After hitting “rock bottom” following global shutdowns related to the coronavirus in March 2020, the S&P 500 has roared ever since delivering a 100% return. You read that right: 100%.
SIDEBAR: Someone out there is highlighting this past 18 month window in their investing masterclass, illustrating that in times of financial crisis, the best action for your portfolio is inaction. Don’t sell. Be patient. Ride it out. But we digress…
After living through the shortest bear market in history, we’re now witnessing company valuations being pushed to new heights only surpassed by the dot-com bubble of the late 1990s. While this may sound unsettling, also consider that with interest rates so low, it would be equally worrying if equities weren’t expensive (reason: low interest rate yields push investors to equities).
So, at this juncture and with cash to invest, should you a) lean towards low interest fixed income that’s not (or barely) keeping up with inflation, or b) buy potentially overvalued equities? Pick your poison.
From our vantage point, choosing low interest debt or expensive equities is not an either/or proposition – everything comes back to diversification. Instead of chasing returns, we prefer the approach of aligning portfolio decisions to your unique life: your upcoming cash needs (and/or life transitions), your tax bracket, and your tolerance + ability to take risk.
“The price for dealing with the pandemic today comes at the cost of tomorrow’s returns in many conventional asset markets.”
Not exactly a glass half-full outlook for the road ahead.
The biggest challenges outlined by the report included:
Whether governments/business can rise to the climate challenge
Increased sovereign debt balances and an expectation for fiscal stimulus to continue
Stagnating globalization, companies shortening their supply chains
Era of US “exceptionalism” possibly coming to an end, leading to a weaker dollar
While we certainly believe that all challenges present opportunities, we feel equally strong that investors should prepare for muted annual returns over the next decade. We touched on this topic not long ago.
According to the same JP Morgan LTCMA report, over the next 10-15 years, inflation is anticipated to flatten at an overall rate of 2.0%. This is a tough pill to swallow when the same report projects compound return rates for the same period to be 1.10% for cash, 1.50% for intermediate Treasuries, and 2.50% for US investment grade corporate bonds.
For equities, the LTCMA report outlined the following predictions for the next 10-15 year investment time horizon:
4.10% for US Large Cap
4.60% for US Small Cap
6.20% for US Value
6.50% for US REITS
5.20% for Euro equities
6.10% for UK equities
5.10% for Japanese equities
6.80% for emerging market equity
Compare these expected returns to the 10% average annual return that the stock market has delivered over the last century. Not ideal.
Instead of guessing which asset class will perform best, or searching for the next Amazon to invest in, legendary investor and founder of Vanguard, John Bogle (who’s 3-fund “boring” portfolio outperformed the largest endowments in 2020, yet again), said it best:
“Don’t look for the needle in the haystack. Just buy the haystack.”
As evidence-based investors, we wholeheartedly agree with this approach.
A personal contact shared a story with us regarding their friend who recently fell victim to an online gift card scam.
The friend received an email from “Target” and was prompted to provide certain information to “verify their gift cards.” Unfortunately, the friend fell for the scam and within a few days had money withdrawn directly from their bank account. The impacted individual is now in the process of working with their bank to recover the stolen funds.
The State of Fraud
Scamming shows no signs of letting up. In its most recent report from the Internet Crime Complaint Center, the FBI saw the largest number of complaints, and the highest dollar losses, since the center was established 20 years ago. According to the FBI, the costliest scams involved business email compromise, romance or confidence fraud, and mimicking the account of a person or vendor known to the victim to gather personal or financial information.
How to avoid
Beware of suspicious email address and fake invoices/attachments: Fraudsters are masters of deception. It’s not uncommon for them to send emails from addresses that might look familiar to you but which contain one spelling difference, or end in .net instead of .com. Never open links or attachments from email addresses that are unfamiliar. Additionally, if you receive a link or attachment that you weren’t expecting from what appears to be recognizable/legitimate email address, it never hurts to send a quick call or text to the sender to confirm.
Ignore scammers pretending to be from the government: Most of us have probably received one of these phone calls. Someone reaches out on a phone call claiming to be from the IRS. In some cases, most recently, the caller will claim you are eligible for an “additional stimulus check.” In others, they’ll say you owe money and will warn that non-payment will result in legal recourse and penalties. Take note: the IRS will never make first contact via a phone call or request payment details for money-owed over the phone. If you receive a call, simply hang up the phone. The same goes for calls from the Social Security Administration and other government organizations.
