Latham & Clark: In search of a better beta: Why benchmark orthodoxy must change (Part 2)

Developing a more holistic understanding of risk and return…

This article follows yesterday’s piece by George Latham and Mike Clark in which they challenged the orthodoxy about benchmarks. It suggests a way forward towards a holistic understanding of risk and return.

A better way to assess risk
So how do we assess total risk, and determine the asset allocation which flows from the total risk decision? At present, the process often just ignores wider investment beliefs, or treats our implicit finance beliefs as a given. When setting strategy, we consider market risk and return, beta, and when managing and evaluating a particular portfolio we pore over alpha. A lot. But how do our investment beliefs relate to the goals and aspirations of the savers we serve, the pensioners of the future? Too often, the answer is “not really at all”. We define and evaluate the mission in terms of narrow financial returns, and short term returns at that. Can it be otherwise? Yes. Leading asset owners around the world have recognised that they really need to think and then act in a way that is aligned with the time horizon of the pool of capital they direct. They have set out investment beliefs which cover, unsurprisingly, investment returns, but also acknowledge other issues such as climate risk. Establishing such beliefs, and being confident that they can be implemented meaningfully, requires hard work, stamina and a willingness to unlearn some of the things trustees have been taught, usually by traditional investment consultants. No longer does asset allocation simply fall out of a “choose your risk tolerance” exercise. There is active interest in the real world outcomes of the entities where the asset owner’s capital is invested. The impact, in real economy terms, has become a metric.

This is a revolution
This mind set views risk differently. No longer do asset owners decide the level of beta risk, set their strategy in terms of standard benchmarks, and either employ investment managers to invest actively to beat the benchmarks (a relative-risk task), or invest passively in line with an (inappropriate?) benchmark. Now they view climate change risk, for example, as a risk that permeates the whole portfolio and needs to be integrated into the investment process from outset. Does the asset owner believe public policy and regulation might begin to price carbon (aka CO2 emissions) in a way that the market does not currently acknowledge? Some do. They may view it more as an uncertainty issue than a risk issue, but they want to reduce their exposure to the related risk, and they seek to do that. It’s financial. They specify their own “better beta”.Finding a way forward
Where do benchmarks fit into all this? Currently, an investment benchmark is almost synonymous with a market index. The benchmark specifies the default risk/return stance of an investment manager’s portfolio. It ensures the asset owner can segment their (beta) strategy into manageable chunks of assets which become investable capital in the investment manager’s hands. And we might conflate a combination of portfolio benchmarks into an asset owner’s strategic benchmark, in a bottom-up way. Instead of this, what if we start from their investment beliefs? A benchmark then becomes a tool to measure the asset owner’s progress towards their goals, which flow from their beliefs. We might firstly think of the benchmark as their desired capital market exposures. This could include “low carbon”. Or we might go further.
We might want to evaluate the asset owner’s energy exposure against an IEA (International Energy Agency) future scenario. Suddenly, we are looking at long-term risks in a different, richer, way. Let us remember that asset allocation is a risk allocation exercise, before it is an asset allocation exercise. However, we tend to think of risk in asset allocation terms, largely because asset classes are readily definable, in a way that risk drivers are not. A fascinating recent paper by CUSP (4) teaches us the way metrics can shape how we address an issue. Sometimes metrics need to compete in terms of the differing views of the world they promote. Investment management needs some new metrics – impact metrics.
One of the key conclusions in Mercer’s 2015 paper ‘Investing in a time of Climate Change’ (5) was that the differential in market returns between sectors as a result of climate change was likely to be more significant than the equivalent effect on asset class returns. This means it will become more important to select exposure to the right sectors of the economy, than it is to allocate between equities, bonds, property and cash. Traditional benchmarks and the asset allocation process do not cater for this, and so a new approach is required.

The role of Impact
Sir Ronald Cohen, co-founder of Apax Partners Worldwide and Chairman of the Global Social Impact Investment Steering Group, stated that “in the 19th century we learned to measure investment return, and in the 20th century we measured risk and return. In the 21st century we will start to measure risk, return and impact. (6)” All economic activity can be thought of as having some kind of social or environmental impact.

In a financialised market (driven by benchmarks) this is considered irrelevant, but increasingly academic and business theorists argue that such externalities do have an effect on economic performance. Michael Porter, originator of the concept of Porter’s Five Forces, has more recently focused his efforts on developing the concept of ‘shared value’ (7). Businesses that create ‘shared value’ for a broad range of stakeholders – including wider society, the environment, employees and customers – are likely to be more resilient and more profitable in the longer term.
The straightjacket of traditional benchmarks has severely hindered these sorts of issues from being considered in asset allocation, stock selection and portfolio performance reporting because they don’t fit the way we frame the goals of the system. The way we think about the purpose of our investments needs to change. We need to find better ways of enabling asset owners to invest in and express positive impact through their portfolios. This can be done if the (standard) benchmark is relegated to being just one key performance indicator among several to be used as a measure of how a longer-term and more holistic ‘mission’ is being achieved. Building on the work of current leaders, several of whom find the UN’s Sustainable Development Goals (8) SDGs) a helpful framing, we must find a better way of expressing this mission, the longer term goals of an asset owner – be it a pension fund, an endowment or a family office. A mission is more effective as a form of words which describe the objective, as opposed to a single metric.We can then develop key performance indicators which allow a level of quantification and rigour to monitor progress towards the mission.

Measuring and reporting the impact outcomes of our investments against such objectives is the way forward to develop a more holistic understanding of risk and return. Understandably, there are as yet no agreed standards on how to quantify this. They will undoubtedly evolve. We will need to ensure that the instinctive and reductive desire of the finance industry to quantify and compare does not end up falling foul of Goodhart’s Law all over again.

George Latham is Managing Partner and CIO of WHEB Asset Management and Mike Clark is Founder of Ario Advisory and a member of WHEB’s Independent Investment Advisory Committee.

Sources and References:

4: See http://www.cusp.ac.uk/pub/wp3/
5: https://www.mercer.com/our-thinking/investing-in-a-time-of-climate-change.html
6: Sir Ronald Cohen, speaking to the UNPRI In Person Conference, London, Sept 2015
7: http://sharedvalue.org/partners/thought-leaders/michael-e-porter
8: https://sustainabledevelopment.un.org/?menu=1300