There has always been something special about the start of a new year. Whether a list is about the satisfaction of a past year well done or the regret of wishing you had achieved more, putting it into print always brings about a renewed sense of purpose and focus.
Russian psychologist Bluma Zeigarnik describes our tendency to have nagging thoughts about unfinished tasks; research shows that making a list of these things can help free us from anxiety. So what is your investment to-do list for 2018? We have come to the end of another eventful year: elections in Germany and Japan, historic US tax reform, central banks worldwide shifting to tighter monetary policy and the meteoric rise in cryptocurrencies, to name a few highlights. A cursory review of literature reveals broad general agreement on the future: the road ahead is more challenging. This provides an unsettling backdrop for even the most optimistic of investors. To ease our collective consciousness, we at the Thinking Ahead Institute have created our own list of five topics investors should think about in 2018.
Sustainability and long-horizon investing
The Future Fund and Willis Towers Watson 2017 Asset Owner Study
highlighted that while sustainability is an important emergent subject for leading asset owners, opportunities were being missed in the overlapping areas of sustainability, ESG, stewardship and long-horizon investing. Investors have to combine two drivers to build a successful sustainable strategy – investment beliefs and an understanding of their wider sustainability motives. Clear beliefs, policies and practices are critical to managing sustainability risks and thinking about long-horizon investing. Best-practice models fully implement financial and other factors into portfolios while reconciling wider stakeholders and time horizons. We continue to see the pace of adoption quickening for better sustainability practices. Investors need to up their game or get left behind. The old paradigm of investors managing risk and return is increasingly being augmented by a third consideration that analyses the real-world impacts of the portfolio, through the lens of the UN’s sustainable development goals. The prize for investors? A stronger social licence to operate, growing trust and the expectation of better long-term, risk-adjusted returns.
Building a robust risk-management framework
While the VIX volatility index is at historic lows (indeed, markets seem no longer surprised by the unexpected), the SKEW index suggests that investors are becoming increasingly concerned about low-probability, high-impact events (tail risk). Following a multi-decade shift towards the political centre in developed markets, the global financial crisis has reversed that trend and investors are likely to face heightened political uncertainty for some time. Over 2018, we face elections in Russia, Italy, Mexico and Brazil, the October EU deadline for the EU/UK agreement on the Brexit deal, proxy wars between major oil suppliers, Saudi Arabia and Iran, and increasingly tense jousting between the US and North Korea. These localised risks have the potential to morph into high-impact systemic risks. The US approach on free trade and China’s aim to deleverage its economy are further potential disruptors.
A robust risk-management framework is key in this changing landscape. Building a deep understanding of scenarios, extreme risks and the investment ecosystem, being adaptable and employing coping mechanisms (such as tail-risk hedging strategies) are vital to survival.
Biases in investment decision-making are more numerous and deeply embedded than investors readily recognise. The subject of diversity is attracting attention at all levels of society, with a particular emphasis on gender, age and background diversity. The merits of diversity and inclusion in an organisational culture follow, in part, from the values of fairness and integrity pursued by leading employers. But diversity also helps reduce groupthink and it has now become generally accepted that improved diversity has value. Several funds have already started putting such rhetoric into practice.
At the Thinking Ahead Institute, we have also sought to understand the benefits of cognitive diversity for the performance of teams. The research we have considered has thrown off some practical ideas along the way: Work hard on equalising the verbal and non-verbal contributions of everybody in the room, and let the task’s context guide the composition of the team. So how diverse is your investment board?
Human decision-making has its limitations. To reduce biases, investors need to make their decisions through a combination of human input (we refer to this as ‘social technology’) and systems/support (we refer to this as ‘physical technology’). Recent research by the Thinking Ahead Institute on The Asset Owner of Tomorrow notes that the slow speed of change in social technologies, such as committees, is being overtaken by the fast speed of change in physical technologies, such as automation. Achieving balance and efficiency in relation to these will require considerable effort and skill in the coming years. There are a number of new applications of technology that support better decision-making, notably new platforms, new asset allocation processes, artificial intelligence applications, Blockchain applications and machine learning. We are also beginning to see an overall shift from products to platforms, and from traditional core institutions to crowdsourced versions. While the need for human judgement remains critical due to the complexity of data, leading investors must upgrade their technology to be competitive.
Purpose and culture
The CFA study Future State of the Investment Profession, describes the scenario of purposeful capitalism, in which the investment industry raises its game with more professional, ethical, and client-centric organisations. While the ongoing debate on the role of the investment industry is unlikely to be settled in 2018, there is growing consensus that, as the CFA states, “The fundamental purpose of finance is to contribute to society through increases in societal wealth and wellbeing.” David Pitt-Watson and Hari Mann note in their recent paper, “A productive finance industry is one that fulfils its purpose effectively and efficiently, bringing benefits to all its customers and supporting economic growth.”
Purpose, trust and value are all connected. We believe the financial services industry will thrive only if end users have trust in the system and obtain fair and sustainable results from the services and actions of its agents. There is an increasing need for ‘T-shaped’ investment professionals (that is, those with both breadth and depth), who are machine friendly, adaptable, and have the technical skills to navigate the industry’s complexities. Additionally, investment organisations are increasingly differentiating themselves by referencing their values and culture. Culture is inextricably linked to (1) the purpose and drive of the organisation, particularly in its passion for serving and (2) the people ethos – how the team is treated and behaves. Asset owners should attend, first and foremost, to their own culture. Collaborating with organisations whose culture and values are aligned should also become an important part of an organisation’s cultural plan.
So that’s our list for the new year. We believe a focus on these topics will serve you well in 2018.