Be aware of the Social Security scam: Also done via phone call, the caller says your Social Security number has been linked to a crime involving drugs and/or sending money out of the country illegally. They inform you that your Social Security number is blocked and that by simply confirming your SSN and paying a small fee, it can be reactivated. Again: Hang up! The Social Security Administration will never call you on the phone and ask for your Social Security number.
Scammers will tell you how to pay: All successful scams entail coercing the victim to part with sensitive information or to pay the scammer. Scammers may insist that you pay by sending money through a money transfer company. Others may suggest putting money on a gift card and then giving them the number on the back. Some will send you a check (that will later turn out to be fake), tell you to deposit it, and then send them money.
Don’t fall for online pop-up warnings: Tech support scammers may try to lure you with a pop-up window that appears on your computer screen. It might look like an error message from your operating system or antivirus software. It may also use logos from trusted companies or websites. The message in the window warns of a security issue on your computer and directs you to call a phone number to get help. Simply ignore. If you are unsure of whether the message was legitimate, you can use your antivirus software to run a scan or contact the soliciting organization directly.
What to do if you are scammed
Anyone can fall victim to these scams. If you have paid someone, call your bank, money transfer app, or credit card company and see if they can reverse the charges. The Federal Reserve Board notes that if you report the fraud within two business days, liability is limited to $50. If you report it after that, you could face liability of up to $500, and if you report it after the 60-day window, subsequent fraudulent charges can wipe out your account entirely.
Whether online or via phone, stay vigilant. Avoid clicking on suspicious links, and never give out personal information to a stranger over the phone. For online accounts, steer away from using short passwords which can be easily hacked by password cracker software. Instead, use strong passwords that are at least 12 digits long and contain numbers, letters, special characters, and a mix of lowercase and uppercase letters.
If you know someone who has been impacted, Identitytheft.gov is a great resource for mapping out a recovery plan.
The topic of inflation is getting lots of attention these days.
Inflation, for starters, is defined as the decline in purchasing power of a given currency. So, as an example, if the US Dollar experienced 2% inflation over a given period, the purchasing of $1 gets reduced to $0.98. Because a dollar is worth less, you must spend more to fill your gas tank, buy a gallon of milk, get a haircut etc. In other words, inflation increases your cost of living.
Is inflation good or bad?
Inflation can be a tricky economic indicator: If it is too high, it erases the purchasing power of consumers; if it is too low, it can reduce economic growth. Inflation can also be bad for stock markets as it often leads to higher interest rates, meaning big firms have to pay more to service their debts which can then erode their earnings.
What is causing inflation now?
Over the past 10 years inflation has basically held steady, averaging a bit under 2%. However, over the past year, inflation has increased at a rate of 5%, well above the ten-year average. While it is easy to point the finger at the Federal stimulus plans that pumped money back into the economy as the world came to a halt, the real cause of inflation seems to be a bit more nuanced.
Members of the Federal Reserve, along with a chorus of economists, argue that most of the inflation we are experiencing now can be attributed to bottlenecks in a variety of supply chains as demand surges with a reopening economy.
Translation: Consumers have cash to burn and suppliers are struggling to meet demand! The overwhelming majority of recent inflation is derived from spikes in industries that were hammered by the pandemic. Demand has skyrocketed in a few notable areas: raw materials, energy, metals, food, used automobiles, appliances, and travel.
Where does inflation go from here?
Whether inflation is transitory (i.e. brief, short-lived) or not is a common question being asked. If employment reports start to outpace analyst estimates, or, if inflation gets too high, the Federal Reserve may pull back on their $120B monthly bond purchases and eventually raise interest rates.
At their June meeting, the Fed moved up their targeted interest rates increase from 2024 to sometime in 2023. There are some members of the Federal Open Market Committee (FOMC) that believe the U.S. should start raising rates as early as 2022.
What’s it mean for you?
