to meet the United Nations’ Sustainable Development Goals (SDGs) by the 2030 target date, a series of policy responses is inevitable, either in direct relation to the SDGs or with respect to some other priorities.
Given popular coverage, the first issue that comes to mind is climate change, but the scope for policy intervention is far greater than that. Looking at the figures for women in leadership at UK large and mid-cap companies, we can see that the average company in many sectors hasn’t met the 30% target for women on boards, let alone the inevitable future target of 50% (no prizes for guessing how we came up with our estimate of 50%). Furthermore, representation on boards may even overstate the extent of female leadership at companies because of the dominance of non-executive directors on boards, and because of the exclusion of executive management positions from the headline numbers. Taking a broader measure of women in leadership which includes executive management and their direct reports, the picture is much worse.
Ann Cairns of the 30% Club said in 2019 that 30% is a floor, not a ceiling (The Sunday Times, September 2019). It seems inevitable then that new targets will be set, even if the UK doesn’t go quite as far as explicitly regulating gender diversity or prescribing quotas, as other administrations have done, particularly in Europe. It follows that future possible responses to slow progress towards an important sustainability objective may create opportunities for tactical asset allocators.
Climate and gender diversity are but two issues from a whole range of international sustainability-related objectives that could be subject to policy announcements in the future. Taxes on tobacco and alcohol are two other examples that have a strong precedent in multiple regions.
The processing of information to make active investment decisions is something investors have been doing for many years. But by incorporating the philosophy of a dual objective, investors can be more explicit and complete in their attempts to invest more sustainably.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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