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Myth: ESG portfolios underperform

Gone are the days when ESG was considered a niche approach to portfolio management, restricted to tree-hugging, barefoot investors passionate enough about the impact of their investments that they would be willing to sacrifice strong returns.

ESG has opened up to the masses and as heart-warming as it would be to solely put this down to a moral and ethical shift in society, if the returns were not hitting the mark, we would not have seen the steady increase in ESG demand that has occurred in the last 15 years (see below graph).

It is a common misconception that ESG portfolios underperform. In 2019, investment research firm Morning Star surveyed the performance of 745 Europe-based sustainable funds and concluded that the majority of ESG strategies performed better than traditional funds over one, three, five and ten years.

Looking at seven categories of ESG funds, in the ten years leading up to 2019, the Morning Star study revealed that not only did a greater number of sustainable funds survive than their traditional counterparts (72% vs. 45.9%), but over the decade, nearly 59% of the surviving sustainable funds outperformed their non-ESG counterpart.

Capital’s ethical portfolio, Fusion ESG, is an actively managed portfolio consisting entirely of ESG funds with a focus of positive impact strategies and resource sustainability. As illustrated below, Fusion ESG has a near 10-year track record of performance that compares well with the ARC Balanced PCI benchmark.

Myth: Sustainable investing is based on exclusion strategies

Exclusion strategies use predetermined criteria to decide which stocks should be excluded from an ESG portfolio. Within these strategies, stocks are screened out because of the negative impact of their business activities on the planet and society. This is a method that has been used for decades but remains largely subjective; there is no algorithm for determining whether a stock is inherently ethical.

For a more objective approach, as part of their equity research, some investment managers (Capital International included) give a numerical ESG rating based on analysis of corporate activities from an ESG perspective.

This approach helps to put a quantitative process in place to establish a view on whether an asset meets the manager’s criteria or whether the asset should be excluded from a portfolio with an ESG mandate. The method however is still prone to qualitative judgement calls.

Inclusion strategies on the other hand select stocks based on their positive impact. As we can see from the below diagram, this approach is much rarer than negative screening; it has however become more common in recent years.

We have also seen an emergence of ‘best in class’ selection which, while often grouped with positive screening, is in fact quite different. A best-in-class asset describes the top ESG performer within a given sector. This however does not necessarily mean that the stock is a positive impact stock; it could simply be the best of a bad bunch.

With investment managers employing such a range of stock selection strategies, investors can easily be misled when looking into ESG options. Asking the right questions and gaining a good understanding of your chosen provider’s strategy is therefore key in ensuring the impact of the portfolio meets your expectations.

Source: https://responsible-investors.com/2019/04/09/global-sustainable-investments-reached-30tn-in-2018/

Myth: ESG can only be applied to equities

Whilst the majority of ESG strategies consist of equities, as illustrated above, ESG bonds have existed for a long time and the market is growing.

In 2019, 479 green bonds were issued globally, representing a 25% year-on-year increase. This momentum did not slow in 2020 with a record of $50 billion in green bonds issued in September alone.

Green bonds have existed from as early as 2007, with one of the earliest examples established by the World Bank the following year. This particular fund supports projects that mitigate climate change or help people affected by its consequences. Since its inception, the World Bank has issued more than 13 billion USD in green bonds through more than 150 transactions in 20 currencies.

In more recent times, Agence France Trésor (the body which manages government treasury in France) launched its first green sovereign bond. Created in 2017, its initial issuance volume totalled seven billion euros. Following suit, UK Chancellor, Rishi Sunak, announced earlier this month that Britain will issue its first ever green government bond in 2021, after seeing an increased demand for fixed income investment opportunities that support environmentally friendly initiatives.

Myth: Sustainable investing is just a trend

There has been a steady growth in ESG demand over the last 10 years which can largely be attributed to an increased awareness of ethical issues. Both individuals and governments have woken up to the state of the planet and are finally taking action to minimise their impact.

This shift in attitude in society and government is mirrored in investor behaviour. A survey conducted by private bank Brown Brothers Harriman (BBH) found that in the next five years, almost a fifth of ETF investors intend to have between 21% and 50% of their portfolio invested in ESG funds.

