Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Beware the power of a good story
Everybody loves a good story – investors particularly so. But sometimes a good story can lead to a crowded trade, or one that defies reality.
“In finance, behaviour is driven by expectations of future returns, and expectations are often driven by stories, particularly during times of heightened uncertainty,” Charalee Hoelzl, investment manager at Ruffer, wrote in the latest Ruffer Review. “The simpler a story – the more it extends and agrees with our preconceptions – the more persuasive it is. A good story embeds itself in investors’ minds: the narrative becomes the expectation.”
Everybody thinks in terms of stories. Hoelzl notes that narratives allow us to mentally rehearse the actions within them, and when you perform an action the same regions of the brain are stimulated as when you read about that action. There’s an evolutionary reason for that – the ability to link a previous experience to the present – but also one that has more to do with contemporary society; humans now process more information daily than ever before, and it’s easier to summarise and simplify that information into stories than to process it in its raw form.
But that simplification has consequences, especially in financial markets. A good story can lead to a crowded trade – or worse, one that defies reality. And multiple narratives can coexist, “reinforcing or undercutting one another”, and investors will need to pick the story that will become dominant – the narrative that will drive investor behaviour and markets.
“For example, the technology story is reinforced by the secular stagnation narrative. This theorises that growth and inflation will remain low indefinitely, because developed economies are plagued by an increasing propensity to save and a declining wish to invest,” Hoelzl writes. “The narrative is powerful because it is grounded in our experience over recent decades.”
“Set against this is the counternarrative that the same technology could harbinger a ‘fourth industrial revolution’. In this scenario, further technological innovation will support continued strong growth and earnings, thereby justifying higher market valuations.”
Narratives have also played a “decisive role” in how investors understand the risks and opportunities of climate change. Prior to the ESG boom, the dominant narrative around climate change was essentially one of austerity – a “complex and discouraging” story that emphasised the costs of climate action and the potential for some countries to essentially get a free ride from the climate mitigation of countries that were acting.
“Then a counternarrative emerged,” Hoelzl writes. “Economist Nicholas Stern proclaimed the “transition to a zero-emissions and climate-resilient world provides the greatest economic, business, and commercial opportunity of our time.” This new framing – of an optimistic, green transformation story – was based on the pace of technological innovation and disruption, which has substantially reduced the cost of producing renewable energy and storing it in batteries.”
That upbeat message was first adopted by a purist environmental crowd before achieving widespread acceptance in global finance, catalysing an ESG trade in markets that has become the prevalent of the strong story behind it but also for the returns it promised investors.
“Whilst it is clearly of benefit that so much capital should flow into tackling climate change and other sustainability challenges, such crowded trades can eventually lead to disappointing financial returns for investors,” Hoelzl writes.
“The technology and ESG narratives are compelling for several reasons, but they need to be justified by growth in revenues and earnings. The challenge for investors is to be aware of, and to challenge, the prevailing dominant narratives and to watch for any signs of impending regime change.”
