CFA Institute

The promise of generative AI is speed and scale, but the hidden cost may be analytical distortion. A leaked system prompt from Anthropic’s Claude model reveals how even well-tuned AI tools can reinforce cognitive and structural biases in investment analysis. For investment leaders exploring AI integration, understanding these risks is no longer optional. In May 2025, a full 24,000-token system prompt claiming to be for Anthropic’s Claude large language model (LLM) was leaked. Unlike training data, system prompts are a persistent, runtime directive layer, controlling how LLMs like ChatGPT and Claude format, tone, limit, and contextualize every response. Variations of these system-prompts bias completions (the output generated by the AI after processing and understanding the prompt). Experienced practitioners know that these prompts also shape completions in chat, API, and retrieval-augmented generation (RAG) workflows. Every major LLM provider including OpenAI, Google, Meta, and Amazon, relies on system prompts. These prompts are invisible to users but have sweeping implications: they suppress contradiction, amplify fluency, bias toward consensus, and promote the illusion of reasoning. The Claude system-prompt leak is almost certainly authentic (and almost certainly for the chat interface). It is dense, cleverly worded, and as Claude’s most powerful model, 3.7 Sonnet, noted: “After reviewing the system prompt you uploaded, I can confirm that it’s very similar to my current system prompt.” In this post, we categorize the risks embedded in Claude’s system prompt into two groups: (1) amplified cognitive biases and (2) introduced structural biases. We then evaluate the broader economic implications of LLM scaling before closing with a prompt for neutralizing Claude’s most problematic completions. But first, let’s delve into system prompts. What is a System Prompt? A system prompt is the model’s internal operating manual, a fixed set of instructions that every response must follow. Claude’s leaked prompt spans roughly 22,600 words (24,000 tokens) and serves five core jobs: Style & Tone: Keeps answers concise, courteous, and easy to read. Safety & Compliance: Blocks extremist, private-image, or copyright-heavy content and restricts direct quotes to under 20 words. Search & Citation Rules: Decides when the model should run a web search (e.g., anything after its training cutoff) and mandates a citation for every external fact used. Artifact Packaging: Channels longer outputs, code snippets, tables, and draft reports into separate downloadable files, so the chat stays readable. Uncertainty Signals. Adds a brief qualifier when the model knows an answer may be incomplete or speculative. These instructions aim to deliver a consistent, low-risk user experience, but they also bias the model toward safe, consensus views and user affirmation. These biases clearly conflict with the aims of investment analysts — in use cases from the most trivial summarization tasks through to detailed analysis of complex documents or events. Amplified Cognitive Biases There are four amplified cognitive biases embedded in Claude’s system prompt. We identify each of them here, highlight the risks they introduce into the investment process, and offer alternative prompts to mitigate the specific bias. 1. Confirmation Bias Claude is trained to affirm user framing, even when it is inaccurate or suboptimal. It avoids unsolicited correction and minimizes perceived friction, which reinforces the user’s existing mental models. Claude System prompt instructions: “Claude does not correct the person’s terminology, even if the person uses terminology Claude would not use.” “If Claude cannot or will not help the human with something, it does not say why or what it could lead to, since this comes across as preachy and annoying.” Risk: Mistaken terminology or flawed assumptions go unchallenged, contaminating downstream logic, which can damage research and analysis. Mitigant Prompt: “Correct all inaccurate framing. Do not reflect or reinforce incorrect assumptions.” 2. Anchoring Bias Claude preserves initial user framing and prunes out context unless explicitly asked to elaborate. This limits its ability to challenge early assumptions or introduce alternative perspectives. Claude System prompt instructions: “Keep responses succinct – only include relevant info requested by the human.” “…avoiding tangential information unless absolutely critical for completing the request.” “Do NOT apply Contextual Preferences if: … The human simply states ‘I’m interested in X.’” Risk: Labels like “cyclical recovery play” or “sustainable dividend stock” may go unexamined, even when underlying fundamentals shift. Mitigant Prompt: “Challenge my framing where evidence warrants. Do not preserve my assumptions uncritically.” 