It is not just an attitude change that is seeing ESG interest soar. The frameworks around ethical investing are developing quickly and companies currently managing to conceal a few nasty, non-ESG truths will soon be left with nowhere to hide.

Earlier this year, the WEF published a white paper on ESG which highlighted 21 core metrics and 34 expanded metrics for measuring ESG impact. The paper was compiled with input from the big four accountancy firms as well as more than 140 global business leaders. This development is potentially transformative for investors. As investment managers begin to adopt the metrics as part of their ESG screening processes, companies seeking investment will be compelled to disclose the true impact of their business activities or face being starved of capital. This shift could see even the old industrial giants change their ways in a bid to avoid being forced out of the market.

Are you interested in ethical investing? Click here to find out more.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

Last week the severity of the UK’s economic situation was spelt out by the Chancellor of the Exchequer, Rishi Sunak, in his Spending Review.

The Spending Review is a periodic assessment outlining public expenditure priorities and the government’s plans to finance these. Usually, they are given over a five-year period. However, the present lack of visibility means this one was only for the next twelve months.

The outlook was not pretty, although the delivery by the suave Sunak was as polished as one would expect.

Quentin Letts in The Times described the experience as follows: ‘Sunak speeches are warm, relaxed, a bubble bath with Schubert on the wireless. There is something aromatherapeutic about the voice with its honeyed inflections. He started his statement at 12.45pm but soon one was feeling drowsy. Which was perhaps as he intended when it came to the two trickier moments: the pay freeze for civil servants, and the overseas aid haircut.’

Some of the figures alluded to were astounding, even mind-boggling, though we already had a vague idea of the scale. The budget deficit this year will be £390bn, or 19% of GDP, about double the deficit in 2008 after the financial crisis.

The UK economy will fall by -11% in 2020/21. The debt to GDP ratio is expected to be 104% - in other words the amount of debt will be bigger than the size of the economy. Under the optimistic scenario this could be 94%, but under the pessimistic scenario – with lockdowns persisting and no swift rollout of the vaccines – this could be as high as 124%.

The budget deficit is still likely to be £100bn per annum in 2024/5, or double the deficit in the previous 2019/20 fiscal year. To reduce this to £50bn per annum (the amount that debt can rise on an annual basis without the debt to GDP ratio increasing), tax rises or spending cuts of £48bn a year will be needed.

Nothing was said about tax rises or spending cuts at this stage, and thankfully they aren’t immediately necessary.

But there was some bad news in the public sector pay freeze, and the cutting of foreign aid from 0.7% of GDP per annum to 0.5%. Also, some £10bn also seems to have been lopped from departmental spending plans.

Despite positive news on defence and infrastructure spending, overall it looks like the first signs of another period of austerity appearing.

Tucked away in the small print was a change to the Retail Price Index (RPI), the old method for calculating inflation, that will be of interest to investors.

The plan is to change the main inflation index to CPIH, or the Consumer Price Index adjusted for Housing, that includes owner occupiers' housing costs.

The RPI measure has tended to be 0.8% per annum higher than the CPIH measure over time, mainly because the former is an arithmetic rather than a geometric calculation. RPI is used for calculating student loan interest, pensions, benefits and the interest on index linked Gilts, so the change will affect many people.

In future, owners of index linked Gilts will get increased interest and redemption values calculated on the lower CPIH measure. However, the Chancellor will only introduce the change from 2030, or ten years from now. There had been fears that the change could be introduced as early as 2025, so there was a degree of relief.

What is changing is the methodology. There will still be something called RPI, but from 2030 it will use the methodology of CPIH, and from that date both measures will in effect be the same, rather than RPI being higher each year.

It seems that for index linked Gilts maturing up to that date there was something in the small print restricting any change to the methodology of calculation. Nevertheless, the change means there may be Court litigation on the part of linker owners ahead.

The DMO, or Debt Management Office, has said it will continue selling RPI linked debt in future, so as to avoid a splintered market where some of the index linked debt is tagged to RPI, and some to CPIH.

Index linked debt was first sold in the early 1980s after the inflation splurge of the 1970s, and now comprises about a quarter of total UK government debt.

