Researchers find little evidence that investment managers help the companies they invest in become greener.  Much of what passes as ESG (environmental, social, governance) investment is little more than investment managers’ telling clients their portfolios are green.  “There could be a couple of bad apples in Europe, but it’s not the entire cart that’s rotten”, as in the U.S., says London Business School finance professor Alex Edmans.

ESG in practice can amount to a pile of marketing, i.e. telling investors their money is green.  Numerous studies show companies’ ESG scores are notoriously difficult to pin down, especially when trying to measure smaller companies, due to smaller companies’ reduced public oversight and fewer resources to devote to their investor relations.

“In the U.S., we observe a substantial disconnect between what institutional investors claim to do in terms of ESG and what they really do. We do not find better portfolio ESG scores for US PRI (Principles for Responsible Investment) signatories, not even for those that report full ESG incorporation…. We also find no evidence that US PRI signatories improve the ESG scores of portfolio companies after investing in them”,  according to the research paper “Do Responsible Investors Invest Responsibly?” in Review of Finance, November 2022.

In Sweden, environmentally oriented investors are more likely to buy mutual funds with pro-environmental names, but they are not more likely to buy funds that are labeled as ESG-compliant as written in the more complex financial statements that households receive every year.
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ESG investors beware.  The name ESG or “sustainable” might be there only to draw you in.

Since its all-time peak on the first day of the year, the stock market has fallen, in waves, likewise for bonds.
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Where have we read this before?  Right, in our last letter.

Significant dislocations and mis-pricings of investments play out as governments and central banks attempt with varying degrees of success to address imbalances and problems amidst supply and demand dislocations.
In a few words, investors aren’t happy when good times end.

Over the first nine months of the year, the U.S. stock market benchmark declined -24.6% and the bond benchmark index dropped –14.6%.

I can’t say when it’ll get better.  It looks to me like an unwinding of a super-charged economy and speculative investment price excesses.

Correcting these imbalances will require time and uncomfortable declines in market prices.  Governments and central banks will, under such pressures, be tempted to lean against the tolls required to set things right.

Rising to meet the challenges, negotiations among interests will be where it’ll get interesting indeed.

This quarter was a rocky one, as has been the year.  Since the all-time peak on the first day of the year, the stock market has fallen in waves, likewise for bonds.

From an economic standpoint, inflation is triggering a hawkish central bank interest rate policy, i.e., higher short-term interest rates.  While the U.S. Federal Reserve has acted strongly according to its stated commitments to markets, they cannot insure the survival of financially at-risk organizations.  We’ve seen this occur with the bankruptcy of badly financed vehicles, e.g., the Celsius Network crypto fund (not one of ours).

Markets look to the future, not the present.  Anything can happen.  Ahead could be a short-term recession or a longer-term one.  The current level of high inflation could be temporary, or it could be more enduring. Evidence suggests we’ll experience something at least in the middle of the spectrum.

​Markets are not fully pricing dire possibilities.  That said, markets tend to predict future upturns fairly well, historically advancing about half a year ahead of a turn toward positive economic growth.

How far down have markets dropped?  Not far, relative to history.  There’s nothing to be said that prices have fallen enough to bring in buyers and exhaust motivated sellers.  While we’ve performed well in this downturn so far, it’s very possible that the downturn might not yet be over.

There’s a difference between active, responsible investing and passive, ESG (Environmental, Social and Governance) investing.  This quarter, we’re taking over the featured investing spot by sharing an aspect of what we do, and what we don’t do.  

ESG investing applies non-financial factors, i.e., environmental, social and governance criteria, to analyze financial returns, opportunities and risks.  When passively managed, ESG funds reflect a broad portfolio of holdings representing a benchmark index.  For stock funds, this might mean holding shares in hundreds or even thousands of individual companies.  It’s a matching exercise.  Whatever the index says, that’s what the passive fund owns.

On the eve of Russia’s invasion of Ukraine, ESG funds held an estimated $8 billion of Russian investments, mostly in the form of the oil companies Gazprom, Lukoil and Rosneft, as well as the financial conglomerate Sberbank and the nickel miner Norilsk.

