We have recently returned from one of our regular trips to London to meet new and existing fund managers, and never cease to be impressed by the breadth and depth of investment skills, styles and talent concentrated in the capital. We met with managers generating returns through systematically harvesting structural risk premia, which academic research proves is ever-present in listed markets, through to a chief investment officer who had flown in from Birmingham, Alabama to present on his firm’s highly impressive track record of ‘stock-picking’. The latter would be the first to say the firm strives to keep their investment process simple, whilst the former require a far more complex approach to building and executing their strategy. Whilst both are very different, they are each successful at what they do. The only common thread linking the two is they both invest in global equities.
During our visit, we also spent some time with PIMCO as we wanted to understand the approach they had established towards ‘responsible investing’. Readers of our November 2015 edition of VFTD will know Environmental, Social and Governance (ESG) factors are increasingly being incorporated into the processes employed by fund managers as they screen for suitable debt or equity investments. As we wrote in that edition, there is empirical evidence that corporations with sound ESG policies are commonly the very same ones with successful and profitable business models. The meeting was very informative and useful – made all the more so by one compelling comment made. Namely, notwithstanding this empirical evidence described, PIMCO believe one of the key benefits derived from investors using ESG factors is in the longer term investment mindset it engenders.
On reflection, we could not agree with this statement more. It was also a very timely one in the context of some of the changes we have seen across global equity markets in recent weeks, which we think have been driven by short termism. Significant sector rotations have been underway as market participants switch allocations from one group of stocks to another. As mentioned above, there are a myriad of investment styles employed by managers to capture investment returns and we think two of them help explain what is going on.
But what are they?
We were fortunate to be recently invited to a day-long investment seminar jointly hosted by the London Business School and the AQR Asset Management Institute. The title of the seminar was Alternative Investing and the Regulatory Environment and one of the sessions, hosted by Paul Woolley – a Senior Fellow at the LBS – really struck a chord. His presentation, the ‘Curse of Benchmarks’, argued the vast majority of executed equity trades (estimated to be up to 95%) totally ignored fundamental valuations. In his research paper, which supported his presentation, he states;
Investors have the choice of two basic investment strategies: Value, which uses estimates of fundamental worth, and Momentum which takes account of fund flows moving across assets. Value is based on cash flows and ignores fund flows, while momentum follows fund flows and ignores cash flows.
He goes on to state that benchmarking and momentum are the embodiment of short termism.
Why is this relevant now?
It would appear the support for those sectors that have enjoyed strong returns for a number of years is waning. Momentum investors have quickly moved cash into other sectors, with financials clearly being the main beneficiary in recent weeks. On a broader basis, money is moving out of ‘defensives’ into ‘cyclicals’ as investor sentiment has turned more positive. The speed of some of these rotations has been dramatic and time will tell whether this will be short-lived or not.
In our view, benchmark investing, ETFs and momentum strategies have resulted in secular over-valuation, the misallocation of capital and – one could argue – severe headwinds for the macro-economy. Short-termism has prevailed and whilst very attractive investment returns have been captured by some, there can be no doubt that future economic and financial stability can only be achieved by investing capital – be it in the hands of corporates, governments or private investors - for the long term.
This brings us full circle to that PIMCO comment about engendering long term thinking. Value investors look to invest in companies with a share price that is trading at a discount to what they believe is its intrinsic value. Most will acknowledge it may take a while for the ‘market’ to catch up with such analysis, assuming it is correct. Patience is required.
The S in ESG, namely Social, is something that commonly takes time to influence. It often involves regime change at board level, and a possible redirection in cultural values and attitudes before behaviours properly adjust and become aligned. We have been thinking for some time that a fourth letter should be added to ESG, being a D for Diversity. It is currently a subset of Social.
By way of example, there is lots of evidence highlighting the improvement women bring to corporate performance as the infographs below clearly highlight.
Source: MCSI ESG Research
Source: Pax Ellevate
Investing in this theme, or Gender Lens Investing, recognises these opportunities and is a growing trend. A number of funds, both active and passive, have been launched, including the State Street Global Advisors (SSGA) Gender Diversity Index ETF; ticker code SHE. According to its supporting literature, by investing in companies with gender-diverse senior leadership, SHE may inspire action to increase gender diversity in corporate leadership teams. Additionally, SSGA will direct a portion of its revenue to charitable organisations that seek to partner in innovative ways with educational programs to remove bias and empower women to take their place in business leadership.
The financial services industry has notoriety for an underrepresentation of women in senior positions and it is something Affinity is active in wanting to change. As mentioned, attitudes and behaviours need to adjust and this will undoubtedly take time. Nevertheless, as business owners, we are ideally placed to influence this and the long term approach we are adopting in managing the organisation, as well as capital for our clients, leaves us well positioned to play our part.
For those of you who have visited our newly launched website, you will see our commitment to this as part of our corporate DNA (see here). In a small way, we hope to create a change to the established mindset and, just like Value investors, we are thinking long term as attention to these issues today will surely pay dividends long into the future.
Finally, to close this last VFTD of 2016, all that remains is to wish our readership a relaxing festive season and a happy new year.
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