Unlike tech investors on the eve of the dot-com bubble, or homebuyers in the run up to the great recession, today we are already aware that the future is going to be drastically different on a particular front: the world’s relationship with carbon. Investors are grappling with what this means for investment portfolios, and whether the efficient capital markets theory, the underpinning of modern asset management, is sufficient to prepare for this inevitable change.
We widely accept that financial markets, often deemed to be the standard bearer of efficiency, do not always appropriately price in negative externalities or systemic risks, and are inadequate in private markets where information is not widely available. It shouldn’t, therefore, come as a surprise that we cannot rely solely on the efficient capital markets theory to price the future of uncertain environmental changes, regulatory overhaul, and new consumer preferences. Prudent investors must reconcile the growing financial implications of investing a future that is moving towards sustainability.
The efficient capital market theory postulates that all known information is priced into markets and that the neutral starting point for most investors is to own public securities in proportion to their relative size, as measured by market capitalization in the case of stocks or debt outstanding in the case of bonds. While many investors try to do better than this purely passive approach through active management, the proverbial benchmarks to beat are passive indices.
While we take it for granted now, the application of the efficient capital market hypothesis did many good things for investors’ portfolios: it gave investors an objective standard with which to evaluate active investment managers, focused active managers and drove down the cost of investing. It also ushered in an era of more robust portfolio construction, better diversification and more effective risk management.
But, it did not encourage investors to think about systemic risks latent in a portfolio where large permanent changes in value could be driven by future events quite different than the past. It also did not particularly encourage investors to actively engage with the companies they own on how they pursue business in the context of the broader environment. Fundamentally, it was a framework that assumed the future is well known by the market today and that future returns would look a lot like historical ones.
Enter sustainability. Many investors who prioritize sustainability believe that the future will be fundamentally different than the past, and some are even taking steps to bring this future closer with urgency. This consideration of the future poses a potentially large challenge to efficient capital market theory. Is it really the case that the effect of necessary government policies and changing consumer preferences are already reflected in the prices of all securities? Many investors who care deeply about sustainability would say that this can’t be the case. Some go further and point to big dislocations in markets that a passive approach failed to anticipate or protect investors from. The financial crisis and dot-com bubble being two recent ones. Perhaps the need to decarbonize is another?