Since the war began, passive fund giants such as Vanguard and Blackrock have sold their Russian stocks, realizing huge losses in ESG and non-ESG funds alike.

Passively invested funds, also known as index funds, have grown to $11 trillion in value, 1/4 of the American stock market.  For those who manage a passive fund, whatever is in the benchmark index must be bought.  What drops out must be sold.

The decision made by index providers MSCI and FTSE Russell to deem Russian stocks uninvestable meant cutting them from their ESG indices, thus passive funds sold their Russian holdings.  At Pennyfarthing, in contrast, we’ve never held a Russian stock, neither via direct ownership nor by recommending a fund.

With one daughter off at college, studying illustration the next three years in England, and another daughter who began her graduate studies in public health, in Paris, my son remains at home, on the cusp of finishing high school….

My dependents have become less dependent.  In contrast to my kids, the investment markets’ price levels are generally the highest in history and cry out for continued support from the U.S. Federal Reserve and the world’s other central banks.  Government spending, tax cuts, wealth are all dependent upon the central bank’s support.

The Fed is buying U.S. government debt at a rate of $120 billion in bonds per month, which depresses interest rates, stimulates credit and supports prices in asset markets.  So many young people can’t afford the high price of a new home even though mortgage rates are low.

The Fed’s economic modeling anticipates inflation running above 3% through the end of 2024.  In financial history, after the Fed’s creation, rising inflation and reversals of easy, excessive credit have preceded stock market declines.

Since 2008, each time the Federal Reserve has reduced its bond purchases, markets have stumbled.  Will inflation, global economic imbalances and supply bottlenecks trip up this market?  Wealth has certainly inflated.

What about those left behind?  Read Fiona Hill’s recently released memoir There Is Nothing For You Here for thoughts about that issue.

These days the Fed’s Chairman Jerome Powell hints at gradual action, hesitantly calming investors’ worries about whether the Fed might reduce its bond purchases, too much, too early -- those kids have too much anxiety to move out.

Arif Naqvi liked to say, “Today’s peacock is tomorrow’s feather duster”, an apt phrase for a man who was once an impact investing celebrity, targeting social equity and economic growth in emerging markets.  He was charming, generous, attractive, but also bullying and narcissistic.

Naqvi’s hedge funds, foreign entities run out of Dubai, became the Middle East’s largest.

Investors included the Gates Foundation and World Bank.  If Bill Gates is investing, others thought, they should, too.

The funds had been audited and favorable opinions issued.  Despite this, as private funds, and this is a very important point to be aware of, the funds’ fraudulent financial practices were hidden from investors for years.  Private funds lack the heightened oversight and financial controls of publicly regulated entities.

Naqvi, with his connections to the rich and politically powerful, his 154 foot super-yacht and along with his fellow fund managers pocketed the funds’ cash in secret bank accounts.  Turns out, investors eventually noticed they had been duped.  The Gates Foundation raised questions.  Wall Street Journal journalists Simon Clark and Will Louch dug in.  Whistleblowers came forward.

Give me your money to invest, Naqvi said, and we’ll reduce poverty and improve public health.  Instead, he has been charged with stealing $780 million.

The takeaway here is that, even when a fund’s purpose is noble, be diligent and trust, but verify.

Italian artist Salvatore Garau last month sold an invisible sculpture in the form of a stamped certificate of ownership for $18,000.  Too bad, if the sale had granted ownership via digital non-fungible token (NFT), I’d speculate it’d have fetched at least $180,000.  One can only imagine….

What’s the investment most opposite from an invisible sculpture and can be purchased at an incredible bargain today?  US Series I savings bonds, among the safest of investments, currently yielding 3.6% annually (cannot be redeemed in the first year, a three-month penalty applies within five years of purchase).

I-bonds’ interest rate varies.  It is a fixed rate, 0% for newly issued bonds, plus inflation, which is currently 1.8%.  Get this...an I-bond will earn you 3.6% annualized until October 31, a rate that will change with inflation semi-annually.  Compare that with other interest rates: short-term Treasury bills, 0.1 to 0.5%; high-yield savings accounts, 0.6%; and CDs, 0.2 to 1.0%.

