Alpha & outcomes

Barry Gill argues that now is the time to sharpen our focus on sustainable investing to deliver either portfolio-level impact, real-world outcomes, or (ideally) both.

Investing is, first and foremost, a belief. A belief the future will be better than the past; a belief that one type of investment represents a better option than another.

We see this most acutely through the philosophical tethering of investment processes to factor-based masts. Whether it be value, growth, momentum or otherwise, every investor follows some form of belief system.

In some ways, sustainable – or environmental, social and governance (ESG) – investing is no different. That investors should extend their market-wide beliefs to include ethical preferences is entirely logical. However, untangling performance motives from moral ones is messy. If individuals themselves find it hard to ascribe the exact proportion of capital outlay dedicated to ethical considerations, then is it any wonder that investment managers, intermediaries and regulators might struggle too? Our brains simply don’t label and categorize motivations and values as neatly as this task demands.

That investors should extend their market-wide beliefs to include ethical preferences is entirely logical.

The simple answer, of course, would be to call the whole thing off; to consign sustainable investing to the woke scrapheap and double-down on the relentless pursuit of profit above all else. Ardent Milton Friedman disciples would no doubt rejoice as he, after all, became an icon for shareholder value: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”¹

However, giving up the ghost like this would be a great tragedy – not least because Friedman himself went on to clarify that the responsibility of a corporate executive is to “make as much money as possible while conforming to their basic rules of the society; both those embodied in law and those embodied in ethical custom”.

Market failures like climate change, biodiversity loss and inequality pose existential threats and are forcing us to look at the ‘basic rules of society’ more deeply and recognize that they have evolved. Greater transparency is demanded from institutions, governments and investors. Upholding globally accepted standards of human rights is now expected; limiting environmental damage is not just about avoiding fines but also intrinsically tied to our continued future dependency on the environment for societal needs. Societal issues are becoming corporate ones.

Encouragingly, we are already seeing greater levels of customization, enhanced preference collection via digital client surveys and data collection, more product innovation across public and private markets, sharper and more effective stewardship efforts, and more transparent performance attribution metrics. All these can improve matters and make a tangible difference.

Regulation is clearly trying to steer capital allocations in more sustainable directions, and at a minimum it is forcing improved disclosures. Although at times the implementation of the regulation feels blunt and missing the mark, the directionality is clear and – ultimately – welcome.

All this leads me to conclude two things about the resources being deployed towards sustainable investing. First, they must contribute meaningful levels of alpha to active mandates. Second, and just as importantly, sustainability efforts must achieve real-world outcomes consistent with clients’ values.

This is the most straightforward and well understood of the two issues at hand. Few investors nowadays ignore the reality that sustainability factors can and do have a material impact on asset valuations. Only by properly understanding sustainability issues and trends can we better spot opportunities and manage risk more effectively.

As a result, ESG integration – i.e., embedding sustainability data and perspectives into the investment process – must be thought of as more than hygiene factor; it is a critical informational tool and input in the arms race to gain an investment edge.

There's not really such a thing as ESG investing, only ESG analysis

Indeed, Alex Edmans, author of Grow the Pie and Professor of Finance at London Business School, recently invoked economist Richard Thaler’s 1999 quip about the “The End of Behavioral Finance”, by titling a recent paper “The End of ESG”. Contrary to the respective titles’ surface logic, both argue their subjects should become so mainstream as to dissolve the need for any explicit mention. His views are perhaps best summed up by this quote: “Considering long-term factors when valuing a company isn’t ESG investing; it’s investing. Indeed, there’s not really such a thing as ESG investing, only ESG analysis.”

But as with any active investment strategy, it is what you do with said information that makes the difference. A cursory glance at an ESG dashboard is not the same as a full-blooded debate about the likelihood and effects of a carbon tax or the potential impact of water scarcity on company’s operations. Unfortunately, though, ascertaining the level of integrational difference from the fund’s regulatory label – such as Article 8 under the EU’s Sustainable Finance Disclosure Regulation – is fiendishly hard at present.

Perhaps somewhat overlooked is the use of engagement as a tool to unlock value. Given the above, genuine active ownership (i.e., outcomes-based and measurable) could well be the next edge to create portfolio value and sustainability outcomes in tandem. Though probably too early to conclude with great certainty, there are studies showing how engagement can help to protect long-term investment value. Dimson, Karakaş and Li’s (2015) analysis of 2,152 engagement exercises with 613 public firms between 1999 and 2009 being the most notable.