There is a possibility, not a certainty, that inflation may impact the everyday investor. Even if inflation moderates, as the Fed anticipates, it is still expected to run at almost 2.5% over the next five years, resulting in a negative inflation-adjusted return on Treasuries. With all that said, though, the economy is an incredibly complex and unpredictable system.
Should you be concerned? For those in, or nearing, retirement who live on a fixed income, any reduction in purchasing power can be unsettling. While there is no way to truly “inflation-proof” your portfolio, there are strategies that can lessen the blow:
Maintain a globally diversified portfolio!
Hold a portion of fixed income in Treasury Inflation-Protected Securities (TIPS)
Consider Real Estate Investment Trusts as a hedge against inflation and underperforming equities (rents and values tend to increase when prices do)
Avoid fixed income assets that have long durations (5+ years)
Prioritize fixed rate debt > adjustable rate debt, and/or consider converting adjustable rate debt to fixed rate where practical.
Cryptocurrency has an identity crisis. Depending on who you ask, some view it as a security (like a stock), a commodity (like gold/oil), or a currency (like the US Dollar). Instead of adding to the semantics, we at wHealth Advisors take a more macro approach to crypto and view it simply as an “alternative asset.”
Besides cryptocurrency, some other examples of alternative assets are real estate investment trusts (REITs), art/collectibles, venture/angel/private equity investing, and commodities – to name a few.
Alternative assets can certainly have a place in the portfolio, however we always suggest minimizing personal expectations for investment returns. If you assume your alternative investment goes bust, how much does that hurt you (emotionally, financially etc.)? Does the loss impact your future goals, or is it just another blip on the radar? Similar to gambling, when it comes to alternative assets, only consider risking money that you are comfortable losing.
Depending on individual preferences/circumstances, an allocation of 0-10% of the overall portfolio to alternative assets can make sense. Additionally, and perhaps no surprise, but alternative assets are best suited for those with longer time horizons and/or higher tolerances for taking risk.
So, should cryptocurrencies such as Bitcoin be a part of your portfolio?
For starters, investing in crypto is incredibly speculative. As we have seen over the past few weeks, a single tweet by a person of influence can spark extreme volatility. When taking a step back, there’s an argument to be made that cryptocurrency – and really, blockchain technology as a whole – is in its infancy a la the internet in the 80s/90s.
In some ways this is promising: the space will evolve, new entrants will emerge (and thus create new opportunities), and transactions will become more and more cost/energy efficient.
On the other hand, the larger and more mainstream this technology and way of transacting becomes, the more scrutiny it will be under (by domestic regulatory agencies and sovereign nations alike).
Before investing in cryptocurrencies, it is important to begin with the basics:
Have an emergency fund that is funded with 3-6mths (or more!) of living expenses.
Pay off any high interest debt.
Invest at least 15% of your gross income towards your long-term future (utilizing diversified mutual funds & ETFs).
Invest in your human capital i.e. your skills/career.
If, after satisfying the basics, you are willing to take on higher levels of risk and believe cryptocurrencies may be the next big thing, consider asking yourself the following questions:
How much am I willing to risk (i.e. between 0-10% of overall portfolio)?
What’s my endgame? How long will I hold? Or, at what target price will I sell?
Do I have a rudimentary understanding of cryptocurrency and blockchain technology?
If the answer to the last question is no – begin there.
Between 1926-2020, the US stock market return was basically 10% per year.
While it’d be great to bank on 10% per year, it unfortunately does not work that way. For those that want consistency over the long haul, they will have to accept lower returns (think: CDs, bonds). For those that truly want higher returns over the long haul, they’ll have to accept more volatility (i.e. the stock market, other speculative investments). Either way, you can never fully escape risk.
Interestingly, though, is how infrequent annual US stock market returns actually fall within the long-term 10% average.
If we look at the calendar year returns +/- 2% from the 10% average (so 8% to 12%), this has happened in just five calendar years (1926-2020). So around 5% of all years since 1926 have seen what would be considered “average” returns. In fact, there have been just as many yearly returns above 40% as returns in the 8% to 12% range. Just 18% of returns have been between 5% to 15% in any given year.
The only way to truly take the randomness out of the stock market is to have a multi-decade time horizon. The best 30 year return was 13.6% per year from 1975-2004. And the worst 30 year return was 8.0% per year from 1929-1958.
