Originally published on WealthManagement.com http://wealthmanagement.com/viewpoints/portfolio-management-must-stop-being-traditionally-conservative-and-start-being-existen-0
By Garvin Jabusch
Traditional asset management spends a lot of time worrying about traditional macroeconomic indicators. Slowing Chinese growth. Eurozone GDP. The latest gyrations in the price of gold. In the short term, these things can and do cause market volatility. Yet history has shown over and again that these and their like present short- to medium-term risks only, and are merely the outcomes of current events. Far more interesting and also potentially dangerous are the longer-term risks embedded deep within the global economy: the causes of events, sometimes known as systemic risks. Earth’s big risks are now visibly real, and we should be reinventing investment management to address them.
We’ve reached the point in history where it’s obvious that no investment portfolio should contain the causes of our greatest systemic risks — climate change and resource scarcity — ever again.
By extension, if the aggregate activities of a company aren’t providing solutions or adaptations to those threats, its securities should be considered risky assets. As investor Jeremy Grantham put it, “life is too short to focus on anything but the biggest threats to our well-being.” Exactly. If a company is not providing a systemic solution, there is no place for its stock in any of my portfolios. Borrowing from biologist E.O. Wilson, I’ve dubbed this approach to investment management the “existentially conservative” one. This is a key differentiator because, as in medicine, the incremental improvement from treating a symptom is small, but the improvement from curing a disease is transformative. Likewise, investing in the symptoms of our global economic system may create incremental value, but investing in curing its greatest ills will be transformative. In full awareness of where the business-as-usual economy has led and is leading us, we can now see that it is past time to change the basic defaults of how to invest and for all investment portfolios to become fully existentially conservative — meaning, simply, that we need to invest to give ourselves the best chance of existing and thriving indefinitely.
This is not related to investing in a way that is politically or ideologically conservative. The American brand of ideological conservatism is driving our civilization, the global economy and the rest of life past the edge of our long-term ability to endure, much less thrive. Unfortunately, traditional portfolio construction methods have a lot more in common with political conservatism than they do with the epistemologically observable world of existential conservatism. If you look at existentially conservative “Next Economics” next to, for example, Sen. James Inhofe’s brand of “burn it all” conservatism, you will see that one thesis is authentically conservative via the definition of the word, and that the other is dangerously and recklessly ideological. American political conservatism today, given its gleeful rejection of science and knowledge just when we need them most, is closer to nihilism than it is to objective reality.
Whether current economic and portfolio models recognize it or not, we are entirely dependent on our underlying ecological, meteorological and geological systems. Simple logic, as indicated by our best scientific findings and guidance, dictates decoupling economic growth from environmental degradation. I firmly hold that we now must ignore the structures and methodologies of the incumbent economy and go straight to modeling an economy that is increasingly efficient and productive while simultaneously becoming less extractive and damaging to our underlying resource and life-support systems. This economy is where future value will be created on a large scale. The way to get there is to imagine many of our most threatening problems solved and to model what the economy that solved them might look like. Then, we must build and invest in portfolios reflecting that economy, the “Next Economy,” and both nurture it and profit from it as it grows. This is in contrast to what most funds do now: They reflect the economy that is today, or worse, the economy that was. We can no longer afford to practice traditional portfolio theory or attempt to reflect benchmarks like the S&P 500. We need to create portfolios that will look like the highly productive, far more sustainable economy of 5 and 10 years hence, capturing alpha along the way as its representative companies grow and gain market share from their legacy economy predecessors.
Currently, most investment managers start with a list of stocks from a benchmark (their “opportunity set”) and use financial and/or other criteria to seek performance with lower risk relative to that benchmark (their “efficient frontier”). Then, if managing a “responsible” fund (ESG, SRI or impact, etc.), they may make additional modifications based on what they like or disagree with by using various “screens.” These methods are effective ways to slice and dice the incumbent economy, but are inadequate because they don’t look beyond today for solutions. They largely just look at which stocks the last 20–50 years have been good. If you recall the last 20–50 years, people were mostly unconcerned about the long-term viability of the planet’s systems to sustain those business practices, or the economy at large. In effect, modern portfolio theory has you start with a list of stocks (your desired benchmark, more or less) and end with a different list of stocks, but it is always fundamentally based on an incumbent economy list such as the S&P 500, MSCI ACWI, FTSE, or what have you. These portfolios thus can’t help but reflect the legacy, business-as-usual economy. It’s what they were designed to reflect, after all. And the problem is that the incumbent economy benchmarks are riddled with systemic risks coming from all sectors, most notably fossil fuels.
Given all we know now, is it not better to ask: Where are the problems? What companies are solving them with business models that work and are growing? How can we tell the difference between meaningful and non-meaningful progress? These are important questions, because answering them has the power to alleviate fears that investing in solutions is merely ideological and, therefore, may not always be in the best interests of investors. Only a cohesive thesis can distinguish between meaningful and non-meaningful progress, and that thesis has to contain within it a vision of what the de-risked economy looks like and how it works. Whether or not a legacy company’s carbon score (or whatever incremental metric you’re looking at) is improving a little bit is beside the point. If a tar sands oil extraction company can make it into the Dow Jones Sustainability Index, we have serious flaws in our criteria for sustainability. But that is what you get when you consider companies whose businesses are unable to distinguish symptoms from systemic disease. Eventually, the disease gets so bad it must be addressed, and the treatments for symptoms become irrelevant (as in bankrupt). This is the inherent risk in investing in the worst offenders of planetary systems’ degradation. To avoid this, we have to start by figuring out where the highly efficient, far less destructive analogs for every industry in the economy are, and which businesses are leading the way to those replacements, effectively and profitably.
Thus, if existential risks are investing risks, then existential solutions are investing opportunities. Where stocks have traded and how portfolio theory has worked historically is irrelevant because the world is changing under our feet and over our heads in ways we have never seen before. Next Economy investing has to be as existentially conservative as we can make it; it must intentionally redesign economics without regard to the inherited paradigm and build portfolios starting from scratch. It must do this with full recognition of the long list of existential risks. Indeed, avoiding key risks must define how we proceed. Risk-factor allocation must now replace sector allocation in every equity model.
It’s time to let go of twentieth-century scripture about how to invest. Today, we can ill afford to concern ourselves with the banal ephemera of a fund’s tracking error versus the S&P 500. Your portfolio has a small tracking error? Congratulations, you must also have a high correlation with fossil fuels, resource exploitation and all the other dangers driving us to resource systems’ brink.
Investment drives economic outcomes, and as long as most invested assets are still in the business-as-usual, incumbent economy, that’s the economy we will get, now and forever. We must dispense with traditional portfolio theory and its insistence that we stay chained to the benchmarks of that incumbent economy. It’s time to reinvent our own system that says, we can endure indefinitely, and here’s what that can look like. Let’s ignore the business-as-usual trap of applying old concepts about mandatory sector allocation. Instead, let’s intentionally design and invest in an economy that can endure, maybe indefinitely, without over-topping the earth’s capacities. Within the context of portfolio management, our job now is to learn from scientific findings in order to improve risk mitigation. We can (and do) debate which solutions work best or can be scaled most rapidly, but not whether there are problems or whether investment at a massive scale is required to address them. Those cases are closed. Anything less than existentially conservative portfolio management is tantamount to investing in, and voting for, collapse.
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