Doubts about the future calculation of RPI have seen sales of linkers drop to just 6.8% of total debt sales this year, compared with an average of 22% over the previous 20 years.

Whether the new-found clarity, and slightly lower long term returns in prospect, result in continued diminution of appetite for linkers remains to be seen.

But one would have thought that they will continue to prove a useful hedge against unexpected inflation for many people – even after 2030.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

There could only really be one subject for this week’s column.

At the time of writing on Friday it looks almost certain that Senator Joe Biden will become the 46th President of the United States, taking the office for the Democratic Party.

While the situation, widely expected, looked uncertain on election night, the impact of subsequent postal voting (the Democrat support tended to use absentee mail ballots rather than voting in person) has swung it round in Biden's favour.

Key ‘rust belt’ states, including Wisconsin and Michigan, returned to the Democrat fold, while Arizona, which has been Republican for over 70 years, turned ‘Blue’.

At the time of writing, it looks as if Georgia, Pennsylvania, and Nevada will also go Biden’s way.

President Trump will in all likelihood be litigating in several states, but while there may be the odd recount, this is unlikely to change the final result. The position may be unclear for a few weeks, but it is likely that when the Electoral College votes on December 14th it will be for Biden.

The real story is that the ‘Blue Wave’ failed to occur, and that the swing to the Democrats, and away from the Republicans, did not materialise.

The Republicans look as if they will hold on to the Senate, while the Democrat majority in the lower house, or House of Representatives, is actually reduced rather than increased as expected.

The Democrat lead as predicted by the polls looks to be massively overstated. Going into the election, even as recently as Monday, the lead nationwide was supposed to be well into double digits. In reality, Joe Biden has polled 2-4% more of the popular vote than President Trump.

The upshot is that, where we might have been talking about what a ‘post-Trump’ world would look like, the new world may not be so different from the old one. And it is certainly conceivable that Trump could run again in 2024, when he would be about the same age that Biden is at present.

Normally, at this point in the cycle, the outgoing President is referred to as a ‘lame duck’, on the basis that he has little time, and little opportunity, to achieve much in the way of policy.

However, at present it seems appropriate to wonder if Joe Biden will be a ‘lame duck’ President over the next four years.

It seems highly unlikely, at this stage, that he will have the votes or support to put through any of his campaign objectives, from $2 trillion in Green infrastructure spending, to increasing the minimum wage, to ‘packing’ the Supreme Court, to adding on extra states like Puerto Rico or the District of Colombia, to increasing corporate taxes back to previous levels, or to taking away the Senate powers of ‘filibuster’.

He will likely have to resort to ‘executive orders’, whereby the President can bypass Congress in the implementation of policy, as Obama and Trump did. He may even have to include some Republicans in his Cabinet, which would not go down well with the left wing of the Democratic Party.

So from a stock market point of view, there are clear advantages in the stalemate, or gridlock, which has resulted. Stalemate was the condition of the latter years of the Obama administration, and the second two years of Trump’s presidency, all of which saw the stock market performing well. This may be the case again.

At the same time, Joe Biden’s more conciliatory stance towards China, NATO and Europe, and more ‘internationalist’ approach to politics will go down well in global diplomatic circles.

In the short term, a Biden Presidency may not be great from a UK perspective, with the UK’s chances of getting a free trade deal with the US better under Trump than Biden. However, the outlook over this may improve with time.

The US stock market is up 7.5% over the past week. There were fears that a delayed result could result in a stock market rout, but the opposite has been the case thus far.

As we saw at the 2016 election, worst fears realised don’t always result in the movements in stocks anticipated.

From an investor’s point of view, the situation looks reasonably positive at present.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

Stock markets have continued to perform well in the third quarter, with the MSCI World index up 3.5% in Sterling terms and more in US Dollar terms.

However, this was led by the US market where the S&P 500 index rose a further 8%, and Sterling investors have to some extent missed out on this, given the poor performance of the UK market (-5%).

The panic of March seems long past. Bear markets tend to be drawn out affairs, lasting typically 6 to 9 months, but the last two have been remarkably short. The COVID crash was about a month in length, from February 20 to March 23, while the last bear market before that – in the final quarter of 2018 – was about three months in duration.