What you can do about it:
It’s impossible to say if the next 30 years will be as kind to investors as the previous 30 were. For those that are still on the journey towards financial independence, it would be best to assume lower returns going forward. Instead of relying on continued 8-10%+ average annual returns (something beyond your control), personal savings and frugality are parts of the money equation that are more in your control and have a 100% chance of being as effective in the future as they are today.
As Morgan Housel, author of the “Psychology of Money” writes, “You can build wealth without a high income, but have no chance of building wealth without a high savings rates, it’s clear which one matters more.”
Over the past month nonfungible tokens, or NFTs, have been all over the news. Saturday Night Live even got involved.
What are they?
NFTs are cryptographic assets that are on the blockchain with unique identification codes and metadata that distinguish them from each other. Since they are unique, they cannot be traded or exchanged at equivalency, which differs from cryptocurrencies such as Bitcoin, which are identical to each other and therefore can be used in transactions (i.e. you can now buy a Tesla with Bitcoin).
Why buy an NFT?
People are spending millions of dollars on NFT collectibles including artwork, digital images, sports cards, GIFs, music, video games, and other forms of creative art. By purchasing an NFT, you have a secure certificate of ownership over a digital object. As a collector, you are hoping that the value of the purchased item increases in value. For those that still remember the non-blockchain days, think of NFTs as a modern form of purchasing and collecting baseball cards. You buy them for your personal enjoyment and they may/may not appreciate in value.
How to buy:
NFT’s can be bought on a variety of platforms, such as Nifty Gateway, Rarible, Open Sea, and The Sandbox. Each platform has an online gallery where you can browse, purchase, or bid on items in a similar fashion as an auction house. A purchase or winning bid is paid for with cryptocurrency. A digital wallet is necessary to store your purchase.
NFT’s are relatively new. The current market is largely speculative and as with all markets, prices will fluctuate. In the modern and digital world we live in, NFTs will be another option for artists, creatives, and others to monetize their work, for collectors to purchase direct with fewer intermediaries, and for brands to establish their presence in the growing metaverse. Some further reading:
2020 will be a year we will never forget. From a global pandemic and civil unrest, to an economic downfall that we continue to battle through today, it has been a challenging year that has impacted millions of individuals around the world. For investors, as we reflect on the past year, it’s critical we revisit some lessons learned to better ourselves moving forward. While it’s unlikely we’ll ever experience a year like 2020 again, many of the principles outlined below are timeless, and can serve as foundational reminders that are applicable every year.
Having an investment philosophy you can stick with is paramount
While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. By adhering to a well-thought out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.
Create an investment plan that aligns with your risk tolerance
You want to have a plan in place that gives you peace of mind regardless of the market conditions. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise.
Don’t try and time the market
The 2020 market downturn offers an example of how the cycle of fear and greed can drive an investor’s reactive decisions. Back in March, there was widespread agreement that COVID-19 would have a negative impact on the economy, but to what extent? Who would’ve guessed we would’ve experienced the fastest bear market in history in which it took just 16 trading days for the S&P 500 to close down 20% from a peak only to be followed by the best 50-day rally in history?
Stay disciplined through market highs and lows
Financial downturns are unpleasant for all market participants. When faced with short-term noise, it is easy to lose sight of the potential long-term benefits of staying invested. While no one has a crystal ball, adopting a long-term perspective can help change how investors view market volatility.
Focus on what you can control
To have a better investment experience, people should focus on the things they can control. It starts with creating an investment plan based on market principles, informed by financial science, and tailored to your specific needs and goals.
The year 2020 proved to be one of the most tumultuous in modern history, marked by a number of developments that were historically… wait for it… unprecedented. But the year also demonstrated the resilience of people, institutions, and financial markets.
The novel coronavirus was already in the news early in the year, and concerns grew as more countries began reporting their first cases of COVID-19. Infections multiplied around the world through February, and by early March, when the outbreak was labeled a pandemic, it was clear that the crisis would affect nearly every area of our lives. The spring would see a spike in cases and a global economic contraction as people stayed closer to home, and another surge of infections would come during the summer. Governments and central banks worked to cushion the blow, providing financial support for individuals and businesses and adjusting lending rates.
