Stephan Langen: Wishful thinking about returns
Stephan Langen: Wishful thinking about returns
This column was originally written in Dutch. This is an English translation.
By Stephan Langen, Head of Portfolio Management at ASN Impact Investors
Much has been said lately about financial returns, benchmarkism and active management. People often miss the point, especially in relation to sustainable investing. The House of Representatives recently took the cake.
A majority in the House of Representatives believes that pension funds should not implement their green ambitions at the expense of financial returns. This was evident at the beginning of this month from support for a VVD motion: pension funds must invest to achieve the highest returns for their participants. Period.
This return requirement is flawed in a number of areas. I dare say that pension funds by definition achieve different returns, regardless of whether they concern green or traditional investments. So what determines the highest return? These different returns are caused by different investors in charge. They make different estimates of the market, and therefore make different choices and realize different returns.
That starts with the asset allocation. This week I read that pension funds have barely achieved a return on their investments in private equity due to the high costs. What would the House of Representatives think of that? Would they consider a ban?
It is too easy to say that investors should aim for the highest returns. We investors know that carrying out such an assignment is entirely dependent on definitions.
An example. If you do not want to invest in the fossil industry, you run the risk that the return of your portfolio will lag behind a broad market index when oil prices rise. But if you do invest in the fossil industry, you run the risk that the return of your portfolio will lag behind sustainable portfolios when oil prices fall.
Research shows that these risks on financial returns are (almost) neutralized in the long term. However, research also clearly shows that the social return of a portfolio with a fossil industry is very negative compared to a portfolio without. And in the long term, this effect only increases.
I suspect that the majority in the House of Representatives and its supporters are mainly focused on the short term. The risk that a sustainable portfolio will lag behind a market index in the short term is a given. You consciously take positions in sustainable companies and exclude non-sustainable companies. This leads to different financial returns.
This deviation increasingly leads to the question of what can be done about it. There is a great desire to claim that you achieve at least the same return with sustainable investing as with non-sustainable investing. The reality, however, is that there are short-term deviations, both positive and negative. Practice shows that these effects neutralize in the long term.
Relevant here is that the desire to beat benchmarks with sustainable portfolios is difficult to fulfill. The portfolios are constructed based on sustainability criteria, of course within investment technical frameworks, and then compared with benchmarks that are completely different in nature and structure. My personal chagrin is of course the fact that questions are only asked if you are behind the benchmark. Outperformance is always 'logical'.
Moreover, a truly sustainable portfolio is by definition an active portfolio. There are no market indices for that. Yes, I also know the ESG indices, but there are questions to be asked about them. In this way, they try to capture the diversity of sustainability criteria in one comprehensive ESG score. But, I have written about it here before, that is too simplistic.
Investing in general and sustainable investing in particular requires research: know what you own.
First, whether fundamental or quantitative, we need different insights for market formation. In that respect, passive investing is actually a kind of parasitism on active investors, because if all investments were passive, there would no longer be a market.
Secondly, research is extra relevant for sustainable investing, because you naturally want to know whether the companies you select contribute to your objectives in both financial and sustainability areas. You want to be able to determine the social return of your portfolio.
Social return, a combination of financial and sustainable returns, should be the benchmark against which investment performance is tested. We have postponed the negative social impact of purely financially driven management for too long.
The call from Parliament now shows how unruly vain hopes are. A high pension in a world that incurs high social costs to remain viable is very risky and not in the interests of the participants. Investors and their supervisors must continue to work side by side for a world in which participants can (continue to) spend their old age comfortably.
That's what I call a good pension.
Stephan Langen is Head of Portfolio Management at ASN Impact Investors. The information in this column is not intended as professional investment advice or as a recommendation to make certain investments.