Could this be a sign of things that the authorities now step in with stimulus much earlier than previously, aware of the potential knock on effects that an evaporation of confidence in financial markets has on the real economy? Perhaps… Who knows?

But it is certainly the case that, after the initial shock and horror of March, markets have acclimatised to the threat of Coronavirus. They have adjusted to the notion that the response of the authorities is from now on more likely to be in terms of local lockdowns, rather than a full national lockdown.

The infection rate has increased, but hospital admissions are on average some way below the Spring, while death rates are still significantly below (130 per day at the time of writing, versus 1,000 back in April).

In Donald Rumsfeld’s terminology, the risk of COVID has gone from being an ‘unknown unknown’ to being an ‘known unknown’ (we know that cases will increase, but just don’t know the extent or duration).

While the recovery has been strong, it is worth considering whether it can be built on further in the fourth quarter.

We identified five risks recently when projecting possible Q4 performance. One of these is obviously COVID. It is unlikely we will have a vaccine before the end of next year at the earliest. So in the meantime it is still a case of mitigation, test and tracing, and in certain circumstances local lockdowns to prevent the virus developing into a national problem once again.

The next risk is stimulus – or the potential withdrawal of it. The very generous furlough scheme could not go on for ever. Its replacement will go some way to preventing a huge spike in unemployment, but it is inevitable that the jobs market now adjusts to a new world. But unemployment will go up and there will be hardship, which could cause consumer weakness over the winter, and it is still not clear where new vacancies will evolve to take up the slack.

In the US, too, there is a hiatus on stimulus, with the Republicans and Democrats unable to agree on a consensus. However, it is likely that in the next month or two a more limited replacement to the April stimulus package will be forthcoming.

Our next risk is Brexit (that never ending saga – will it ever go away?). We have already passed Boris’s self-imposed deadline of October 15th, when he said he would walk away from the talks if nothing was agreed. It is likely that negotiations can continue through to early November before the two parties need to go off and prepare for a ‘No Trade Deal’ scenario. Our base case is still that a ‘skinny deal’, which may not cover fishing and the level playing field issues, can be agreed, and that it is in everyone’s interests to do so. We can’t see the matter being delayed further into next year, although, if one has learned anything from Brexit, it is, ‘Never Say Never.’

The next risk, perhaps the most prominent at present, is the US election. We would go with the opinion polls, given the recent widening in Joe Biden’s lead. Four years ago Hilary Clinton was 5% ahead in the polls and lost, but the 10% lead Biden currently has seems too big a gulf for Trump to cross. It would also negate the risk of an indecisive poll in which Trump potentially refused to move, which some have postulated.

The Democrats have, historically, provided a favourable background for stock market performance, and this is likely to be the case again, with Biden a relatively moderate character. Though there would be winners and losers, energy is likely to be among the latter, with renewable infrastructure a winner, while the Democrats have also talked of moving against the tech giants.

However, the Democrats are likely to provide more stimulus, and this could be crucial next year when the initial effects of the first round have worn off and unemployment is potentially climbing towards 8 or 9%.

Our last risk was US and global trade and diplomatic tensions with China. With the head of the UK’s MI5 saying recently that China is likely to be the biggest threat to the UK in the future, this may be the risk that has the longest lasting ramifications.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

After working for various companies across Europe and the Middle East, Ryk Becker’s current role has brought him full circle with a return to his home nation of South Africa. As Executive General Manager, Ryk has been leading the Group’s operations in both our Cape Town and Johannesburg offices since April.

Due to travel restrictions, Ryk only arrived in South Africa earlier this month after five months of managing the team remotely from his home in the south of England. Now that Ryk has had time to settle in and finally meet his colleagues face to face, let’s find out a little more about the new addition to our South Africa team.  

Where did you grow up?

I was born in Kroonstad, but we moved to Harrismith when I was about 2 years old. Harrismith is a border town between the Free state and Kwa-Zulu Natal. The town lies on the banks of the Wilge river and at the foothills of Platberg which forms part of the Drakensberg range. I spent my entire childhood here quite carefree, playing lots of sport and spending lots of time in the surrounding areas camping with my friends.