On top of the health crisis, there was widespread civil unrest over the summer in the US tied to policing and racial justice. In August, Americans increasingly focused on the US presidential race in this unusual year. Politicians, supporters, and voting officials wrestled with the challenges of a campaign that at times was conducted virtually and with an election in the fall that would include a heightened level of mail-in and early voting. In the end, the results of the election would be disputed well into December. As autumn turned to winter, 2020 would end with both troubling and hopeful news: yet another spike in COVID-19 cases, along with the first deliveries of vaccines in the US and elsewhere.
For investors, the year was characterized by sharp swings for stocks. March saw the S&P 500 Index’s1 decline reach 33.79% from the previous high as the pandemic worsened. This was followed by a rally in April, and stocks reached their previous highs by August. Ultimately, despite a sequence of epic events and continued concerns over the pandemic, global stock market returns in 2020 were above their historical norm. The US market finished the year in record territory and with an 18.40% annual return for the S&P 500 Index. Non-US developed markets, as measured by the MSCI World ex USA Index,2 returned 7.59%. Emerging markets, as measured by the MSCI Emerging Markets Index, returned 18.31% for the year.
EXHIBIT 1 – Highs and Lows
MSCI All Country World Index with selected headlines from 2020
As always, past performance is no guarantee of future results.
Fixed income markets mirrored the extremity of equity behavior, with nearly unprecedented dispersion in returns during the first half of 2020. For example, in the first quarter, US corporate bonds underperformed US Treasuries by more than 11%, the most negative quarterly return difference in data going back a half century. But they soon swapped places: the second quarter was the second-most positive one on record for corporates over Treasuries, with a 7.74% advantage.3 Large return deviations were also observed between US and non-US fixed income as well as between inflation-protected and nominal bonds.
Global yield curves finished the year generally lower than at the start. US Treasury yields, for example, fell across the board, with drops of more than 1% on the short and intermediate portions of the curve.4 The US Treasury curve ended relatively flat in the short-term segment but upwardly sloped from the intermediate- to long-term segment. For 2020, the Bloomberg Barclays Global Aggregate Bond Index5 returned 5.58%.
EXHIBIT 2 – Sharp Shifts
US Credit minus US Treasury: Quarterly Returns, March 1973–December 2020
Past performance is no guarantee of future results.
Uncertainty remains about the pandemic and the broad impact of the new vaccines, continued lockdowns, and social distancing. But the events of 2020 provided investors with many lessons, affirming that following a disciplined and broadly diversified investment approach is a reliable way to pursue long-term investment goals.
Market Prices Quickly Reflect New Information about the Future
The fluctuating markets in the spring and summer were also a lesson in how markets incorporate new information and changes in expectations. From its peak on February 19, 2020, the S&P 500 Index fell 33.79% in less than five weeks as the news headlines suggested more extreme outcomes from the pandemic. But the recovery would be swift as well. Market participants were watching for news that would provide insights into the pandemic and the economy, such as daily infection and mortality rates, effective therapeutic treatments, and the potential for vaccine development. As more information became available, the S&P 500 Index jumped 17.57% from its March 23 low in just three trading sessions, one of the fastest snapbacks on record. This period highlighted the vital role of data in setting market expectations and underscored how quickly prices adjust to new information.
One major theme of the year was the perceived disconnect between markets and the economy. How could the equity markets recover and reach new highs when the economic news remained so bleak? The market’s behavior suggests investors were looking past the short-term impact of the pandemic to assess the expected rebound of business activity and an eventual return to more-normal conditions. Seen through that lens, the rebound in share prices reflected a market that is always looking ahead, incorporating both current news and expectations of the future into stock prices.
Owning the Winners and Losers
The 2020 economy and market also underscored the importance of staying broadly diversified across companies and industries. The downturn in stocks impacted some segments of the market more than others in ways that were consistent with the impact of the COVID-19 pandemic on certain types of businesses or industries. For example, airline, hospitality, and retail industries tended to suffer disproportionately with people around the world staying at home, whereas companies in communications, online shopping, and technology emerged as relative winners during the crisis. However, predicting at the beginning of 2020 exactly how this might play out would likely have proved challenging.
