Financial markets offer an opportunity for entrepreneurs to source capital for their business plans and thereby support growth of our global economic system. Markets also create opportunities for investors to generate financial returns. By providing capital to fund uncertain business plans and the future cash flows associated with them, investors can earn a ‘risk premium’ as a reward for taking over the risk from the entrepreneurs. But for wealth to grow it is necessary to understand how the market can be used best to achieve this in consistent manner.
Some would argue that investing in a purely capital-weighted – or ‘passive’ – market portfolio is the most efficient way to receive this premium. It is crucial to realize however that this approach only works if other investors still engage in an active way to discover the prices at which securities should trade, based on their underlying fundamentals. Without these “active” investors, the market can never correctly price the underlying trends and future risks associated with assets’ future earnings.
And even if there are still enough active investors, the standard assumption in Finance Theory is that investors will act rationally, be homogeneous and have similar objectives. Furthermore, it assumes that investors will have equal insight into all the information required to determine the true value of assets and that there are no limits to their ability to trade or the amount of capital that can be put to work by investors at any point in time (no limits to arbitrage).
In reality, investors are either human or work through algorithms designed by humans. This means that their emotions influence their decisions and their coding and that they have different preferences, risk tolerances and objectives (among each other and over time). Also, and crucially important, they are influenced by each other and the contexts in which they operate. Thanks to excessive optimism, fear or pessimism, a lot of inconsistent decision-making and time-varying behavior is observed in investors in all sorts and shapes.
We believe therefore that markets are adaptive, complex and not fully rational. As a result, they are much more uncertain and erratic than standard finance theory suggests. Importantly, the nature of complex systems, as seen in many other fields such as neuro science, biology and geology among others, demonstrates an evolution that is path-dependent and does not gravitate automatically to an “equilibrium” value that can be mechanically determined by models or mathematics.
This leads us to believe that taking such market characteristics into account enables an active investor to add value versus a passive investing approach that is based on the unrealistic assumption of full market efficiency under all circumstances. To make active management work, however, it is necessary to have a deep insight into what drives markets. Investment decisions must stem from a rigorous process that identifies opportunities in a timely manner and always acknowledges the risks associated with the uncertainty that is inherent to the market.
There are several pillars supporting this approach. First, creating financial value must use responsible investing insights. With ever greater demands from society for more responsible conduct, the future success of business models is becoming increasingly dependent on how their economic activities impact the environment.
Academic research remains mixed on how environmental (E), social (S) and governance (G) factors can help drive future investment returns. But our own experience in running sustainable investment strategies, together with more forward-thinking research that analyses the direction of change in these ESG variables rather than their existing levels, indicate that a responsible investing approach can enhance the robustness and attractiveness of returns. This allows us to set stronger incentives for the corporate sector to contribute to a more sustainable future.
Second, an investment approach needs to be adaptive. The world and its financial markets are changing more rapidly than ever before. New information sources that help to understand the underlying economy and investors’ behavior are growing exponentially. These changes must be embraced and therefore investment processes need to be dynamic to cope with new economic and market trends as well as the rapid evolution of new technologies that impact our economic system and create new opportunities to enrich our investment approach.
Third, investors must appreciate uncertainty and acknowledge that unexpected events can always happen. Investment portfolios must be robust enough to digest unexpected shocks if they are to “survive” in the financial market ecology. Market risk also creates opportunities, of course, but these should always be balanced against the size and shape of the active investment exposures that are taken. It is key to understand that there are no free lunches in investing and that observed volatility does not capture fully all the future risks.
Fourth, active management benefits from diversity of thought. By bringing together a mixed set of investment professionals with expertise in portfolio management, client advice and fundamental, behavioural and data-driven analysis, more creativity and forecasting power is fostered.
Fifth, we cherish our culture of partnerships. By creating an open-minded team culture, we stimulate collaboration between teams and with our clients. This enables a continuous dialogue on market themes and evolving client needs. It brings perspective and enhances the pace of learning and adaptation within our investment teams. Moreover, it cultivates co-creation of flexible and bespoke investment solutions with our clients.
Finally, an investment approach must intelligently and consistently leverage man and machine. By combining human creativity and machine rigor in investment processes, it is possible to make stronger, better timed and more consistent decisions. Solid fundamental research, in-depth market knowledge and portfolio management experience can be augmented with new, artificial intelligence (AI) technology such as machine learning, neural networks or natural language processing.
Robots and algorithms still struggle to interpret certain data, such as the next tweet from President Trump, a communication error by an important central bank, an unexpected data security scandal or a shocking natural disaster or terror attack though, so it is still important to bring man and technology closer together.
An active investor who can incorporate the above investment principles into a reliable, intelligent and adaptable method will improve their chances of delivering excellent investment returns. It is a challenge that we always look forward to meeting both with – and for – our clients.
Valentijn van Nieuwenhuijzen, chief investment officer, NN Investment Partners