Where has your career taken you so far?

My early financial career started in South Africa. I left South Africa in 2000 after an opportunity became available with ABN Amro Bank in the Netherlands. It was too good to turn down at the time and I never looked back. From there I moved on to opportunities in Dubai (UAE) and Doha (Qatar) for 7 years, followed by a long period working for Lloyds in various roles which took me to the Channel Islands (Jersey & Guernsey), the Isle of Man, London and Frankfurt. My role at Capital brings me full circle back to South Africa.

What attracted you to Capital?

I was lucky enough to spend 4 years back in South Africa (2010-2013) working as Country Manager for Lloyds Banking Group, a role I enjoyed very much. Over the years I have kept my eyes open for any similar opportunities i.e. a foreign entity with operations in South Africa looking to grow and expand.

When I saw the position at Capital, it immediately took me back years. The prospect excited me, as there were so many similarities to my previous role. That in itself was just part of the initial attraction. When I started talking to Greg and Anthony, having worked for a very large financial institution like Lloyds, it was refreshing to see how passionate they were about what had grown from a family business to a now very well recognised international business with very ambitious plans. I decided I wanted to become part of that journey. Building and growing a business is what I always loved doing. It didn’t take too much convincing. Meeting the team in IOM gave me a really good feeling about the business. Then of course there was having dinner with Peter Long.  As one of the founders of the business, seeing his continued interest and passion as a NED was the deal-maker.

Did you always envisage a career in finance? What did you want to be when you were younger?

No – I never liked maths at school perhaps because in those days in South Africa, I quite often stood in the queue for “6 of the best” for not knowing something.

My passion was nature conservation, so I went on to study Zoology and Botany, followed by a few years working on various game reserves (I specialised in the relocation of rhinos). Nature conservation is a calling and earning a good salary was difficult at the time. I returned to university to study Hotel Management but ended up liking Finance so much that I just continued to major in that.

Tell us about your family...

I have been married to Deana (Dee) since 2003. We met whilst we both worked in Dubai and got married in Mauritius. We have 2 daughters, Saba (16) and Darcy (14). Dee and the girls previously spent 4 years in Cape Town whilst I worked for Lloyds Banking group, so are very familiar with South Africa. As a family we all love food, nature, travel and holidays. As a consequence there is always some cooking or baking going on in the house and we always like to have a holiday planned. Our favourite destinations Greece (Naxos), Italy (Umbria) and South Africa (Cape Town).

What have your first few months at Capital been like?  

Well, for one, it wasn’t the most traditional start to any new job. Before I was to start on 6th April in South Africa, their borders closed due to COVID-19, and I had to work remotely from the UK for five months, which brings its own challenges.

Capital use the latest technology so although I wasn’t present in South Africa, I connected everyday with the team via video. I’m lucky to have a very engaging team who accepted that this was just the way it had to be for a while. Because we were all working remotely, being in the UK didn’t make much of a difference. The one thing I missed out on though was buying them a drink in person!

My initial reflections are:

• I have a fantastic team on the ground with a huge amount of knowledge and drive.

• We have very good relationships with our existing customer base that we can build off.

• We can scale the business, as the opportunities remain fantastic in South Africa

What do you do to relax in your free time?

I used to play a lot of sport, but these days if I want to get away from it all, I go running or cycling. I lived in a wonderful part of the UK in the New Forest where I was fortunate to have both forest and coastal areas nearby. I liked to go down to some of the beaches on the English South coast and spend a day with Dee and girls relaxing. I normally sit on the beach as I don’t like the cold water, whilst they go for some refreshing dips in the sea. I also love reading - no specific genre just anything and everything.

What’s your favourite place to visit?

South Africa’s Kruger Park will always be a favourite of mine, but I also love the Greek Islands and Italy. The people, the scenery, the food – it’s just wonderful. I also enjoy spending time in the Maldives which we visited as much as we could when we lived in the Middle East.

What are your aims for the first year at Capital?

Very straightforward – I need to analyse the opportunities to contribute to our next 3-year strategic plan; steady the business following COVID-19; accelerate the growth in SA and Africa by identifying new institutions/entities in search of a quality offshore partner; and continue to support the local team with the various challenges they have.