In the end, the economic turmoil inflicted great hardship on some firms while creating economic and social conditions that provided growth opportunities for other companies. In any market, there will be winners and losers—and investors have historically been well served by owning a broad range of companies rather than trying to pick winners and losers.
Sticking with Your Plan
Many news reports rightly emphasized the unprecedented nature of the health crisis, the emergency financial actions, and other extraordinary events during 2020. The year saw many “firsts”—and subsequent years will undoubtedly usher in many more. Yet 2020’s outcomes remind us that a consistent investment approach is a reliable path regardless of the market events we encounter. Investors who made moves by reacting to the moment may have missed opportunities. In March, spooked investors fled the stock and bond markets, as money-market funds experienced net flows for the month totaling $684 billion. Then, over the six-month period from April 1 to September 30, global equities and fixed income returned 29.54% and 3.16%, respectively. A move to cash in March may have been a costly decision for anxious investors.
EXHIBIT 3 – Cash Concerns + Global Equity Returns
Past performance is no guarantee of future results.
It was important for investors to avoid reacting to the dispersion in performance between asset classes, too, lest they miss out on turnarounds from early in the year to later. For example, small cap stocks on the whole fared better in the second half of the year than the first. The stark difference in performance between the first and second quarters across bond classes also drives home this point.
A Welcome Turn of the Calendar
Moving into 2021, many questions remain about the pandemic, new vaccines, business activity, changes in how people work and socialize, and the direction of global markets. Yet 2020’s economic and market tumult demonstrated that markets continue to function and that people can adapt to difficult circumstances. The year’s positive equity and fixed income returns remind that, with a solid investment approach and a commitment to staying the course, investors can focus on building long-term wealth, even in challenging times.
3US corporate bonds represented by the Bloomberg Barclays US Credit Bond Index. US Treasuries represented by the Bloomberg Barclays US Treasury Bond Index. Bloomberg Barclays data provided by Bloomberg. Indices are not available for direct investment.
5Bloomberg Barclays data provided by Bloomberg. All rights reserved. Indices are not available for direct investment.
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The world is watching with concern the spread of the new coronavirus. The uncertainty is being felt around the globe, and it is unsettling on a human level as well as from the perspective of how markets respond.
At wHealth Advisors, we accept the fundamental principle that markets are designed to handle uncertainty, processing information in real-time as it becomes available. We’ve witnessed this volatility over the past 3-4 weeks. Such declines can be distressing to any investor, but they are also a demonstration that the market is functioning as we would expect.
Market declines can occur when investors are forced to reassess expectations for the future. The expansion of the outbreak is causing worry among governments, companies, and individuals about the impact on the global economy. As an example, last month Apple announced that it expected revenue to take a hit from problems making and selling products in China. Airlines are preparing for the toll it will take on travel. Local businesses are worrying how their bottom lines will be impacted from preventive measures such as self-quarantines and social distancing. From the largest companies in the world down to our corner coffee shops, these are just a few examples of how the impact of the coronavirus is being assessed.
The market is clearly responding to new information as it becomes known, but the market is pricing in unknowns, too. As risk increases during a time of heightened uncertainty, so do the returns investors demand for bearing that risk, which pushes prices lower. Our investing approach is based on the principle that prices are set to deliver positive future expected returns for holding risky assets.
We can’t tell you when things will turn or by how much, but our expectation is that bearing today’s risk will be compensated with positive expected returns. That’s been a lesson of past health crises, such as the Ebola and swine-flu outbreaks earlier this century, and of market disruptions, such as the global financial crisis of 2008–2009. Additionally, history has shown no reliable way to identify a market peak or bottom. These beliefs argue against making market moves based on fear or speculation, even as difficult and traumatic events transpire.
When it comes to managing your portfolio, it’s prudent to develop (and stick with!) a long-term plan than can be maintained in a variety of conditions. For our clients, we consider a wide range of possible outcomes, both good and bad, when helping to establish an asset allocation and plan. Those preparations include the possibility, even the inevitability, of a downturn. Amid the anxiety that accompanies developments surrounding the coronavirus, decades of financial science and long-term investing principles remain a strong guide.
We send our best to you and yours. Wash your hands, avoid touching your eyes/nose/mouth, and, as always, feel free to contact us at email@example.com.
