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The most compelling findings regarding financial decision-making are found not in spreadsheets, but in science. A blend of psychology, biology and economics, much of the research on this topic has been around for years. Its application in mainstream personal finance, however, is barely evident. Perhaps a simple analogy will help you begin employing this wisdom in money and life: The Rider and the Elephant.
First, a little background.
Systems 1 and 2
Daniel Kahneman’s tour de force, Thinking, Fast and Slow, leveraged his decades of research with Amos Tversky into practical insight. Most notably, it introduced the broader world to “System 1” and “System 2,” two processors within our brains that send and receive information quite differently.
System 1 is “fast, intuitive, and emotional” while System 2 is “slower, more deliberative, and more logical.” The big punch line is that even though we’d prefer to make important financial decisions with > SEE MORE
I’ve been getting lots of questions lately about the merits of owning TIPS [Treasury inflation-protected securities] versus nominal bonds. With that in mind, today I’ll discuss how to determine which is the more appropriate strategy.
To begin, we need to recognize there are two ways one can hold TIPS and nominal bonds: purchase the bonds individually or invest in mutual funds/ETFs. When investing through taxable accounts and IRAs, one can do either. However, in corporate retirement plans, such as a 401(k), one is limited to funds.
5-Year Maturities For Comparison
To keep the analysis simple, and because my firm generally recommends building bond portfolios with an average maturity of about five years, I’ll analyze TIPS and > SEE MORE
Investment strategies targeting environmental, social and governance (ESG) issues and concerns have exploded in popularity. The Global Sustainable Investment Alliance recently estimated that $22.9 trillion worldwide is managed under the auspices of “responsible investment strategies,” a 25% increase just since 2014, and which now represents roughly 26% of all assets under professional management.
While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to-earnings (P/E) ratio.
Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Academic research I reviewed in a recent article has confirmed that the evidence supports the theory.
It is logical to expect that investors shunning certain stocks should lead to those stocks having higher future returns, but it is also logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. Again, academic research confirms that the evidence supports this hypothesis.
Thus, when it comes to ESG investing, it appears that there are two opposing forces at work: lower returns and lower risk. One hypothesis is that the two might offset each other in terms of delivering risk-adjusted returns. Andre Breedt, Stefano Ciliberti, Stanislao Gualdi and Philip Seager contribute to the literature on ESG investing with their July 2018 study, “Is ESG an Equity Factor or Just an Investment Guide?”
Factor Or Guide?
They sought to determine the impact that ESG investing has on risk-adjusted returns, employing asset-pricing models for benchmarks. They used the MSCI ESG database, which contains monthly ratings for 16,799 worldwide companies. The study covers the period January 2007 until October 2017.
Following is a summary of the authors’ findings:
- ESG scores might have a developed-region bias; emerging markets have lower ESG scores than developed markets.
- ESG score is negatively correlated to the size (SMB) factor and slightly positively correlated to the low-volatility (LV)/low-beta (LB) factors. Large-cap stocks and low-volatility/low-beta stocks have higher ESG scores.
- An equity-market-neutral portfolio constructed with ESG ratings as a predictor shows flat worldwide performance. (Performance is marginally positive in Europe but negative in the United States. None of the results, however, is statistically significant.)
- The portfolio’s total performance can be explained by negative SMB exposure, negative momentum (UMD) factor exposure, and positive LB exposure.
- The portfolio’s remaining unexplained performance is flat.
- The environmental (E) and social (S) scores do not contribute to performance and the positive benefit of the governance (G) score is explained well by its correlation to the profitability factor.
The authors concluded their results indicate that “any benefit from incorporating ESG credentials into a portfolio is already captured by other well-defined and known equity factors. An ESG-tilted process does not deliver higher risk-adjusted returns.”
While the evidence from Breedt, Ciliberti, Gualdi and Seager’s study demonstrates that ESG information yields no additional benefit, importantly, neither does it negatively affect risk-adjusted returns. It does, however, allow investors to express their social views through their investments without any penalty, at least in terms of risk-adjusted returns.
This commentary originally appeared August 17, 2018 on EFT.com.
Larry Swedroe is the director of research for The BAM Alliance.
This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by the author are their own and may not accurately reflect those of Beacon Hill Private Wealth LLC. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
Past performance is no guarantee of future results. There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Investors should talk to their financial advisor prior to making any investment decision. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit.
Since the financial crisis of 2008, U.S. equities have earned substantially higher returns than international equities. Ken French’s data shows that the U.S. equity market has earned annualized returns of 15.6 percent per year from 2009 through 2017, while international equities earned 9.9 percent. Such periods inevitably lead some investors to question whether international diversification makes sense. This skepticism is reinforced by the fact that U.S. equities have outperformed international equities over an even longer period. The S&P 500 Index has outperformed the MSCI EAFE Index — its international equity equivalent — since the MSCI EAFE’s inception back in 1970. It’s easy to understand why an investor would believe that such a long period of outperformance must surely mean that U.S. investors should avoid international equities. This is all without mention of the current global equity environment thus far in 2018, where the U.S. equity market has trounced the equity performance of the international developed and emerging markets year-to-date.
While the preceding data may be enough to give any investor holding emerging markets stocks heartburn, it tells us little to nothing about the future performance of the U.S. equity market compared to other countries or to a diversified basket of international countries. Below, we’ll look at five lessons that I believe confirm the need to ignore such past performance and remain committed to a globally diversified equity approach.
1. Broad-based international index returns don’t relay the complete story.
Based upon the information presented above (U.S. equities have substantially outperformed international equities), where would you guess U.S. equity market returns have ranked relative to equity returns of the various countries included in international equity indexes? My guess is that you might say No. 1 or at least top three. Some might even be 100 percent confident that U.S. equity returns were at least in the top five.
You might be surprised that seven other countries generated higher equity market returns than the U.S. market over 1998–2017. Those countries from first through seventh were Denmark, Australia, Hong Kong, Canada, > SEE MORE
I’ve followed the TIPS market fairly closely since I started in the advisory business in 2003, and we’ve used them for a portion of many clients’ fixed income portfolios (and continue to do so today). The year I started in the business was only a few years after the inception of the market, and we now have about 20 years of returns history to examine. In the early years, there was a very logical argument that TIPS should dominate the fixed income portfolios of individual investors because they were essentially the perfect fixed income security, issued by the U.S. government and linked to inflation. Since credit risk is redundant for most investors and individuals have spending that grows with some measure of inflation, TIPS seemed to have everything an investor could want. Further, the historical correlation between unexpected inflation and stock returns has been negative while it was expected to be positive for TIPS. This meant TIPS had the potential to provide more powerful diversification of stocks when compared with nominal Treasuries.
The reality of TIPS, however, has been more muddled. TIPS have exhibited bizarre behavior for stretches of history (e.g., in the years following the inception of the market and during the financial crisis). In the early years, > SEE MORE