16 December 2020
I began advising investors in 2003 and have worked with pension schemes, private wealth managers and other asset owners since then.
I’ve seen several crises over that time, most notably the 2008 crisis which occurred at a formative time in my industry development, the lessons of which certainly influenced me for many years after. But here are four reflections I’m taking away from this one.
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 investors 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 The world changes and every time is different, but the conformity and groupthink in investing causes outdated theories to continue to circulate unchallenged.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.
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. For example, it's estimated that every £10 worth of fossil fuel energy creates an additional £8 of cost on human health plus at least £8 of environmental damage. But it isn’t all about fossil fuels: battery companies require cobalt which could be mined by children in the Congo in terrible conditions. Closer to home in the UK, successful 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 and contribute to the breakdown of communities, while paying far less tax than they probably should.
For decades these sorts 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's 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's now front and centre.
I learnt to love currency risk
In the early 2000s 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 UK 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.
Keep it simple, there are two main ways for investors to make money…
…which are to lend money, or own a piece of equity. These are the two forms of investing for which centuries of data exist in support, and which 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 alternative strategies, investors in these areas have generally not been left with all that much to show for it (after fees). Some alternative investments can add value, and in moderation, there is nothing wrong with some alternative assets, but I believe recent times have shown us that in a crisis (when it matters) most everything is broadly correlated with debt or equity, 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.