What was your first record?

The BeeGees and CC Catch

In your opinion, what are the qualities leaders should possess?

• Inspirational vision

• Leading, guiding and protecting his/her team

• Make time to listen, act and support without fail

• Confidence

Post-COVID-19, what do you think the future of office work will look like?  

I think there will be a strong drive to have more flexible working arrangements in place, which will cater for a better work life balance; however, we need to counter that with a focus on maintaining the Capital culture. I think we will find a halfway house of sorts.

Three people dead or alive to invite to a dinner party – who would you choose? And what’s your signature dish?

Sir David Attenborough, Elon Musk and Ernie Els. I’d be barbecuing fillet steak and corn on the cob which I’d serve with various salads.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

With plans to study Economics at Lancaster University, A-Level Student, Rory Donegan, recently spent a week in our Douglas office working with our Investment team. He now tells us more about his experience:

I recently undertook a week of work experience at Capital International in the Isle of Man. During the time I spent in the company’s Douglas office, I worked predominantly with the investment department, helping them to analyse the potential of some British utility holdings.  

I have just finished my A-Levels at Ballakermeen but didn’t sit any exams this year because of the pandemic. Regardless, my two years studying Politics, Economics and Business Studies in sixth form proved very useful during my week with the investment team. We spent a lot of time working through stock market data and comparing the financial records of the companies that I was asked to make a verdict on.  

The team gave me access to the Bloomberg terminals (which I was already familiar with) and an introduction to the Thompson Reuters (now Refinitiv) databases to help me with my decision-making. On day three, I was tasked with presenting my research and financial analysis to the Investment Management team who seemed to find it useful. Before coming to Capital, I didn’t have any real expectations; I was just looking for an insight into how investment management teams coordinate, even when their main responsibilities are split between commodities, funds and direct equity. It was a very interesting week, and I am grateful to Capital for allowing me to join them. On the last day, I spent time in the dealing room where I learnt how trade requests from clients are processed. This seemed to be a very fast-paced environment, and it was interesting to see how this side of the business works.  

Overall I learnt a great deal, not only about how to analyse an industry’s equity performance and compare potential holdings within the sector, but also how to present my findings and work as part of a team. The investment team were very enthusiastic about what they do and were very kind to me during my time with them.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

I recently read The Black Swan by Nassim Nicholas Taleb. The book focuses on extreme and rare outlier events (both positive and negative) and the tendency to find simplistic explanations for these events.

One of the ideas I was particularly drawn to was the concept of Medocristan and Extremistan, fictional countries distinguished by non-scalability vs. scalability. In Medocristan nothing is scalable; everything is constrained by boundaries. For example, the salary of a doctor is constrained by hours worked, and the weight and height of individuals are constrained by biological factors. This results in a place which is thin-tailed where even the most extreme outcomes will not significantly affect the mean, and all outcomes can be explained by a bell graph or a normal distribution. In Extremistan, royalties from a song, book or an individual’s wealth, for example, are not constrained by boundaries. These distributions are scalable, will be much harder to analyse and will not fit into any standard models. The increased possibility of an event occurring outside the normal distribution is much greater and one of these events could change the properties of the distribution itself. These events are what Nassim Taleb refers to as “black swan events”.

The Link between Wealth Distribution and Stock Returns

Just like in Extremistan, wealth in society has significant concentration in the right tail, where the likes of Jeff Bezos and other members of the billionaire club sit. One might conclude that a causal relationship should be found between this and individual stock returns, simply because a large proportion of the world’s wealthiest 1% or even 0.1% probably made their money through ownership of companies which they helped to create or transformed in some way.

After doing some research, it turns out the distribution in stock returns is possibly even more concentrated than wealth in society. Professor Hendrik Bessembinder wrote a paper on this phenomenon in which he highlighted that the majority of stocks do not exceed the returns of short-dated treasury bills. When first read, this statement sounds absurd. It is common knowledge that over long periods of time the stock market has outperformed treasuries and most other asset classes. However, he highlights the skewness or concentration of returns in the best performing stocks is particularly large.