As financial planners that adhere to an evidence-based investment philosophy, we at wHealth Advisors use historical stock market data to infer a potential range of future outcomes. With reliable data only going back to the mid-1920s, trying to predict future market performance based on these “historical” figures is a fool’s errand. Instead, we like to work with our clients to focus on the things that they can control:
Reducing the cost of asset management and investment expenses
Minimizing tax liabilities by proactive tax planning
Aligning stock market exposure to tolerance/ability to take risk
Ignoring market noise and sticking to the plan
An evidence-based climate scientist, on the other hand, relies on data that goes back roughly 11,500 years to the Paleolithic Ice Age – a more robust sample study, to say the least. So, let’s get right to the point of this blog: Climate change is real and it is going to impact the long-term performance of our global markets (and thus, our portfolios) in unpredictable ways. This is factual science, not a controversial position. For starters, look to PG&E, the California utility company that filed for bankruptcy this January after facing $30 billion in fire liabilities after its power lines sparked what became California’s deadliest wildfire yet last fall. Besides utility companies, climate change will inevitably impact business in nearly all industries – agriculture, insurance, and energy to name a few. All industries operate within a global ecosystem and any climate event that results in a negative outcome (regardless of region or industry) will have negative downstream effects to our financial markets.
In an effort to stay abreast of these potential impacts from an investment (and humanity) standpoint, I attended four events as part of Climate Week 2019 in NYC:
NYC Climate Strike (marched with my wife, son, and mother)
Climate Finance & Investment Summit hosted by the London Stock Exchange
2019 Annual Climate Week Briefing hosted by Moody’s Investor Services
Quantifying Climate Risk hosted by S&P Global
What the world’s largest asset managers are doing:
Of the many speakers I had the pleasure to listen to, Hiro Mizuno, the Chief Investment Officer of the Government Pension Investment Fund (GPIF) of Japan, shared some of the most thought-provoking insights. As the CIO of GPIF, Hiro manages the single largest sovereign pension fund in the world. In a room full of big fish that included the NY State Comptroller (oversees NY State pension, 3rd largest in US, $210B) and Investment Director for CalSTRS (CA state pension, 2nd largest in US, $238B) – Hiro was the whale (manages over $1.5 TRILLION – approximately 1% of all assets in the world).
What makes Hiro’s insights so valuable is that, unlike a typical investor whose long-term outlook spans roughly 15-30 years, GPIF’s long-term outlook extends somewhere between 50-100 years. To Hiro, climate change is not some abstract thing, it’s a very real threat to the world (and thus, the world economy) and it requires action across all of society and industry today. Given GPIF’s size and time horizon, the fund is in a unique position to change the world. One way that it attempts to do this is by rewarding companies for behavior that it deems good for the world economy over the long-term while penalizing behavior that is bad. In theory, and in oversimplified terms, this rewarding/penalizing is done by overweighting (i.e. investing more) in the companies doing good and underweighting (i.e. investing less) in the companies that need to do better.
In order to judge whether a company is doing good or needs to do better, they are first compared to the other companies within the sector they operate. If the sector is energy, for example, we might compare Exxon, Shell, and BP. Companies are then compared to each other based on their Environmental, Social, and Governance (“ESG”) conduct. Breaking these three ESG legs down further:
Environmental: Considers a company’s greenhouse gas emissions, their waste and pollution outputs, and their water and land use.
Social: Considers workforce diversity, workplace safety standards, customer engagement, and community impact.
Governance: Considers company structure, transparency, and disclosure reporting.
When deciding which companies to reward/penalize, GPIF and other asset managers would consider factors that are common across all industries while also including factors that are unique to the sector. In this example, some of these factors would include the energy company’s greenhouse gas emissions, their investments in renewable energy and carbon capture technology, and their level of transparency/disclosure. In a perfect world, Exxon, Shell, and BP could be compared apples to apples and rewarded/penalized commensurate with their efforts. For example, if Exxon was doing the most to limit greenhouse gases, if it invested the most in renewables/carbon capture, and if it disclosed these metrics with reasonable transparency, they might receive a larger investment from GPIF. Inversely, if BP was the environmental laggard of the energy industry, GPIF could reduce their investment exposure on the basis that BP is not being a good environmental steward which is bad for the world economy over the long-term.
