Are Sustainable & Impact Portfolios Worth The Price?
“When the facts change, I change my mind..." is generally attributed to the economist John Maynard Keynes (although he may not have actually said it), and it perfectly sums up our position on global capital markets.
In any rational asset pricing model, the “market” is a relevant portfolio, and in aggregate it’s what we all hold collectively.
Active v Passive
As a firm, unless there is a strong preference to the contrary, our default has always been to guide our clients into the market in the most efficient way possible, via low cost passive index funds.
If instead you are going to try to bet against the market, of two possible alternatives to this approach being “active management” and “factor based investing or smart beta”, our recommendation has generally been to pursue a factor-based approach. Within this, we suggest a modest tilt of a portfolio towards stocks with a high book to market ratio (otherwise known as “value investing”) and stocks which are generally of small capitalisation relative to the market.
We find no evidence in decades of academic data to support any argument that investors should try to beat the market via “active management “. To back this up, we reference Nobel Prize winner Bill Sharpe’s excellent paper, the arithmetic of active management which simply states,
“If "active" and "passive" management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar, and
(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.
These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
The team at Everlake were genuine pioneers of both passive and factor-based investing in Ireland, being the first advisers to implement funds for our clients from Dimensional Fund advisors, and we have consistently advocated for an evidence-based approach to investing.
What Has Changed?
So what has changed in the evidence to lead us to advocate a different approach now?
The key insight which we now build into our recommendations is the increasing recognition around the world of the fact that for centuries the market has not properly priced externalities such as pollution and in particular Carbon Dioxide - a key greenhouse gas and contributor to climate change - into the cost of capital. This has given a near free-ride to some firms and in particular fossil fuel companies such as oil and gas producers.
The need for the recognition of the link between how we invest our capital and climate change has now been formally enshrined into Irish Law through the EU Sustainable Finance Directive which introduces the concept of light green (sustainable) and dark green (impact) investments via article 8 and 9 fund definitions respectively.
Borrowing from another academic field, that of behavioural finance, as a firm we have decided that the best way to move the needle and consciously address climate change is to apply a “nudge” approach with our clients.
How We Approach ESG Investing With Our Clients
Rather than default to a market article 6 or “unsustainable portfolio” which doesn’t see pollution as a cost to society but which is a low financial cost to the investor, our preference is now an article 8 sustainable portfolio. This has slightly higher financial costs, and by extension a lower expected financial return, but less negative environmental impact.
This shift means that we no longer see investment decisions purely through a financial lens from the narrow perspective of an individual investor. Instead we seek to apply an external cost benefit analysis to the negative or positive impact on others of those investment decisions. Our preference is therefore to start our conversations about investing with a sustainable article 8 portfolio, and to ask our clients to express their preferences and values about investing with reference to positive or negative impact.
A client can of course still invest in an article 6 portfolio, which will be a low financial cost to them personally as an investor, but it clearly and demonstrably carries a higher cost for everyone else. The question as yet is unclear as to what extent regulations will continue to allow article 6 investors this free ride in the future.
Our preferred article 8 approach seeks to weigh these issues in a sensitive and positive manner, and to strike a balance between personal investment returns and negative environmental impact. In doing so, we attempt to inform our clients of the trade-offs that they are making.
By contrast an article 9 portfolio has a still higher financial cost to the investor personally. All things being equal and going back to Bill Sharpe’s arithmetic paper, this will have a lower expected financial return for the investor personally, but will accrue potential external positive impact benefits for everyone else. For those investors with a strong desire for positive impact, we believe that the sum of those parts is worth the price.
Do you believe that sustainable and impact investing for the good of all is worth paying for?
Schedule a call with us to discuss this further.
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