Professor Bessembinder’s paper looked at the total wealth creation from the US stock market from 1926 to 2015. He found that out of the 26,000 stocks that appeared in the CRSP database*, about 86 of the top performing stocks (less than 1% of the total amount) accounted for over half of the wealth creation. He also found that just 4% of stocks (the top 1000 names) accounted for all the wealth creation.

Large returns from a few stocks essentially offset the modest and negative returns from the majority. In some ways the results are unsurprising, with only very few companies in existence for the 90 years between 1926 to 2015, and the median stock only being listed for 7 years, insufficient time to build up significant compound returns.

* The Center for Research in Security Prices is a provider of historical stock market data

Does trimming your winners make sense?

The paper also found that more than half of stocks have negative lifetime returns; leading me to believe that trimming exceptional companies might not be the best idea.

Investment managers will often trim holdings they feel have run or they believe are trading at higher multiples than when they originally took the position. They will usually recycle these into stocks at lower valuations and stocks which are “out of favour” with other investors.

Knowing that only very few stocks return a meaningful amount, does this approach make any sense? The idea behind this is that a stock mean reverts around a fair value and by recycling into stocks the manager deems undervalued, this should improve the performance and possibly the risk management of the portfolio.

Whilst this sounds like criticism of investment managers, I am merely pointing out that for one investment manager to be selling what they deem to be an overvalued stock, another must be buying this “overvalued” stock believing it to be “undervalued”.

I am also not against active stock pickers. In fact, for passive indexes (investment strategy that tracks a market-weighted index) to perform well, it is essential that excellent index agnostic investment managers exist. It has been shown that high active share leads to a higher variance in outcomes for investors. This is usually skewed to the downside, but newer studies have shown investment managers who have high active share and low turnover tend to perform better over long periods of time.

Source: The search for outperformance: Evaluating ‘active share’ Vanguard Research

Another study by Cremers and Pareek found that among high active share portfolios, those which have substantially different holdings from their benchmark only outperformed if they had low turnover. Investment managers who had holding periods of over two years on average outperformed by over 2% per year.

It was also concluded that funds with high turnover generally underperformed. Among patient investment managers, those with low active share or “closet indexers” underperformed even with long holding periods. The reason behind this might be explained by not only lower trading costs but by benefiting from mispriced securities, which only normalise over a long period of time. In summary, markets provide opportunities for long-term active investors.

Does the statement from Bessembinder hold true in other markets and over shorter time frames?

Bessembinder’s study was over an excessively long period of time. Most investors are unlikely to have a 90-year time horizon, but by reducing this to a more modest period, would the findings still hold true? Reducing the time horizon will in turn reduce the variance seen in the underlying equities. It’s likely that many of the top performing equities of each decade might not be able to reinvent themselves to reach the age of 90, so a slightly different approach might be needed to capture decade winners in portfolios.

To examine this, we can look at total return and the contribution to returns of the FTSE 100.  While the results weren’t as extreme as Bessembinder’s, they were still very telling of how a few equities delivered most of the market performance.

Source: FTSE100

Between 30th June 2010 and 30th June 2020, 175 equities had delivered a total return of 84% for the FTSE 100. The top 10 equities delivered over 50% of those returns, with the top 30 holdings delivering over 90% of those returns. Investors who didn’t hold the top 30 contributors and held only the other 145 equities did far worse than the market, receiving 7.81% or 0.76% annualised over the 10-year period. These stocks also underperformed Gilts* which delivered 15.75% or 1.47% annualised over 10-years.

Although the results weren’t as extreme as Bessembinder’s 90-year study, they do highlight that his original statement holds true. The majority of equities even over a 10-year period underperform Gilts. This leads me to believe that it is not only lower transaction costs which help low-turnover, high active share managers outperform but stock selection something which is backed up further by the facts around active share.  

*As a proxy for Gilt returns, I used the FTSE Actuaries UK Conventional Gilt up to 5 Years Index.

Source: FTSE100

Given only a small number of equities heavily influence returns, how do we make sure we have exposure to these equities?

