Sunday Brunch: investing is not just about generating alpha

At it's heart our financial system is really simple. Money flows from savers (retail, pension funds, endowments and family offices) to spenders (companies etc who want to invest, hopefully in productive assets). In return the savers get a financial return. One area where this system struggles is when the actions of the spenders impose costs on the wider society that mean that the net return to savers (financial return minus imposed costs) is reduced.

This is the concept behind Universal Owners - savers (ie investors) who hold broadly diversified portfolios. Describing this in financial terms, they are unable to avoid/diversify away these external costs on society, and so regardless of how good their asset managers might be at beating the index, their long term financial returns are diminished. Universal owners need to think about their investments differently, in a way that is alien to how most asset managers currently work. Change is coming.

"we are all Universal owners now" - Dr Ellen Quigley.

"What is the purpose of investing. No, that isn't a trick question" - Lukomnik & Hawley.

If you work in the finance industry your answer to the Lukomnik & Hawley question probably includes phrases like 'risk weighted returns' and 'generating financial alpha' for your clients. But in a way this misses a fundamental point. Investing is also about the real economy, what some people call Main Street (differentiating it from the financial world or Wall Street).

Ignoring for a moment that we live in Main Street, and so it's success directly impacts the quality of our lives', Main Street is also important to our real world financial returns. Studies suggest that over 75% of our financial return comes from the performance of the market as a whole, something financial people call beta. Which means that the skill of our asset manager, who is normally focused on relative outperformance or alpha, is likely to be less important to us than the financial health of the world in which we live, which generates our beta.

It's this insight that lies at the heart of the concept of the Universal Owner. These are investors (asset owners) who have an interest in the long-term health of the financial system as a whole. Why? Because they mainly rely on the return generated by the total market, not on stock picking skills. They cannot diversify away the risks to our economic system, such as climate change, biodiversity loss, rising inequality, and global pandemics. Given this they can only counter whole-system threats by effecting change in the real economy.

Why is the current approach not working?

I think it's clear to most of us that the current approach to sustainability investing is not working. This is not from a lack of effort, lots of people are working very hard. So maybe the message is not quite right. Maybe we are not reaching the financial decision makers in the right way.

One thing I learnt as an activist investor was the importance of seeing things from the other sides perspective. If I wanted to change their behaviour, I needed to create a message that worked for them. Which meant showing why the action I wanted them to take was beneficial to them.

Much of the analysis on sustainability starts with the ethical imperative for sustainable investing - the need to create environmental and social outcomes. Despite the rightness of the ethical and values based arguments, on it's own it doesn't seem to be moving the dial. We are not mobilising anywhere near enough financial capital. For every step forward, we seem to see two steps back.