3. Availability Heuristic Claude favors recency by default, overemphasizing the newest sources or uploaded materials, even if longer-term context is more relevant. Claude System prompt instructions: “Lead with recent info; prioritize sources from last 1-3 months for evolving topics.” Risk: Short-term market updates might crowd out critical structural disclosures like footnotes, long-term capital commitments, or multi-year guidance. Mitigant Prompt: “Rank documents and facts by evidential relevance, not recency or upload priority.” 4. Fluency Bias (Overconfidence Illusion) Claude avoids hedging by default and delivers answers in a fluent, confident tone, unless the user requests nuance. This stylistic fluency may be mistaken for analytical certainty. Claude System prompt instructions: “If uncertain, answer normally and OFFER to use tools.” “Claude provides the shortest answer it can to the person’s message…” Risk: Probabilistic or ambiguous information, such as rate expectations, geopolitical tail risks, or earnings revisions, may be delivered with an overstated sense of clarity. Mitigant Prompt: “Preserve uncertainty. Include hedging, probabilities, and modal verbs where appropriate. Do not suppress ambiguity.” Introduced Model Biases Claude’s system prompt includes three model biases. Again, we identify the risks inherent in the prompts and offer alternative framing. 1. Simulated Reasoning (Causal Illusion) Claude includes <rationale> blocks that incrementally explain its outputs to the user, even when the logic was implicit. These explanations give the appearance of structured reasoning, even if they are post-hoc. It opens complex responses with a “research plan,” simulating deliberative thought while completions remain fundamentally probabilistic. Claude System prompt instructions: “<rationale> Facts like population change slowly…” “Claude uses the beginning of its response to make its research plan…” Risk: Claude’s output may appear deductive and intentional, even when it is fluent reconstruction. This can mislead users into over-trusting weakly grounded inferences. Mitigant Prompt: “Only simulate reasoning

Many asset owners are adopting net-zero objectives to manage their investment exposure to climate change risk. A net-zero investment objective aims to attain net-zero portfolio greenhouse gas (GHG) emissions by 2050, in line with the global goal of zero growth in real-world GHG emissions set by the Paris Agreement. Strategies to achieve a net-zero investment objective typically include reducing portfolio emissions to lower transition risk, investing in climate change solutions to capitalize on macro trend opportunities, and using engagement and advocacy to reduce systemic risks. Adding a net-zero objective to a traditional investment program presents challenges for asset owners because they must grapple with balancing a net-zero objective with fiduciary duty responsibilities, setting climate risk policy, and how to benchmark net-zero investment strategies, incentivize managers, and determine performance horizons. In “Net-Zero Investing: Solutions for Benchmarks, Incentives, and Time Horizons,” we explore these issues and propose solutions. Net-Zero Objectives A net-zero objective must not compromise an asset owner’s risk, return, and actuarial objectives. On the contrary, a well-executed net-zero investment program can support the attainment of these objectives in line with fiduciary duty responsibilities. Portfolio decarbonization and real-world decarbonization are not ends in themselves, but rather means to an end — to protect and enhance a plan’s assets. The concept of fiduciary duty differs across geographies, but the duties to act with care and prudence apply universally. Net-zero investment programs that carefully consider climate risk while striving to achieve an asset owner’s financial risk and return objectives fit within these duties. Climate Risk Policy In a traditional investment program, asset owners may measure investment risk as tracking error, volatility, value-at-risk, or another mean-variance risk metric. A net-zero investment program requires risk measurement, too. Mean-variance analysis, however, fails to capture climate change risk because historical data is insufficient to predict how climate change risk could affect stock price behavior. Portfolio climate change risk is complex, with multiple contributing factors, including transition risks, physical risks, and systemic risks — risks that don’t map to the factors in a mean-variance risk tool. Although GHG emissions are widely used as a proxy for climate risk, simply measuring and managing portfolio emissions does not fully account for climate change risk. Additional transition risk factors that can be monitored include the existence of company science-based emissions reduction targets, transition plans, or capital expenditures on emissions reduction. Measuring the physical risk factors of companies is time-consuming and data-intensive; third-party databases can often provide good solutions. As climate risk measurement evolves, asset