I-bonds’ interest is also state and local income tax-free.  If redeemed to pay for college expenses of immediate family members, I-bonds’ interest could be federally tax-free depending on income level, $97k for a single, $123k for a joint tax return.

You can buy or receive up to $15,000 in I-bonds per year via the US Treasury Direct web site or with your federal tax refund.  If you buy as a gift for others, with the intention to pay for college, be sure to buy in the parent’s name, due to financial aid eligibility and the above tax advantages.
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Right now, I-bonds are the superior low-risk investment … or, you can always buy yourself an invisible sculpture?!?

There’s more money circulating than ever, expanding at an all-time record.

Remember baseball cards on paper?  There’s a new digital spin on them.  It’s called NFTs, non-fungible tokens, aka digital rights.

I could take a photo of this page and, if recent transactions are any guide, receive thousands of dollars from someone who bought the right to enjoy the view.

After selling this page as an NFT, I could send you this letter, you could still read it and then you could do whatever you wish, dropping it into the trash or your filing cabinet.  The whole time, our letter’s NFT owner could be enjoying it all.

As they say, the kids just love it.  The National Basketball Association (NBA) has offered digital trading cards  through their partner Dapper Labs.  They’re booming, issued as limited quantities in potentially limitless editions.  Turns out, the fine print states buyers own nothing but a moment they view on the issuers’ digital platform, the app experience.  It’s the right to enjoy the view, for hundreds or even thousands of dollars apiece.

More money boosts speculative demand, driving up prices.  Spend wisely, or not.  When will it end?

Surely, you’ve heard of the video game retailer GameStop stock’s climb in price recently as a result of an online mob’s chitchat to buy.

If you haven’t heard about it, god bless you.  It’s an endless dog chasing its own tail, a rabbit hole on a blank page upon which any story could be told.

One bunch of speculators sought to manipulate another even as they themselves were unknowingly manipulated.

Does it make sense to you?  It doesn’t to me.

I’ll tell you my version of the story.  It’s a scam, one that combined the lure of striking it rich with a desire to punish greedy hedge funds.  It all works, until it doesn’t.
  
Speculators urged others to buy in order to achieve higher prices.  It’s anti-social behavior at its darkest, to entice naive buyers.

Ignore poverty, an economy transforming in favor of the wealthy, climate change or an ailing healthcare system, nothing to see over there.  For the past two weeks, the financial news focused on small-time speculators as they battled big, nasty hedge funds which had bet on a decline in the stock price.  GameStop stock soared +2,300% in one week.

In my old days at the U.S. SEC, we’d have investigated this as a scheme to defraud, a messy case to be sure.

Over its second week, GameSpot stock fell -87% amidst public discussion over how much money was made and lost.  Should have sold out when you had the chance.

We define who we aren’t as we unite over who we are.  Or do they get what they deserve?  It’s a little of both.
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When values fade, empathy darkens.  And GameStop is not the world that I love.

​Covid, economic conditions and the election have made analyzing investment prospects as challenging as ever.  Because the Federal Reserve proclaimed near-zero short-term interest rates until 2023, injecting trillions of financing into the investment markets, to keep them buoyant, the stock market went up.

Over the long term, returns on stocks over the past century annualize to around +7% per year.  However, there have been 10-year periods when overall real returns have been negative for stocks, and 20-year periods when returns were nearly zero.  Is the market nearer its +7% long-term average with regard to its future returns or will it test its -2% annual return boundary over the upcoming decade?  At current benchmark prices, the market appears expensive.  Given all that could happen, i.e. tax increases, economic recession and numerous possibilities we cannot yet imagine, low stock market returns ahead seem quite possible.

In many ways, our portfolios don’t look like the overall stock market as reflected by its broadest benchmarks.  Within the sub-benchmarks, large stocks have out-performed small stocks by 21% on the year.  Expensive growth stocks have out-performed cheaper value stocks by 32%.  These two characteristics have factored into our portfolio performance, for better or worse.

As Ray Dalio, the legendary investment manager behind Bridgewater Associates, says about both investing and for living a good life: 1) determine what it is you want, 2) determine what is true, and 3) focus your energy on making #1 happen in light of #2.

What we’ve been living within is an Age of Illusion.  It won’t last.