It is paramount as investment managers and allocators that we try and find the minority of companies which deliver all the returns: the positive black swans. I believe these companies exhibit certain characteristics which, if sort out through analysis, gives investment managers a greater chance of owning them, allowing them to deliver abnormal returns. This, when coupled with unconstrained index agnostic global investing, should increase the chances of outperformance. The four main characteristics I believe these companies exhibit is the potential to grow revenue and earnings multiple fold over the long term, scalable business models, economic moats and exceptional management teams. These stocks should also be purchased at entry prices which significantly undervalue the long-term opportunity for their businesses.  

Sources

Bessembinder, H., 2017. Do Stocks Outperform Treasury Bills?. SSRN Electronic Journal,.

Cremers, M. and Pareek, A., 2014. Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently. SSRN Electronic Journal,.

Taleb, N. and Chandler, D., 2007. The Black Swan. Prince Frederick, MD: Recorded Books.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

How long does it take to produce a vaccine?

10 to 15 years is the average development time for any new vaccine. Inoculation against COVID-19 could however be possible as early as January 2021, just one year after the initial outbreak.

There is a set process of research and testing that any vaccine must go through before it is approved for use on the general population. The initial research and development stage is often the easier part; it’s getting through the painstaking three-phased clinical trials that proves difficult. With each phase usually taking around two years to complete, the race to release a Coronavirus vaccine has seen companies progress at record speeds, passing through multiple phases in the space of a few months.

Who’s in the running?

Currently, there are 6 vaccines in the third and final stage of testing, including one from the UK (AstraZeneca); three vaccines from China (two from Sinopharm and one from Sinovac Biotech); and two from the US (Pfizer and Moderna).

The common belief seems to be that whichever company ends up winning the vaccine race will see profits soar overnight, with investors making their way to Monaco on their mega-yachts. The race, however, is unlikely to conclude in this way and investors should act with caution.

Backing a winner

All the wishful thinking in the world won’t change the fact that vaccine development is difficult, and failure highly likely.

A pharmaceutical firm may think they have found the answer, but the numerous stages of rigorous testing that follow could send research teams back to the drawing board at any point.

Not even the experts know who to back. There are too many variables and unpredictable aspects which make investment at this stage risky. It might seem like there’s a clear front-runner, but even the odds-on favourite can fall at the final hurdle, by which point a firm will have spent millions on research but have absolutely nothing to show for it. This type of scenario could prove very damaging to a contender’s share price, with investors seeing a sharp drop in value.

Vaccines are expensive and not necessarily profitable

The costs associated with developing and mass-producing a vaccine are huge, and recouping those costs can be difficult. Investors shouldn’t expect an immediate win if their vaccine of choice is the first approved. It will take a while to recover the cost of development, and manufacturing capacity may prove problematic. It may also happen that the race is won, but a second, more effective and much cheaper vaccine is approved soon after, resulting in only short-lived glory for the first vaccine over the line.

Another possibility is that no profit is made by vaccine developers. In a deal with Europe’s Inclusive Vaccine Alliance, AstraZeneca, for example, have committed to delivering 400 million doses at no profit, with other companies making similar promises.

Inflated and fluctuating prices

Currently sitting amongst investment app Robinhood’s 100 most-traded stocks are Moderna Therapeutics (NASDAQ:MRNA) and Inovio Pharmaceuticals (NASDAQ:INO.

While the two American firms have proven popular with investors, neither have any approved products on the market and their inconsistent financial track records are certainly nothing to write home about. Earnings for both firms have in fact diminished over time with Moderna’s trailing 12-month revenues down by over 40% for the past three years and Inovio’s down by over 90%.

Speculation seems to be driving price movements at the moment. American firm Novavax for example has never before managed to develop an effective vaccine, yet their share price has seen a 3,161% increase since January this year. Similarly, after reports of side-effects during a clinical trial, Moderna’s share price fell by almost 11% in just one day.

To invest on a whim or a slight glimmer of hope is a huge gamble, yet investors seem to be ignoring prior financial performance and paying astronomical prices that may not properly reflect a company’s true worth.

The pharmaceutical businesses that remain in the running sit both simultaneously on the precipice of innovation and failure, with only time telling who will win the vaccine race.

Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.