How can we know if investors are coherently linking sustainability concepts?

Abstract

The influences of sustainability factors on long-term financial market dynamics are complex. Investors’ abilities to coherently link sustainability concepts from across diverse domains may dictate success in navigating long-term complexities. A coherent understanding can avoid unintended consequences and mitigate governance conflicts for institutional investors. Analysis of whether investors are coherently linking sustainability concepts presents an underexplored empirical challenge for both psychology and finance. This article presents a methodology for measuring how coherently investors link sustainability concepts. The approach uses the concept of investment beliefs and straightforward mathematical techniques on a unique small-sample dataset of the self-reported investment beliefs of senior asset managers on sustainable investments and long-termism. Three findings emerge. First, investors are able to successfully link small numbers of sustainability concepts in a coherent way, but have difficulty doing so for larger numbers of concepts. Second, expert investors seem to be making global linkages among sustainable investment concepts from different domains (global linkages) and thus may be cultivating broad worldviews on sustainability. Third, some sustainability concepts link together more coherently for investors than others. This article advocates further research into the coherence of sustainable investment understanding, as well as a scrutiny by investors of their own investment belief systems.

Keywords:

• investment beliefs
• long term
• sustainability
• coherence
• unintended consequences

Acknowledgements

The author thanks Gordon Clark, Heather Hachigian, Sarah McGill, Steve Lydenberg, Adam Dixon, Fabrizio Ferraro, Ashby Monk, Natalie Beinisch, Claire Molinari, and Rob Bauer for their respective contributions in refinement of conceptual material appearing in this article on the various topics of sustainable investment, investment beliefs, and long-termism. A debt of gratitude is also owed to Towers Watson for sharing access to its very unique database without which the empirical elements of this study would have been impossible. Thanks are also due to numerous attendees at conferences organised by oikos/UNPRI, and the University of Oxford for helpful discussion and feedback on earlier drafts of this article. Finally, the author also expresses his appreciation to the Oxford University Press for its support of his doctoral research through a Clarendon Scholarship.

Notes

A fine distinction should be drawn between durable drivers and ‘invariant properties’ (Mandelbrot and Hudson 2004); otherwise deeper confusion of correlation and causality is risked.

Many definitions and interpretations of sustainability exist. The viewpoint of sustainability adopted here is decidedly anthropocentric and deals with the collective capacity for Earth's economic physical/environmental and social systems to interact in such a manner (to paraphrase the Brundtland Commission (World Commission on Economic Development 1987)) as to provide for the needs of present human civilisation without compromising the needs of future human generations.

For example, strong financial market performance may lead to wealth effects that promote consumption and present a drain on natural resources. Another example might be immoderate financial market volatility leading to destruction of pension assets and requiring upsizing of government debt to provide economic support for retirees and the elderly.

Environmental social and corporate governance (‘ESG’) factors are perhaps one of the more popular groups of sustainability considerations considered among contemporary institutional investors.

An example of a typical investment belief might be (e.g.): ‘Over the long term passive investment strategies tend to outperform active strategies in terms of net risk-adjusted returns’. Koedijk and Slager (2011) present perhaps the most exhaustive treatment of investment beliefs available at present.

See http://www.unpri.org/signatories/index.php?country=USA#ao

As would be the logical end consequence from heeding, Koedijk, Slager, and Bauer's (2008) suggestion of synthesising related beliefs.

Whether these publicly professed beliefs align with investment beliefs in practice is a question meriting strong examination but reserved for later study.

For a negative example consider two beliefs: one in persistent liquidity of major stock and bond markets and the other in diversification across asset classes rather than risk factor exposures (such as, e.g. inflation risk exposure, foreign exchange risk exposure, energy price risk exposure). In the global financial market selloffs of autumn 2008 these beliefs in liquidity and asset class diversification proved detrimentally interrelated: many investors were not as diversified as previously imagined and liquidity in many areas of stock and bond markets evaporated almost instantly. While causality is difficult to determine, these two phenomena are suspected to have mutually aggravated one another through a positive feedback loop (Triana 2009). Returns on these beliefs proved to not sum linearly (or subtract linearly for that matter).

Even ‘purebred’ sustainability investors, however, may have periodic need to add or jettison specific beliefs.

See Martin (2000) for a fuller discussion of some of the shortcomings of the correlation approach.

While Pearson's phi is a robust measure Spearman's rho is (arguably) more appropriate for the ordinal belief data under study. Notably the two measures exhibit a high level of agreement here.