The third axis: what comes next after returns and risk
The following speech was delivered by Richard Brandweiner, CEO of Pendal Australia, at the KangaNews 2019 Sustainable Debt Summit on 18 March 2019.
From fringe to foreground – the evolution of sustainable investing and the opportunity for investment management
In the beginning of our modern sensibility, there was only one axis.
Investment returns, company profits, GDP growth.
As individuals, we would go to a stock broker to invest on our behalf and outcomes were judged solely on returns.
In the 1960s and 1970s, the investment industry discovered it was able to measure a second axis. With the advent of modern portfolio theory, we came to understand that there was volatility which could be measured which was inherent in achieving those returns. We pretended we could forecast it, and risk became the second axis. Now many generations later, no self respecting professional investor would ignore volatility in making an investment decision. In fact, we have become obsessed with it, almost as if it’s the fulfilment of our craft.
So, is that where it ends?
Is the entirety of the purpose of investment management encapsulated in getting as far to the top left of that neat two dimensional chart?
Where does our role as an intermediary fit?
An allocator shifting capital from savers to borrowers or businesses. Determining, as part of a supreme collective, what deals live or die, where profits are to be made and how the users of capital should behave.
All the while, contributing towards externality after externality, both positive and negative.
There is, in fact, a third axis. But we are only just starting to become aware, and we are certainly a long way away from being able to measure it.
The third axis is impact.
Glenn Stevens put it neatly – “For finance is not, for the community, an end in itself. It is a means to an end. Ultimately it is about mobilising and allocating resources and managing risk. Finance matters. Its conduct can make a massive difference to economic development and to ordinary lives – for good or ill.”
“There is, in fact, a third axis. But we are only just starting to become aware, and we are certainly a long way away from being able to measure it.
The third axis is impact.”
Maybe, the third axis doesn’t matter.
Maybe if we just allocate to the most profitable enterprises and leave them be – as specialists in what they do – the world will continue to become a better place.
Except for two things….
1) Firstly, time horizons and incentives are not aligned.
In terms of time horizons, as we know, the big things that really matter move more slowly than the impact of short term financial returns.
And in terms of incentives, given the opaque industry of agents within financial services, with its specialised expertise and discretion to act on behalf of others, unless it recognises a bigger purpose, it has considerable opportunity to act in ways that are not in the interests of the outside world that it is there to serve. I no longer think this is a controversial statement.
Yet, the externalities generated by allocating capital are real. Markets generate economic value, and there is little that can match their ability to allocate goods and services and encourage innovation and technological improvement. The allocation of capital impacts employment, infrastructure, productivity, taxation and, of course, our society and our environment more broadly.
I suspect, as I’m sure many of you do, that the impact of these externalities far outweigh anything else and are much bigger than we generally realise. Like an iceberg. What we don’t’ see because we can’t measure it, in all likelihood dwarfs our simple view of the world.
Of course, a proper market and effective competition, like Adam Smith envisaged, requires companies to bear their real costs and not leverage asymmetries of information and power.
And fortunately, as each day turns into the next, and time horizons evolve from one to another, externality after externality gets priced in. We can see consumer behaviour shifting as we speak.
2) Secondly, the size of the financial system – its volume – is too significant in our small world, and so the responsibility becomes too real.
Over $7 trillion turns over in capital markets globally every single day. That’s equivalent to about 10% of annual global GDP.
The financial services sector comprises between 15 and 20% of the global economy, and has doubled over the last fifty years.
The Willis Towers Watson Pension Fund Survey puts the total capital controlled by asset owners and fund managers globally as $131 trillion, equivalent to almost twice the annual production of our entire world.
The financial system controls the assets of the world.
Whether you’re more interested in the Gospel of Luke – “from everyone who has been given much, much will be demanded” or simply Uncle Ben from Spiderman, “with great power comes great responsibility” – it is impossible not to recognise the immense responsibility that comes with power of allocating such vast volumes of capital in the world.
The world into which we retire will in no small part be a function of how we invest. Those who invest for short term profits and ignore the impact of their allocations of capital are not creating real value.
I’m reminded of a famous sermon by John Wesley in the nineteenth century:
“And it is our bounden duty to do this: We ought to gain all we can gain, without buying gold too dear, without paying more for it than it is worth. But this it is certain we ought not to do; we ought not to gain money at the expense of life.”
Altogether, this is about the third axis, the third dimension. Perhaps not the fulfilment, but a step towards a greater understanding of investment decision making. Our challenge is to improve measurement in the third dimension, to make it real for all agents and to institutionalise it in the way that modern portfolio theory changed our profession.
Now, it is debt that brings us together today –
ESG was all about the equity gang, partying, as they do down at the bottom of the capital structure, blindly holding on to their ‘first loss’ pieces of paper.
In the ecosystem of sustainable investment, equities investing is like the showy spring flowers: – flashes of newsworthy colour, high profile divestment announcements and all the drama of activism and only seasonal proxy voting.
Yet the reality is that most of the equities action is taking place in secondary markets – at least a step removed from the processes that direct funds to the real economy.
