The behaviour of financial markets is determined not by a scientific rulebook but by the collective guesswork of millions of biased human brains. Information reaches asset prices via haphazard attempts by these brains to second-guess what all the other brains think about the information.
With that in mind, consider these reasons for buying a stock:
· It is cheaper than it has been in the past, and so the price should revert upwards
· Business conditions for the company are expected to improve
· The company is set to experience huge growth in earnings
· Someone else will buy the stock off me for a price higher than that which I paid
· The company has generated stable earnings for a long time
Some of these reasons are fundamental in nature, some are macroeconomic, some are sentimental, but all are behavioural. Any application of expectation is behavioural, either subtly or explicitly, and every decision to buy or sell an asset requires the investor to have an expectation. Even systematic strategies are built on the foundation that asset prices are expected to behave in a particular way based on some assessment of past behaviour under a set of conditions.
This doesn’t just apply to individual stocks, but regions, sectors, and even entire asset classes. Consider the importance of inflation expectations in determining actual inflation; consider momentum strategies that buy expensive assets on the belief that the asset will get more expensive; and consider growth stock investing where investors pay for company earnings that don’t exist yet.
On that basis, using ESG considerations as an input to the tactical asset allocation process is not unusual. In fact, it would be completely in keeping with most investors’ existing approaches to tactical asset allocation. If an investor believes that other investors will reward a stock, country, region or sector for ‘good ESG’ factors by pushing up its price, then they will act in accordance with their expectations of what other investors will do, and buy the asset. Conversely, as information comes to light that an asset has ‘bad ESG’ characteristics, investors will discount the asset price by incorporating (albeit haphazardly) that information into their investment decisions.
So why aren’t market participants already doing this? Well, they are. Consider Volkswagen. In September 2015, the month that VW admitted having deceived emissions tests, VW stock was down almost 40%. That was just short of €18bn wiped off the company’s market capitalisation. A few months later, in April 2016, VW announced that it was setting aside around €16bn to cover costs of the scandal. Those two figures are uncannily close; had the market correctly priced the scandal by sending the stock down 40%? Almost certainly not, and in any case, it doesn’t matter. What is important is that investors had made their decision to sell based on a newly discovered ‘bad ESG’ characteristic. It is inconceivable to imagine that investors, globally, were collectively able to forecast the financial implications for the company. When all was said and done, the costs amounted to many more billions; it turns out investors had in fact under-priced Volkswagen’s sins.What about the perceived riskiness of Volkswagen since the scandal? Using the standard measure of risk – volatility – it appears investors now price VW as a riskier stock; the volatility of the company’s stock price in the 3 years prior to the scandal was 25%, whilst in the 3 years following it, it was 33%.
But there are limits to the use of ESG as a factor in tactical asset allocation. First and foremost, there’s two sides to the coin; ‘good ESG’ assets can become overpriced, and in that case, the ruthless process of information discounting would require the savvy investor to ‘short’ ESG. That would surely be controversial, and it would also be an admission that the objective of raw portfolio returns trumps the objective of being sustainable.
So perhaps it is impractical to start factoring ESG into our tactical asset allocation process but, the truth is, we already do. So why stop now?
To the pound 