First featured on LCP Viewpoints
I’ve seen several crises over my investment career most notably the 2008 crisis which occurred at a formative time in my industry development the lessons of which certainly influenced me – and I think many of my peers – for many years after (for better and worse). So I think it’s especially important to reflect on a year as tumultuous as 2020 on what we are all taking away and what we learnt.
Here are five reflections I’m taking away from this one. And yes, they are deliberately a little provocative (otherwise, where’s the fun ?!) I could have written about risk management, liquidity and decision making – all valid lessons – but I’ve already heard those about a million times.
- Beware experts on a previous version of the world
Oil, interest rates, inflation, tech, unemployment … the list of things defying conventional theories and reaching unprecedented levels continues to grow. Meanwhile many in investing are waiting for things to revert to some long -term ratio from 1852. The world changes and every time is different, but the conformity and groupthink in investing causes outdated theories to continue to circulate unchallenged. It’s time to update our thinking to the current version of the world. I’m not saying that we can’t learn from history, and there are a small number of timeless principles that remain relevant, but far too often investors are caught fighting the last war, or hanging onto specific backtests, formulas and strategies that worked great in the past, but markets are always in a state of flux. Unfortunately no-one hands you a new rulebook or rings a bell when things change.
2. Capitalism as we’ve known it has hit the buffers
It’s never been clearer that many, or even most, large companies have created profit and value for shareholders by heaping huge external costs on the environment, or communities. In one example, it’s estimated that for every £10 of fossil fuel energy creates an additional £8 of cost on human health and at least £8 of environmental impact. And this isn’t just about fossil fuels: battery companies buy chemicals mined dangerously using exploitative human labour in terrible conditions, closer to home retailers and outsourcing firms exploit workers in precarious situations on zero-hours contracts while tech and social media companies create addictive products that foster intolerance, contribute to the breakdown of communities, while paying far less tax than they probably should.
For decades these sort of practices were justified by the Friedman doctrine that corporate management should – or were even obligated to – pursue a narrow shareholder value vision (while remaining within the rules). But 50 years after Friedman’s seminal essay the scales are tipping firmly against this vision of capitalism. it is now clear that the rules were painfully insufficient, open to manipulation through regulatory capture and always running well behind the times. What takes its place is yet to be seen, but a broader focus on stakeholders and externalities is gaining currency, and can no longer be ignored or downplayed by investors and asset owners – indeed for many it is becoming central to their investing philosophy.
This roots of this movement can be found in the 2005 book Capitalism as if the World Mattered by Jonathan Porritt, as well as the UN Principles for Responsible Investing published the year after. The concept of Universal Owners (asset owners that factor in the cost of externalities of their portfolios) has been around since 2011.Today, many asset owners are placing this front and centre of their investment philosophy, and annual Responsible Investing reports from large asset owners are the norm. The influence is now clear to see on the corporate agenda too: last year the Business roundtable of America redefined the purpose of a corporation to: “Promote an Economy That Serves All Americans’.
3. I learnt to love currency risk
In the early 2000’s the theory started to develop as UK investors diversified their equity holdings internationally that by hedging out the fluctuations in exchange rates investors would get the same return for lower risk (minus the relatively small cost of hedging). There was never a complete consensus on what the right hedging level was, and academic work on the subject could be found to justify almost any level between 0% and 100%. What the last few crises have shown UK investors is that having overseas currency exposure particularly in US dollars, Euros and Japanese yen is an excellent structural tail risk hedge that materialises naturally through investing in overseas stocks and measuring gains and losses in sterling. This is because these other main currencies have tended to appreciate sharply against sterling in times of crisis, increasing the sterling-value of assets held overseas. The last thing investors should try and do is pay to take away their valuable structural hedge. For further reading on this check out this piece by my colleague Jacob Shah.
4. Resilience is vital, but looks like inefficiency
Risk is a number in a model, but resilience is the ability to survive. The snag is that risk models can give neat answers to two decimal places, but are invariably based on history, and things that have never happened before happen all the time. The only thing that can save you in that situation is resilience. For investors this might mean an allocation to cash, or the ability to easily raise cash (eg from government bonds) in order to keep satisfying outgoings. It might mean being cautious with the level of leverage and cash commitments. For businesses it might mean running with extra cash, or a greater margin of safety. The difficult thing is all these actions may show up as in-efficiency in your model most of the time, but could be what allows you to keep going and actually realise the longer term.
5, There are really only two ways to make money
Which are: lend money, or own a piece of equity. They come in many flavours but those are the two forms of investing for which centuries of data exist in support, and can be easily accessed at a very low level of charges by almost anyone. Much work over recent decades has gone into other forms of return, so-called uncorrelated risk-premia, but despite the hype and the hard work that has gone into research, and picking managers and strategies, investors in these areas have generally not been left with all that much to show for it (after fees). Some approaches can work, and in moderation there is nothing wrong with some of these strategies, but I believe recent times have shown us that in a crisis (when it matters) most everything is broadly correlated, one way or the other, and there are no magic asset classes. Investors should not get too carried away with the idea that a significant number of unrelated sources of return exist or can be found. Owning your basic equity risk premia in a diversified and low-cost way gets you very far in investing and has been a tough strategy to outperform.
What are YOU taking away?
If you liked this you might be interested in my top-read posts of 2020 –