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Special Report

Impact investing


Investing is not a zero-sum game

The arms race among investors never stops. The rampant bull market of the past decade could already be a thing of the past and institutional investors are understandably nervous about the future. But even during bull markets, the question of how to generate returns is often replaced by another, arguably different, question of how to beat markets. 

The two questions are often used interchangeably by pension funds because they simply cannot rely on investing in risk-free assets to meet their objectives. At the same time, pension funds have a professional duty to apply the best practices in investment. 

For these reasons, pension funds depend on increasingly complex financial tools. Such tools, at the best of times, are created using robust financial economic theories.

While financial tools apparently grow in complexity, financial theory is still relatively simple. It is a social science that shares the same flaws of the other social sciences – for example, the difficulty of using experiments reliably. 

This tension produces a gap between theory and practice. Factor investing is a good example of this divide. In simplistic terms, proponents of factor investing tend to make two assumptions: that there are behavioural biases; and that these biases can be exploited to an investor’s advantage. The first assumption is clearly true, while evidence that the second is true is mixed. 

This is not to say there is no merit in using concepts such as factor investing or, more generally, risk management in investment. However, it is striking that all of these concepts are based on a vision of investment as a zero-sum game. The idea is that to meet their objectives, investors have to beat other investors. 

Does that vision represent reality? Pension funds may find that they will only deliver their results if they become good at doing something that, at least in principle, is simple. That is, investing in good businesses that are creating growth and prosperity. That is what investing should be about. Of course, it could be argued that identifying those businesses is exceptionally difficult. But rather than focusing on beating the market, investors should focus on contributing to value creation.

That is why there is perhaps more merit in long-term investing in public and private equity. This approach is often best encapsulated in concentrated equity portfolios with a long-term horizon. These portfolios are based on a deep analysis of each constituent. Analytical tools should be qualitative as well as quantitative and go beyond the simple economics of making and selling things for profit.

Readers' comments (1)

  • Investors, and in this case pension fund managers, have different reasons for wanting to beat other investors or to “beat the market” including a need to make up for a shortfall in their portfolio’s results, to boost their egos or even to justify and even make up for the cost of paying internal or external managers to handle their investment portfolios. If the argument here is that ultimately there is no need to try to outperform the market/other investors because, as long as one adopts a long-term view, “good results” will follow, then I don’t see that this conclusion has been supported.

    Additionally, I’m not sure what is meant here by the notion that investors should perhaps focus instead on “contributing to value creation.” Value of what? Of their portfolios? Or of society at large? If the former is meant, then you still need to argue that it isn’t advisable or reasonable for investors to want to outperform the market, and I can see that certainly at times this could be true but in other cases arguably untrue. If the latter is meant, and that investors should focus on trying to improve the general social well-being through their investment activities, then firstly one must realize that this is not expressly the mandate of either pension fund managers or investors in general – even if “it should be.” Secondly, just how an investor contributes to social welfare by the mere fact of (passively) holding shares of businesses for long-term periods is a good question. That “investment” does not go to the companies in question unless they were bought from the company directly or (IPO) so the monies invested cannot be said to help a company to finance its operations. What is left? That by passively buying and holding for the long term helps reduce “value-destroying” stock price volatility?

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