SustainAbility: Melt up!

The new year hangover we wrote about in our last blog lasted a week and on 19 January the S&P 500, the US stock market, made an all-time high.

At the time of writing, the same index is up more than 20% over the past 12 months. Pessimism and caution are expensive characteristics for investors currently, as it would appear equity markets are in something of a ‘melt-up’.

Melt-ups tend to occur towards the end of big moves in markets. Since this current bull market began, in October 2022, the S&P 500 is up 36%, a painful move for anyone who has not participated. In that time cash has accumulated on the side lines, particularly as rates on cash have improved in recent years. But with signs of interest rates falling cash no longer seems as attractive and with equity markets rising the returns from them appear more appealing. This move of cash from the sidelines into equity markets is what causes a melt up. Is it right to participate in this, or to be cautious?

Whilst share prices in the short term are simply about supply and demand ("Why is stock X up today?" is a regular question, with the best answer being "More buyers than sellers"), in the long run they represent the prospects of individual companies, and at the index and market level a broad mix of companies. To be cautious about equity markets in the long run is to be cautious on the factors driving the individual companies within them.

Currently these include an explosion in data and software, led by artificial intelligence (AI), a huge increase in infrastructure investment, led by decarbonisation and electrification, and weight loss drugs creating structural and positive change in the healthcare industry. To not be invested is, to some extent, a view that these trends are not durable, or that they are already priced into markets. In our view, neither of these things are obviously true.

This leads us to the idea that time in the market is more important than timing of markets. We can, and many do, debate the intricacies of day-to-day markets, but in the end does that really matter? Is it not more productive to follow long-term definable trends, than short-term market narratives? To think about AI, decarbonisation, and healthcare rather than melt-ups, expectations for interest rates, and inflation? Of course, we present this as a binary choice, which it clearly isn’t. We can think of all these things, and do. The lesson, however, of the last year is the former – AI etc – has been more important than the latter, and keeping long-term exposure to these areas, which sustainable funds do, is, we believe, a sensible idea.

Risk versus volatility

The last few years have been volatile ones for investors. It began with the rapid sell-off, and then recovery, related to the pandemic in 2020/21. It continued into 2022 with the Ukraine war and increase in interest rates which impacted markets negatively. Finally, we had the rapid market recovery of late 2023 as both interest rate and inflation expectations fell.

This volatility can create the appearance of risk as the natural tendency of investors is to consider the two variables as one and the same. Of course, there is some truth in this, volatility can be a sign of risk. Sometimes though, it is not.

Volatility is a measure of share price movements, and in aggregate of these, fund price movements relative to a benchmark. This benchmark can be an index, a peer group, or another asset class. Risk, however, is an absolute measure: what is the risk of my losing my capital? This can come down to several things, such as the nature of company business model, the levels of debt within a business, and the level of competition in an industry. In essence, volatility and risk are measuring two separate things.

It is possible to have a low risk yet volatile asset. Warren Buffet, who has spoken on this, commented at the 2007 annual shareholder meeting (note ‘beta’ mentioned below is the expected increase or decrease of an asset relative to a benchmark, and is often used as a measure of risk):

"I mean, actually, take it with farmland. Here in 1980, or in the early 1980s, farms that sold for $2,000 an acre went to $600 an acre. I bought one of them when the banking and farm crash took place. And the beta of farms shot way up. And according to standard economic theory or market theory, I was buying a much more risky asset at $600 an acre than the same farm was at $2,000 an acre.

Now, people, because farmland doesn't trade often and prices don't get recorded, you know, they would regard that as nonsense, that my purchase at $600 an acre of the same farm that sold for $2,000 an acre a few years ago was riskier. But in stocks, because the prices jiggle around every minute, and because it lets the people who teach finance use the mathematics they've learned, they have – in effect, they would explain this a way a little more technically – but they have, in effect, translated volatility into all kinds of – past volatility – in terms of all kinds of measures of risk.

Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you're in, and it comes from not knowing what you're doing. And, you know, if you understand the economics of the business in which you are engaged, and you know the people with whom you're doing business, and you know the price you pay is sensible, you don't run any real risk."

We would agree. If we can buy good companies at sensible prices, the risk inherent in that decision can be low. If we can buy these companies at low prices, the risk is even lower. This does not mean of course that the share price of a company cannot be volatile and will be if macro events create volatility. Overall though, risk and volatility are best thought of separately.

Regulation - Sustainable disclosure requirements

The regulatory environment for sustainable funds in the UK is becoming clearer through the FCA’s Sustainable Disclosure Requirements (SDR). The final framework has now been declared with funds fitting into sustainability improvers, focused, impact and mixed buckets. The mixed category is to allow fund of funds portfolios to own a mixture of the other three classifications.

In my view, this structure will bring clarity and improve standards. It will place a standard on the sustainability label, requiring asset managers who use it to make firm commitments as to the work they undertake and investments they choose to make on behalf of their clients. It will no longer be possible to simply rebrand existing funds sustainable or use solely simplistic thematic constructs to pick stocks and create portfolios. 

Our sustainable investment teams have sustainability as well as financial objectives, are clear about areas of the market we won’t invest in and have an independently challenged process around our sustainable investment decision making. These will be core requirements for sustainable funds in the future and we welcome this.

Once embedded, investors should be able to buy sustainable funds with confidence and be able to compare different approaches to find the one best suited for them.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.