Sunday Brunch: investing is not just about generating alpha

Or why investors should care about what happens in the wider economy

Sometimes we think it’s worth asking the obvious (stupid?) question. The question today is what is our financial system for? This is not going to be a discussion of degrowth or similar concepts. This is a simple, financially focused question. What is our financial system supposed to deliver. To me, its fair financial returns to the savers of this world. But this means different things depending on where you work in finance.

At it's heart our financial system is really simple. Money flows from savers (retail, pension funds, endowments and family offices) to spenders (companies etc who want to invest, hopefully in productive assets). In return the savers get a financial return. One area where this system struggles is when the actions of the spenders impose costs on the wider society that mean that the net return to savers (financial return minus imposed costs) is reduced.

"What is the purpose of investing. No, that isn't a trick question" - Lukomnik & Hawley.

This is the concept behind Universal Owners - savers (ie investors) who hold broadly diversified portfolios. Describing this in financial terms, this group are unable to avoid/diversify away these external costs on society, and so regardless of how good their asset managers might be at beating the index (at generating alpha), their long term financial returns are likely to be diminished if the total market is negatively impacted.

Studies suggest that over 75% of our financial return comes from the performance of the market as a whole, something financial people call beta. (Ibbotson 2010; Brinson, Hood, and Beebower 1986; Hawley and Lukomnik 2018)

Which means that the skill of our asset manager, who is normally focused on relative outperformance or alpha, is likely to be less important to us than the financial health of the world in which we live, which generates our beta.

"we are all Universal owners now" - Dr Ellen Quigley.

As a result Universal Owners, which means most of us now, need to think about their investments differently, in a way that is alien to how most asset managers currently work. Change is coming and we need to prepare.

You can read more about Universal Owners, and how they need to think differently about financial return, in our recent (free) Sunday Brunch.