Things aren’t quite as cut and dried when it comes to ‘outcomes’. The word itself is woolly; and the sheer number of activities regularly bundled into the catch-all term is huge. As already alluded to, this poses a great challenge to investment marketing departments the world over.

For us, real-world outcomes are those that are linked to client preferences and that emphasize quality over quantity when judging impact and effectiveness. There has to be a robust level of measurability involved, while also recognizing that ‘not everything that counts can be counted’, as the old adage goes.

Given sustainable investing cannot be reduced to one simple activity, such outcomes span across integration, screening, thematic and impact, and active ownership. They also apply to an investment manager’s own values and purpose and cover indexing and active, as well as public and private markets.

Every asset pricing model basically says the market portfolio is the core.

A key outcome we should all be focused on is market stability and integrity. This might surprise many as ever since Harry Markowitz famously codified investing and risk taking with his work on Modern Portfolio Theory, there has been a contingent assumption that the ‘market’ cannot be influenced – that it simply ‘is what it is’. Indeed, Eugene Fama – famed for creating the Efficient Market Hypothesis – acknowledged this when interviewed by Andrew Lo: “Every asset pricing model basically says the market portfolio is the core, and you start with that.”³

But as systemic risks rise, market participants are increasingly recognizing the limitations of this belief. Jon Lukomnik, co-author of the 2021 book Moving Beyond Modern Portfolio Theory: Investing That Matters, sums the situation up nicely: “Prevailing investment orthodoxy just can’t simply deal with systemic risks, which has led investors to focus on the manifestation of risk as volatility but do nothing to tackle the underlying risk.”

Prevailing investment orthodoxy just can’t simply deal with systemic risks.

Beta therefore matters regardless of the type of investor you are. We must look at alpha and beta in harmony because only by bundling them back together can we get a true understanding of the return profile investors experience – investment performance being a critical and uncontroversial outcome for clients.

Furthermore, regulators and standard-setters are increasing their focus on these issues. For example, the UK’s Financial Reporting Council (FRC) state that in order to improve outcomes for their clients and beneficiaries, as well as develop sustainable benefits for the economy, environment and society, “market participants should work with other stakeholders or participate in relevant initiatives to address market-wide and systemic risks and promote well-functioning financial markets.”

The need for market reform efforts and policy-level engagement as part of overall active ownership work is key to maintaining the integrity of markets. (See: The Future of Stewardship). For stewardship efforts, we are taking steps to clarify and align our objectives with clients. We broadly split the possible outcomes into three categories: addressing investment opportunities and risks; real-world outcomes relating to systemic risks; and real-world outcomes relating to global norms.

These buckets allow us to hone in on the materiality of issues in a more systematic way. A complementarity should exist here between issuer-level engagement and systemic risk priorities. For example, by targeting the leading companies in a sector to improve human rights standards this should raise best practice standards for that whole industry.

Beyond the inevitable increases in customization to meet clients’ varied sustainability preferences (See: Morals, markets, and menus), we are also likely to see an increased alignment of end client and asset manager values as clients’ selection criteria decisions extend out to include purpose; especially when it comes to defining issues of our time like climate change and biodiversity loss. Some corporate-level circles will simply have to be squared with portfolio-level realities as net-zero commitments and deadlines hurtle towards us.

There are, of course, no silver bullets or magic solutions to sustainability’s thorniest questions. What we can say with confidence though is that there is a key role for finance in helping society transition to a more sustainable future while at the same time serving the financial needs of end clients. If investment managers are to meet them, we need to be laser focused on the opportunities for alpha and managing risk, real-world client outcomes, and the resource model best suited to achieve all this.

¹The Social Responsibility of Business is to Increase Its Profits, The New York Times Magazine, September 13, 1970
²The End of ESG, Alex Edmans, January 4, 2023.
³'In pursuit of the perfect portfolio: The stories, voices, and key insights of the pioneers who shaped the way we invest’, Andrew W. Lo and Stephen R. Foerster, August 17, 2021
⁴Effective Stewardship Reporting - Examples from 2021 and expectations for 2022 |FRC, November 2021