Debt, of course, is far more cool.
– the proportion of new issues to debt traded in secondary markets dwarfs that of equities
– the need for borrowers / issuers to come back to the market regularly (this is the exception in equities, not the rule)
– and, of course, debt’s depth of penetration into economies. At any moment, it creates exposure to many more segments, asset sizes (right down to microfinance) and organisational structures.
It is uniquely placed to meet the vast challenges we face in the 21st century, because our very model of sustainable development– the one the world has agreed on in the form of Sustainable Development Goals – focus on issues that are more frequently handled by the entities that issue debt rather than equity – banks, governments, corporates of course, but also many unlisted assets and enterprises.
The annual SDG financing gap in developing countries is estimated at approximately USD 2.5 trillion, and although this seems huge, it constitutes only 3% of GDP, 14% of global annual savings, or 1.1% of the value of global capital markets.
There is a role for all of us to play to galvanise debt markets to fulfil the challenge, opportunity and responsibility of investing. Whether we are Issuers, Arrangers, Fund Managers, Asset Owners or Ratings Agencies.
Or Private Investors, themselves.
I’m here to ask you to come with us, a fund manager, on this journey
– to be mindful of externalities and seek out investments that create positive outcomes
– and to continue to call for more accountability and for more transparency.
“There is a role for all of us to play to galvanise debt markets to fulfil the challenge, opportunity and responsibility of investing. Whether we are Issuers, Arrangers, Fund Managers, Asset Owners or Ratings Agencies.”
For us, at Pendal, it reinforces what we believe is the critical importance of active management. We see our role as stewards of capital – generating returns while being mindful of externalities, and holding issuers and management to account.
This is something that passive or algorithmic strategies simply cannot do.
Active managers bring a unique analytical discipline to the task of sifting the value from the noise and being able to identify debt instruments that contribute to the solutions.
One part of it is very much about understanding the fundamentals of the contract – there’s good evidence, at least on the equities side, that focussing on the sustainability issues that intersect with business fundamentals can deliver meaningful alpha.
And furthermore, demand based on these fundamentals will impact the cost of capital over time and ensure markets do their thing, with the right information.
But we need to go further than returns, even over the medium to longer term.
We need to understand how efficient capital allocation gets the non-financial environment and social outcomes we need. It boils down to a commitment to – at least considering – ‘what needs funding?’ in the mix of questions about what assets we seek out as we build a portfolio.
And this can provide some counterintuitive results for those who hear ‘sustainability’ and think ‘ethical screening’ – but it can prompt a rich dialogue with clients as well as issuers. For instance
– It might be more sustainable to finance a company with a high CO2 emissions profile so that it can invest in new technology that lowers those emissions.
– It might be more ethical to fund a bank that needs to invest in changes to its systems, governance structures and its people, rather than to divest at just the time they need support to make changes.
– Controversially, it might be better to invest in a tobacco company and push them through engagement to cease their cynical marketing to young people in the developing world.
Thinking about ‘what needs funding’ is most relevant when it comes to ‘impact’ investments – many of which are green bonds or social impact bonds.
The role for asset managers in this space is significant. There are thousands upon thousands of genuinely useful, sustainable activities and enterprises out there that need funding and these are of such great interest to our clients, that it’s fair to say that demand for quality offerings exceeds what we would describe as investment-grade supply.
One of the most important things we can do is to educate the market on what ‘good’ looks like. We just released a paper on gender bonds with our Responsible Investment Research boutique – Regnan, which took a look at what next generation gender bonds could look like, based on would be attractive to our funds and clients.
And of course, there is a critical role for us to play in demanding greater transparency and improved measurement. As we have invested in more and more green and social bonds, we note the market has some way to come. There is a parallel in terms of corporate sustainability reporting (lots of push back, slow up take and difficulty in sourcing information). We recognise it’s an evolution – the first step is the hardest – but with guidance, ‘leader transparency’ and experience this steep learning curve should flatten out over time. There is already plenty of evidence that better corporate sustainability reporting tends to be ‘rewarded’ over time.
“The role for asset managers in this space is significant. There are thousands upon thousands of genuinely useful, sustainable activities and enterprises out there that need funding and these are of such great interest to our clients, that it’s fair to say that demand for quality offerings exceeds what we would describe as investment-grade supply.”
The recent Climate Bonds Initiative’s report into post-Issuance reporting practices globally in the green bond market found that, of the 367 issuers in the CBI research universe only 53% provided impact reports. Interestingly, these CBI findings are in line with our own analysis across our holdings of Australian Green Bond issuers.
Impact reporting aims to provide insights into the environmental or social benefits of Green, Climate, Social or Sustainability bond financing. Best practice is evolving to incorporating the quality of the E or S outcomes that are part of the underlying projects as part of the security selection process. We need this to improve over time.
Ladies and gentlemen,
Investors and allocators of capital are, in no small way, the architects of our future. All of us here are at the drawing board. We have the unique power that comes with a privileged position in our society. Please, let us act together to create the future that we want.
Because the future is worth investing in.