owners can focus their efforts in the meantime on investments that contain the highest climate change–related risk, typically their public equity portfolios. Risk management encompasses managing upside risk as well; investing in climate change trends and solutions provides opportunities for increasing portfolio returns. Benchmarks As with all investment strategies, net-zero investing requires suitable metrics and benchmarks. Some asset owners default to their existing market index benchmarks, reasoning that climate risk management efforts should be reflected in portfolio returns. Others passively track a decarbonizing benchmark. Some create a custom reference benchmark portfolio that reduces the investment universe to a subset of companies better aligned with the investment strategy. Lastly, some asset owners employ a “scorecard” approach that combines a market index for measuring financial performance with performance metrics for each net-zero strategy component. We compare the utility of decarbonizing benchmarks and scorecards. The Paris-Aligned Benchmarks (PAB) and Carbon Transition Benchmarks (CTB) are the most widely used decarbonizing benchmarks. PAB and CTB indexes are designed to be derivative indexes of parent market indexes based on criteria set by the European Union. They aim for a 50% and 30% emissions reduction, respectively, relative to parent indexes and a 7% annual reduction thereafter. Decarbonizing benchmarks provide a useful way to launch a net-zero investing program, but they do have several disadvantages, including potentially high tracking error versus the parent index, limited influence on real-world carbon emissions, and, for many decarbonizing benchmarks, lack of transparency in construction methodology. The scorecard approach can be used to address a primary issue with net-zero benchmarking –namely, that no single index or benchmark can satisfy all measurement needs for an investment program that has both financial risk and return objectives and net-zero objectives. A scorecard benchmark can include a set of metrics or performance indicators that measure both financial objectives and net-zero objectives. As an example, the UK pension scheme NEST established three key expectations for its external asset managers as part of its net-zero investment program: (1) report on climate risks and opportunities using the TCFD framework, (2) reduce emissions, and (3) vote and engage on company transition plans and efforts. NEST holds its managers accountable for climate change objectives in addition to financial objectives. Scorecard benchmarks are commonly used in other industries to gauge performance; the investment industry’s reliance on market indexes as a sole performance benchmark makes it an outlier. Incentives Asset managers who are compensated solely to beat a market index may not directly pursue investment actions that contribute to asset owner’s net-zero objective. To motivate managers to achieve net-zero objectives, asset owners must provide appropriate incentives. Although asset owners have little influence over asset management compensation systems, they can set terms for net-zero mandates that include sufficiently motivating compensation structures. In a 2011 report titled “Impact-Based Incentive Structures,” the Global Impact Investment Network (GIIN) suggests asset owners consider several factors when deciding how to structure impact-based compensation, such as whether to reward for short-term performance, long-term performance, or both. The industry is just beginning to see the emergence of net-zero incentive compensation structures. As an example, one asset manager has linked deferred compensation to net-zero targets. We expect that we will see further development as net-zero investing gains momentum. Time Horizons The long-term goal of attaining a net-zero objective by 2050 must be achieved by meeting interim targets over short- and intermediate-term time horizons. Climate change can impact portfolio assets in material and unexpected ways, both near term and in the coming years, as the world attempts to mitigate this

After a down year for financial markets, investors’ priorities have naturally shifted from growing their assets to preserving their wealth. While risk management may be the key component of wealth preservation, what often gets overlooked is how much smart tax planning can do to help clients retain more of their wealth. Clients stay loyal to their financial advisers when they recognize that they bring much more value than simply identifying top-performing investments. Talking to clients about the full range of services you provide, including sophisticated tax-planning strategies, will strengthen existing relationships and appeal to more prospects. Below are some suggestions on how to upgrade your tax-planning game. You may already be doing all or most of these, so consider these ideas a checklist to determine if you’re applying all the best practices or whether there are areas where you need to improve. Regardless of what happens in 2023 — whether the markets rebound or a recession brings more challenges — expanding and demonstrating the value you can deliver to clients will be a huge asset. When the markets are serving up nothing but lemons, it’ll help you make lemonade. 