Sustainability

We will all be investing in a sustainable fashion within a generation. Well, that was the assertion I recently made at an investing conference, based largely on my sense of where the public debate is going. I added, moreover, that whilst I didn’t know when it would happen, I thought that, when it did, it would happen quickly. What we now consider a choice, and still largely a minority one, will quickly become the default.

I thought of how smoking was squeezed out of public places. First, there were no rules: you could smoke where you wanted. Second, there were dedicated smoking areas with the default setting being that you could smoke. Third, the default was non-smoking with dedicated smoking areas. Fourth, now there is almost no smoking in public places, sometimes even including outdoor spaces. In sustainable investing, we are at step two. I am not suggesting sustainable investing is not happening. But the default is you can own what you want, but that if you want to do sustainable investing, you can seek out the places where sustainable investing rules apply.

What are the factors? I see four: the environmental imperative, fairness, technology and youth. Starting with environment, and not making any actual statement about climate change, we can all agree that it is still the global consensus; it is in the news and it is widely reckoned to be a problem. And, even continuing not to make any actual statement about climate change, we can agree that businesses that are efficient in their use of resources, whether those resources are private or public (the environment), look better long term bets. If I was to make a positive (or negative, as it were) statement about climate change, then investing in an environmentally sustainable fashion is absolutely necessary.

Next is fairness. Unless it is just me, I hear the widespread talk of fairness and the need for fairness. For what it’s worth, I think fairness is the post-communist Anglo Saxon version of the older equality. Equality sounds blunt and so twentieth century. Fairness is softer and subtler: more equality of opportunity than equality of outcomes. Again for what it’s worth, I think the pendulum is swinging towards fairness (equality) and away from liberty. Liberty has had a good run since 1980 and the Reagan / Thatcher revolution but the tide is turning. We are not heading back to the 1970s – history does move forward – but we are not staying where we are. So, social sustainability becomes another criteria.

If the environment and fairness are the issues, technology is the facilitator in two ways. As we all know, social media exposes more of our workings to the sunlight of popular judgement. There is nowhere to hide. Even if, in future, social media is regulated, the net increase in sunlight, compared to twenty years’ ago, is huge. On the other hand, while technology exposes more, it also allows us to clear up more efficiently. We can measure more and what we can measure, we can manage. And it gets better. Imagine blockchain in the supply chain: your finished product contains information on the source of every component, every manufacturing process, and every displacement. Implementing sustainable practices becomes easier.

Finally, we come to youth: the driver and the reason why I think it will happen and quickly when it does. Again, I may be missing something, but my sense is that their spectrum of opinion on the issues of environment and fairness has shifted towards protecting the environment and promoting fairness. They have swung from liberty - not in the sense of favouring authoritarianism but in attaching less importance to liberty than the generations that grew up with much of the world under authoritarian rule. This is not to say that there is not divergence of opinion amongst Millennials and Gen Z. It is just that the left and right flanks have shifted. I say this as a parent of Millennial and Gen Z children. I can wait for them to develop my opinions, but they aren’t going to, just as I diverged from my mother and father.

So what? Selfishly, we want further to prepare our business for this change. For the capital markets as a whole, it will mark a shift in asset pricing. It is hard to know whether capital will simply become unavailable for certain industries or whether it will be priced very high. What of oil extraction? What of the chance that we simply decide not to do it anymore? These are “how” and “when” questions and we don’t have answers to these, but we are willing to bet that sustainable investing will lose its optional status. At some point, in what remains of our investment lives, it will become the default.

Millennials are also known for their love of avocado toast and their susceptibility to FOMO – fear of missing out. To be fair, the notion that everyone else is out somewhere fabulous that you don’t know about can afflict anyone, not just Millennials, and it can certainly afflict investors. The current investment climate has been particularly provoking for those susceptible to FOMO. We are nearing the end of an investment cycle which means that equity returns have been high – particularly in FAANG stocks - and although October’s losses may have been chastening, FOMO is still strong among many investors.

Having a diversified portfolio can be frustrating at times like these because the very purpose of diversification is to reduce exposure to any particular investment and to counterweight all investment positions – including the outperforming ones – with something that behaves differently. The impact of an investment cycle on a diversified portfolio should therefore be dampened; in consequence, diversified investors will always feel somewhat disappointed in a rising market but will feel the benefit of their diversification in a falling market. Of course this means that in the long run their portfolios will do better overall. Consider the example of a manager who returns an average of 15% pa for 14 years but loses 25% in year 15; in the end they post lower returns than a manager who averages only 12% pa over 15 years. This is because the most important principle in investing, more important than participating in absolutely all the upside return, is avoiding permanent capital loss.

If this sounds like an “eat your greens” approach to investment, well, it is. The good news, however, is that investors who have been diligently diversifying in order to avoid permanent capital loss should start to see the benefit of their approach over the next few years. Our clients’ portfolios, positioned to steer a steady course with increased quality and liquidity and reduced exposure to risk, should demonstrate better resilience in difficult markets than riskier portfolios. However, we do not counsel clients to opt out of the upside entirely – we have carefully constructed portfolios to capture some of the upside in the late stages of a bull market by using equity market call options and favouring a mix of equity and government bonds over credit. These should allow clients to participate in some of the upside volatility in markets over the next few years – and, importantly, assuage any lingering FOMO.

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