It’s been well over a decade since the young field of behavioural economics — which challenges classical economic theory by digging into complex psychological factors behind decision-making — took the political world by storm. Barack Obama appointed Cass Sunstein, co-author of the hit behavioural economics book Nudge, to his White House team. David Cameron set up a “Nudge Unit” within the UK Cabinet Office.
The trend has been slower to catch on in the investment world. But one leading behavioural economist claims to have cracked a way for investors to capitalise on this area of research to achieve outsized returns. Is he on to something? Read on and see what you reckon. As Patrick highlights below, some ESG investors may well be looking for fresh ideas after a bruising year in 2022. (Simon Mundy)
Time for investors to get psychological?
If you make your employees feel valued, your company will perform better, any number of management gurus will breezily tell you. But is this necessarily true, given the potential costs involved? And if it is, what should investors do about it?
Behavioural economist Dan Ariely claims he has the answer. The Israeli-American Duke University professor has become one of the most prominent academics in his field, with a series of best-selling books exploring the flaws and quirks in human reasoning. Now he’s turned his sights to the investment space, with a system for assessing employee motivation — and evidence of a strong correlation with stock returns.
“We are trying to get people to stop focusing on what’s easy to measure, and to get people to measure what’s right,” Ariely told me.
Through his firm Irrational Capital, set up with former fund management executive David van Adelsberg, Ariely has come up with something called the Human Capital Factor, a metric to reflect workers’ views of their companies. It uses millions of internal survey responses, as well as data from public sources such as Glassdoor, to build a picture of workers’ motivation and sense of “psychological safety”.
Crucially, the HCF looks not only at overall sentiment, but about how evenly it is distributed. So a company where senior staff are much happier than their juniors, or men happier than women, will take a big hit to its score.
Should investors care about any of this? Analysts at JPMorgan seem to think so. In a string of reports, they’ve highlighted the “long-term persistent outperformance” of companies with the highest HCF scores, with an annualised return of 6.9 per cent above the MSCI USA index between 2009 and 2020.
That positive correlation with share prices is weak or totally absent with many other ESG-focused products or indices, Ariely noted. He singled out the SHE Index, which focuses on gender balance, pay gaps and gender-related policies. Such initiatives risk encouraging a “box-ticking” approach, and fail to capture the perspective of female employees themselves, he argued.
He takes a similarly dim view of the preoccupation with the ratio of executive pay to the median worker’s. What really counts, he argues, is how employees feel about that pay gap, and about their wider corporate culture. “It’s about understanding how it changes their pride in going to work, their feeling of connection with the company, their interest in the company doing very well,” he said.
Investors persuaded by Ariely’s theory now have a chance to bet on it. Last year, Chicago-based Harbor Capital Advisors launched two exchange traded funds that follow an index created by Irrational Capital, comprising US companies with strong HCF scores.
Tech companies are strongly represented in that index, which is contrastingly light on energy and utility stocks. That led to nasty underperformance in last year’s market turmoil, although it still maintained its long-term lead over the S&P 500.
If investors start taking behavioural psychology more seriously, Ariely hopes, corporate leaders might do so too — and take a more scientific approach to getting the best from their staff. “It is kind of incredible how people in HR are usually considered in the lower ranks of the organisation,” he said. “People should start thinking about HR as a [research and development] function.” (Simon Mundy)
US ESG equities underperformed in 2022, dogged by tech stocks
US Republicans made hay of the environmental, social and governance (ESG) agenda in 2022. Their motives have often been more about politics (and defending oil companies), but they also caught ESG in a moment of weakness. In 2022, US ESG stocks were battered by market forces far more than by political rhetoric”.
Obviously markets worldwide had a lousy year. The S&P 500 index declined 19 per cent, its worst annual performance since 2008. The Nasdaq index fell 33 per cent.
ESG funds underperformed the broad stock market. The largest ESG fund, the Parnassus Core Equity fund, which has $25bn of assets under management, declined 24 per cent over the past 12 months. BlackRock’s biggest ESG fund slumped 20 per cent and Vanguard’s biggest ESG fund dropped 23 per cent.
But one year of returns tells a limited story. Parnassus has outperformed the S&P 500 over a five-year period and so did BlackRock’s biggest ESG fund. Vanguard’s FTSE Social Index fund soared in 2020 and 2021, surely helped by an incredible run for Tesla, its seventh-largest holding. But as Elon Musk’s troubles weigh on his electric car company, Vanguard’s flagship ESG fund has tumbled to earth too.
ESG funds in the US rely heavily on the performance of the technology sector. The top three holdings for the big BlackRock and Vanguard ESG funds are Apple, Microsoft and Amazon. All three struggled in 2022, but had huge gains in 2020 and 2021 as the pandemic eased.
And for all the Republican attacks on BlackRock for “boycotting” oil, ExxonMobil is a top 10 holding in the asset manager’s biggest ESG fund — something that bolstered its performance last year. (Patrick Temple-West)
How will Joe Biden’s green-focused Inflation Reduction Act change the investment landscape? France’s 1970s nuclear drive offers a possible guide, writes Huw van Steenis.
With a person dying from hunger every 36 seconds in east Africa’s worst drought for 40 years, it’s time for radical change in how we finance global public goods, writes Oxfam’s Dhananjayan Sriskandarajah.
How effective is your company at combating climate change? The FT and data provider Statista are currently compiling the 2023 editions of Europe’s Climate Leaders and Asia-Pacific Climate Leaders — two surveys listing the businesses that have gone furthest in reducing their carbon emissions intensity. If you think your company might be eligible, please click through to the Europe and Asia-Pacific calls for entries, where you can find details on how to participate.