1. Strengthen Your Relationships with Top-Notch Accountants Your contact list may already be full of tax professionals who can assist clients in filing their forms and reduce their annual tax bill. But how close are those working relationships? If your partnership with each accountant doesn’t regularly produce two-way referrals, it might not be as strong as it could be. Make sure you’re working with the most capable and talented tax pros. Do they deliver innovative and sophisticated client solutions? How much experience with high-net-worth clients do they have? Depending on the answers to these questions, you may need to build more relationships to ensure your clients are getting the best service out there. 2. Upgrade Your Tax-Planning Technology Capabilities Are you currently looking for tax-loss harvesting opportunities only in the final quarter of the year? Do you depend on spreadsheets or manual processes to identify them? If so, work with technology partners to automate tax-loss harvesting for you and your clients. You’ll be able to identify tax-saving opportunities throughout the year and implement them in a way that isn’t burdensome and time-consuming for you and your staff. 3. Update Clients about Tax-Planning Opportunities Tax laws constantly change, but the past few years have seen more changes than usual. So provide regular, jargon-free communications to clients that explain what’s different. For example, send an e-mail, newsletter, short video, or blog post about the Secure Act 2.0 legislation passed late last year. The law raises age limits for required minimum distributions (RMDs) from IRAs and retirement plans and offers opportunities to convert unused funds in a 529 college savings plan to a Roth IRA for the account’s beneficiary. Such messages will ensure that clients take full advantage of these new rules and emphasize that you’re watching legislative and regulatory changes with an eye towards how clients can leverage them. Do your high-net-worth clients know that the higher threshold for federal estate taxes will sunset in 2025 if Congress doesn’t extend them? Or that estate-planning tools like Spousal Lifetime Access Trusts (SLATs), for example, can preserve their higher estate tax threshold? Keeping clients in the know about these things will demonstrate that you are being proactive on their behalf. 4. Expand Your Tax-Planning Approach Tax-favored retirement and college saving plans and municipal bonds are among the best investment vehicles for lowering clients’ taxes. But clients need to know that your tax-planning recommendations can go beyond such mainstays. For example, if clients have high-deductible health insurance plans, talk to them about the benefits of health saving accounts (HSAs) to save for future medical needs, especially in retirement. Good Tax Management Reinforces Wealth Preservation Even if the financial markets fully recover in 2023, many investors will be holding onto one of 2022’s key lessons: that wealth preservation is important in any environment. Showing clients and prospects all that you can do to minimize the impact of taxes on their savings and investments will underline how committed you are to preserving their wealth. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / ffennema Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

This is Part II of my series on performance measurement for private market funds and in particular on the difficulties of using the internal rate return (IRR) measure as equivalent to an investment rate of return. In Part I, I discussed the rise of global AUM in private market funds and how this trend may have been driven by a perception of superior returns compared to traditional investments. I believe that a root cause for this belief is the generalized use of IRR to infer rates of return, which is problematic. In this post, I will discuss in more detail how IRR works and why investors must be careful not to view the metric as an equivalent measure to infer investment rates of return. What is an IRR? IRR is a discount rate. It is the discount rate that would make the net present value (NPV) of an investment zero. Note: In my first post in this series, I introduced a hypothetical example involving an asset and a set of intermediary cash flows to illustrate the challenge this causes when equating an IRR with a rate of return on investment. The situation involved a property acquired in 1976 for $100,000 and then sold for $1 million in 2016, or 40 years later. The model was complicated by introducing intermediary cash flows in the form of renovation work for an amount of $500,000 