In the new regime of higher interest rates and inflation, a sustainable, active and thematic approach to investing could help mitigate the potential impact of systemic risks on portfolios, says Newton FutureLegacy portfolio manager Bhavin Shah.

Shah thinks some investors are ignoring a big hazard: longer term systemic risks associated with climate change. With the majority of investors chasing the same market cap indices, he warns that being exposed to this market (systemic) risk is unlikely to result in satisfactory portfolio outcomes in the years ahead.

Systemic risks

“The market in aggregate prices risk efficiently, in the short run, but with a focus on quarterly earnings and annual performance, it is not aligned with most investors’ time horizon. This can be decades or even longer,” says Shah.

“The market has also become increasingly concentrated and now is being driven by the fortunes of a handful of mega-cap companies. This, combined with a mismatch in time horizons, is likely to mean that investors risk driving off a cliff if they ignore some longer-term systemic risks by simply following the index.

“By taking a more diversified and sustainable approach focusing on long-term trends we think investors can get ahead of the curve and mitigate these risks which, in turn, should lead to better outcomes and better risk-adjusted returns.”

Sustainability = robustness

Shah argues using a diversified and sustainable investment approach can help build resilience into portfolios. Focusing on companies with quality characteristics, such as low levels of indebtedness and strong free cashflow conversion, also helps build robustness.

The Newton FutureLegacy portfolios use Newton’s sustainable framework which is research-driven and focused on real world change. It is used by Newton’s analysts and portfolio managers to identify companies that contribute most to better environmental and fairer social outcomes while excluding the worst offenders.

FutureLegacy invests in three types of sustainable company:

• Solution providers – companies that are finding solutions to the most pressing social and environmental needs through products or services.
• Balanced stakeholders – companies with sustainable internal processes. Those Newton identifies as best in class for governance or as having high standards on human capital management and balancing the needs of all stakeholders.
• Transition – companies at the start of their sustainability journey but showing a credible commitment to transitioning their business model and as a result, are viewed by Newton as creating real world change. 

Investing principles

Another important consideration for building resilient portfolios, according to Shah, is to revisit the premise of why we invest in the first place.

He says the true reason we invest is to meet specific objectives, whether it be to meet a liability, meet income requirements or to build or preserve wealth in real terms. It is not to beat a market cap benchmark, he adds.

Using these principles to build portfolios could lead to the creation of solutions that are likely to be more resilient in the long run, says Shah. Focusing on longer term trends, using a thematic lens, helps to look beyond the shorter-term noise of daily market movements, benchmark concentrations and quarterly results, he adds.

“These benchmarks have been created and defined by the financial industry to measure short-term performance but if we go back to the roots of why people invest maybe we can build more robust portfolios that meet clients’ requirements,” says Shah.

Active management

This is where active management is vital, says Shah, because he thinks a pure market or passive approach to investing risks exposure to systemic risks that are being under appreciated. While passive investing can be efficient, it may not be effective or right as these investment models are built on backward-looking data. “We believe as we are edging closer to both planetary and social boundaries these systematic risks may turn into systemic issues that will be internalised by the market,” he adds.

“Taking an active approach to investment, we think, can help mitigate some of these risks and help investors meet their investment objectives with better risk-adjusted returns. We would argue that’s a better form of investing than just trying to beat a benchmark that has been artificially created.”

Thematic investing

Investing thematically also builds portfolio resilience, says Shah. “Investing is inherently probabilistic. You are trying to put the odds on your side and that is where investing through a thematic lens helps.  This involves taking a fundamental long-term approach, focusing on areas where there are structural growth opportunities and avoiding areas of structural decline,” he explains. “So, even if you get something wrong in the short run, if you have the structural trend right, this can be a tail wind and time is your friend – which we think is a recipe for successful long-term investing.” 

Shah thinks fundamental diversification is also important to building resilient portfolios, especially at at time when interest rates have been higher. “It is important to take a fundamental and flexible approach to adapt to the new environment,” he says. “Understanding each part of your portfolio and having different parts of the portfolio exposed to different asset classes, trends and economic sensitivities can help to navigate a challenging market backdrop.”

Shah concludes: “It’s not about trying to predict the future; it’s about trying to make sure you are building fundamentally diverse and robust portfolios because events will happen, and you will never predict them. 

“So, while you have a central a view of the world, your anchor, you want to make sure you have securities with differing sensitivities in your portfolio just in case you are wrong because that helps you pivot as the environment changes.”

The value of investments can fall. Investors may not get back the amount invested.

The Strategy follows a sustainable investment approach, which may cause it to perform differently than strategies that have a similar objective but which do not integrate sustainable investment criteria when selecting securities. The Strategy will not engage in stock lending activities and, therefore, may forego any additional returns that may be produced through such activities.