According to Hiro and the other keynote speakers and panel participants, the biggest wrench that prevents this process from working as intended is the lack of transparency and disclosure by public companies (specifically, public companies in the US). The Securities and Exchange Commission (“SEC”) currently limits mandatory disclosure to issues that materially impact shareholders/investors. Unfortunately, the SEC does not deem the ESG metrics as having any “material” impact (despite a petition from $5 trillion worth of institutional investors that do deem ESG factors as having a “material” impact). Unlike the US, two dozen other countries require this type of mandatory reporting and seven stock exchanges already require ESG disclosure as a listing requirement.
Long story short: If a company is not measuring or reporting their greenhouse gas emissions, and the SEC does not mandate this reporting as part of shareholder disclosure, GPIF and other asset managers have little to no ability to factor ESG measures into their overweighting/underweighting analysis.
While there is much promise that modern finance can play a role in the fight against climate change, the current bureaucratic roadblocks make this an uphill battle. Withdrawal from the Paris Climate Agreement and the repeal of the Clean Power Plan make it clear that the current political environment does not favor enhanced ESG disclosure. According to S&P Global, only 15% of public companies have acceptable ESG reporting disclosures while 37% have taken NO action to disclose. Asset managers have since lowered the bar and are now rewarding companies simply on the basis of whether or not the company disclosed any ESG details/disclosures.
What this means for you, the individual investor
With the rising popularity of ESG-focused mutual funds and ETFs targeted towards individual investors, there are options to invest in funds that underweight greenhouse gas intensive industries (i.e. energy/utility companies) in favor of less environmentally offensive industries. However, similar to the dilemma faced by Hiro and GPIF, a lack of mandatory ESG disclosure means that these ESG-focused funds are being designed without any uniformly reported data (remember, 37% of companies don’t even report on ESG!).
There is also the question of subjectivity. What about companies with poor track records that are trying to improve? Take Dow Chemical Company, they (and acquired company, Dupont) have committed environmental travesties but recently pledged $1 billion to “nature-enhancing” projects between now and 2025. Does Dow belong in an ESG fund*? Given the chemical industry’s lack of transparency and disclosure, how does an ESG fund determine whether to overweight or underweight Dow vs. its competitors? Combine these subjectivity concerns with the fact that a) ESG mutual funds typically cost more than comparable index funds and b) many are still new and have a limited performance history – the decision to invest in ESG is complicated.
In order for the financial industry, and Chief Investment Officers such as Hiro, to have an impact on climate change, reporting requirements need to include ESG metrics. At this moment in time, even as a staunch environmentalist, I do not view an individual’s portfolio as an effective tool to combating climate change. My hope is that with increased ESG reporting standards that this will change. For now, and like the recommendations we provide to our clients, let’s focus on what we can control.
The most effective ways individuals can mitigate their carbon emissions (listed in order of impact**):
Have one fewer child (pound for pound the most environmentally impactful decision an individual can make. NOTE: Prince Harry and Meghan Markle recently committed to having just two children for this very reason.)
Live car-free (unrealistic for many, so consider hybrid/EV when purchasing a new vehicle)
Avoid airplane travel (also unrealistic for many, consider purchasing carbon offsets to minimize carbon footprint from air travel through social enterprise firms such as Terrapass)
Eat a plant-based diet (bonus: this is also linked to improved health and longevity)
In a time where many of us feel overwhelmed or disheartened about the risks ahead, I consider myself rationally optimistic. With risk comes opportunity. Capitalism, whatever your opinion on it, has afforded us a standard of living beyond what our ancestors could have ever imagined. By combining capitalistic forces with sound environmental policy (i.e. policy that is rooted in science!) I am confident that we can (and will) pivot to a more environmentally and financially sustainable future. The onus begins with each and every one of us – so ditch the car, go for a walk with your intentionally small family, and eat some veggies!
Hope that you enjoyed and thanks for taking the time to read! Please feel free to contact our team at firstname.lastname@example.org.
*Dow Chemical Company is included in the Dimensional US Sustainability Core Fund (DFSIX).
** Seth Wynes and Kimberly A Nicholas 2017 Environ. Res. Lett. 12 074024