Responsible Investing

We are observing how one of the world’s most successful investors—the New Zealand Super Fund—manages its capital, and considering whether we might not mimic some of what the Fund has been doing. The idea is to improve our own returns both on an absolute basis and on a risk-adjusted basis.

Here are two more strategies the Super Fund has used to compound its capital faster than Yale.

Investing responsibly. Investing according to ESG (Environmental, Social and Governance) principles has become so popular so fast that it has taken on characteristics of a fad. And, indeed, many people define ESG in such a way—elevating personal ideology over investment common sense—as virtually to ensure poor investment results.

The Super Fund takes a more nuanced approach. The Fund begins by adopting the position that it is obligated by its enabling legislation to pursue responsible investing. (The reality is far less clear, but whatever.) The Fund then carefully reviews the academic literature on responsible investing, compares the academic views with its own experiences, and ultimately adopts what it believes to be the most sensible approaches.

The main thing these sensible ESG characteristics have in common is that the Fund believes them to be material to the performance of the investment. For example, climate change might be material to the performance of a relatively small group of companies today, but it is likely to become ever more important if global temperatures continue to climb.

Sound governance, by contrast, is probably material to almost every company. Of course, thoughtful investors were buying well-managed companies long before ESG became fashionable.

The real question is this one: what does an investor mean by “sound governance?” In a way, it’s easier to back into the governance issue. For example, if two similar firms have very different costs of capital, it’s probably because capital providers believe one of the firms is far better managed than the other. That will indicate to the Super Fund which company is likely to be the better investment.

The Fund notes that some ESG factors don’t necessarily improve returns, but they may act to reduce risk. If Company A operates in an environmentally sound way and Company B does not, investors will likely prosper by investing in Company A even if the two stocks end up with the same return. Why? Because the stream of returns at Company A will be less volatile than the stream of returns at Company B.

Social factors—the “S” in ESG—tend to be the most problematic, because it is more difficult to conclude that they are material to a company’s performance. Many social factors are socially desirable, but there is very little evidence that they have anything to do with the returns a company’s stock produces.

And yet, ESG investors very much want to see certain social factors implemented by companies, whether those factors affect the value of the companies’ stocks or not. They believe that adopting these factors is simply part of being a good corporate citizen.

This presents the Super Fund with a dilemma. It wants to employ ESG factors that are material, but some social factors don’t seem to be. In these perplexing situations what the Super Fund typically does is to avoid selling the stock—that would simply harm their returns—but instead to engage with the board and senior management on the issue, pressing their arguments and appealing to the boards’ and management teams’ better nature.

Creating a Reference Portfolio. Before the Super Fund invests a New Zealand dollar it creates what it calls a “Reference Portfolio.” The Reference Portfolio is similar to a “custom benchmark” except that it contains only traditional asset classes (stocks and bonds) and that it is actually investable.

A custom benchmark, by contrast, is based on the investor’s strategic asset allocation and will likely contain hedge funds, private equity and venture capital, for which there are no investable benchmarks. The Reference Portfolio is more similar to what many investors would think of as a “naïve” benchmark, that is, a stock/bond/cash mix that has the same risk level as the more complex custom benchmark.

In other words, the Super Fund could, if it wished, simply engage a few passive, index managers to replicate the Reference Portfolio, rebalance it several times a year, and be done with it. But by following the strategies we are talking about in this series of posts, the Super Fund has substantially improved upon the return of the Reference Portfolio—and by taking no more risk.

The purpose of the Reference Portfolio is to establish the risk level of the Super Fund. The Fund creates various possible Reference Portfolios and then observes how they actually performed in the past—especially during periods of market disruption—and how they are expected to perform in the future.

In the case of the Fund, the Reference Portfolio began with a 75% exposure to global stocks and then rose, five years later, to an 80% exposure. The 20% balance is invested in global fixed income.

An 80/20 mix of stocks and bonds may seem too risky for most individual investors, but that may not actually be the case. For investors who are willing to tolerate price volatility in their portfolios in return for better returns, an 80/20 portfolio can make sense.

The real problem for investors isn’t market volatility, but the need to remain committed to stocks even during periods of time when stock prices are swooning. If those investors are prudently spending 3% of the value of their portfolio annually, and if they have 20% of their money in bonds, they could (theoretically) weather a seven-year bear market, something that has almost never happened.

The longest bear market in U.S. history, following the bombing of the World Trade Center in 1993, lasted seven years—but lost less than 1% over that period. The worst bear market, following the Crash of 1929, lasted less than three years but lost 86%. (Well, okay, that one was painful.)

Next week we’ll wrap up our review of the tactics and strategies used so successfully by the New Zealand Super Fund.