Megatrends such as rapidly evolving technological innovation or the slow-moving, but highly damaging environmental implications of climate change, are making long-term investing a major headache for institutional investors because profitability of investments across asset classes over time is becoming increasingly difficult to predict.
The Global Investment Megatrend report published last week by Willis Towers Watson and the UN backed Principles for Responsible Investment (PRI), says researching and distilling the implications of these huge shifts into investment will help to make portfolios more resilient in the long run, and aims to show how.
David Hoile, Global Head of Asset Research at Willis Towers Watson, said: “It is increasingly apparent that these megatrends, and the ability to understand and manage them, should form part of all institutions’ investment processes.” The report is based on surveys and interviews with 300 investment institutions. It also includes an investment model demonstrating how megatrends can be incorporated into sustainable investing, developed by the Thinking Ahead Institute (TAI), which has 40 investor members with combined responsibility for over $13 trillion in assets and is an outgrowth of Willis Towers Watson Investments’ Thinking Ahead Group. Nathan Fabian, Director of Policy and Research at PRI, called the framework a “new mode of thinking” that he sees could find broad application in the way so-called Sustainable Development Investing (SDI) will be done.
Integrating megatrends into portfolios has been a struggle for investment institutions because it demands holistic thinking, which the report calls: “how to connect the short- and the long-term; how to connect thefinancial and extra-financial; how to integrate risk and uncertainty.” The TAI model seeks to overcome this. It outlines strategic responses to megatrends by looking at two dimensions that are based on beliefs:
The first is motivation ascribed to sustainability, which is the strength of belief in an extra financial motive.
The second is materiality: the extent to which institutions believe that megatrends are material to investment outcomes.
Based on this model, asset mispricing can be identified and active targeted/tilted opportunities around megatrends can be pursued, says Hoile. The report rates technological advances and environmental changes at the top of those trends that represent major opportunities and threats to investment.
Big data, identified as one of the current technological megatrends in the report, will, according to Hoile, represent the “next wave in terms of thinking about these issues and generate risk management or investment opportunities”.
Such technological progress can lead to major disruptions in the financial system. And megatrends help us to understand the disrupting factors how SDG pathways could become changed, adds Fabian. He explains: “If you look at the role of technology, as both a displacer of employment but also an increaser of productivity, we have some ultimate pathways here which if we don’t understand and manage in the way we invest and set expectations for companies, we might end up with some quite perverse outcomes for the clients and beneficiaries that we are trying to serve.”
The report applies a systems’ view of megatrends, which it says “allows better assessment and management of risks faced by individual firms as well as
systemic risks”. It argues that rather than looking at how individual firms might compete it is more meaningful to look at the inter-relationship of businesses and firms and the financial system as a whole. Hoile explains: “The issues that Mark Carney recently highlighted around the tragedy of the commons, where self-interested actions of individuals leads to the demise of the group, [come into focus]. We think about things from a much broader systems’ perspective. We can start to bring out the broader issues and the broader impact that the firms or businesses have not only in terms of economic value, but also in terms of societal value.”
Three principles lie at the heart of this systems’ thinking:
One: using a bottom-up approach by looking at businesses as the “primary domain” that link to megatrends.
Two: dealing with the inherent uncertainty around megatrends by applying a microeconomic cost-benefit analysis to identify material shifts in industry economic costs or societal value.
Three: focusing on practical outcomes, i.e. identifying barriers that may prevent a scenario from being realised.Thinking about systems’ effects and looking at investment as an ecosystem is vital, according to Hoile, because it allows asset owners and asset managers to “anticipate, adjust, adapt and invest in transformation and changes” and achieve the UN Sustainable Development Goals (SDG’s).
The PRI plans to apply the report and its insights widely. It will inform the PRI’s company engagement program and provide a platform and research for signatories around related themes. In addition, new investment tools in cooperation with the investment industry are being planned.
The work will also inform the PRI on its work on financial system change and how to bring together economic and societal value.
Fabian, who is a member of the EU’s High-Level Expert Group on Sustainability (HLEG), sees such work on megatrends as an important source in the design of financial regulatory changes that can shape the “rules of the game”.
“This [thinking] provides a framework that we will use for years into the future to help guide our work on how we influence the design of the financial system,” he said.