in 1981, while obtaining lump-sum payments from the tenant in 2000 for five years of tenancy ($200,000) and then again in 2010 ($400,000). The resulting equation to obtain the rate of return was proposed as: Where r is the reinvestment rate, f is the financing rate, and ror is the rate of return. Equivalently, IRR is the number x which would solve the equation in the example above if we assume that x = ror = f = r. By making that assumption that equation has only one unknown: Which can be rewritten as: Or,        You may recognize the NPV formula: the present value of all the cash flows discounted at a rate equal to irr is equal to zero. One equation, one unknown, but unsolvable by hand. You need to write a code to find out the solution to this equation. Why would one make such an assumption and present the result as a rate of return? First, as just explained, a rate of return does not exist for an asset that has more than two cash flows. Hence, for any private capital fund, there is simply no rate of return that can be computed, unless there are no intermediary cash flows. In a way, there is a void. As investors are used to thinking in terms of rates of return, maybe out of habit from the stock market, they really want a rate of return. Second, the IRR coincides with a rate of return under certain conditions. Specifically, IRR is correct if the rate at which all distributions are re-invested equals the IRR, and all investments after the initial one were financed at a rate equal to IRR. As a result, IRR is the best candidate to fill the void because there are cases in which it will be right, or close to right. The problem is that for many private capital firms track records, it is not even close to right. Since the issue comes from this re-investment assumption, the accuracy of IRR is related to its level. If the IRR is somewhere between 4% and 15%, say, then, it is alright because you could re-invest (and borrow) at that rate. That is, an implicit assumption of a reinvestment/financing somewhere between 4% and 15% for an investment in North America or Western Europe is plausible and therefore the IRR is plausible. Interestingly, in practice, whenever an IRR is negative, it is not reported. Instead, fund managers write “not meaningful.” A negative IRR assumes that every distribution is reinvested at a negative rate of return. In other words, money is burnt. A negative IRR is therefore not meaningful, indeed. For the same reason, however, any IRR above, say, 15%, is not meaningful. Yet, people seem keen to present high IRRs as perfectly meaningful. I demonstrated this tendency in my first article in this series. In that post, I shared some potentially influential news articles and statistics in nine exhibits from 2002 to 2024. One quick fix would be to require that any IRR outside a 0% to 15% window is reported as non-meaningful — unless there are no intermediary cash flows. Practitioners often argue that if someone knows the multiple of money, they can tell whether the IRR is correct or not. They mean that if IRR is 30% and money multiple is 1.1, then IRR is wrong, but if IRR is 30% and money multiple is 3, then IRR is correct. One issue I illustrated in my last post is that in all the exhibits except for one, a money multiple was not shown or discussed. Even if we search through the whole of the 10K fillings of any of the private capital firms, the only money multiple that is provided is one gross of fees — and not net of fees. The Yale Endowment, which is so influential, as I exposed in my last post, has never shown its money multiple.[1] Note that money multiple has different acronyms and is not always computed the same way. The two most-used acronyms are MOIC and TVPI. MOIC (multiple of invested capital) is usually how much has been returned to investors before fees divided by how much had been called to invest (not including the fees). TVPI (total value to paid-in capital) is usually the sum of what has been distributed to investors net of fees plus the value of un-exited investments (net asset value), divided by the sum of all the money called from investors (thus, including fees). Note also that it is possible for an investment to have both a high multiple and

It is no secret that 2022 has been a rough year for pretty much all asset classes across the board. While US equities have fallen more than 20%, the average fixed-income security hasn’t fared much better: Most are down at least 10%. Of course, bonds and other fixed-income assets are supposed to offer diversification benefits and provide something of a cushion for when the equity component of a portfolio runs into rough times. Clearly, they are not performing these functions especially well of late. With this in mind, we sought to understand when fixed-income assets have actually done what portfolio managers and investors expect them to do. We looked at returns for the S&P 500 and the average total bond fund going back to 1970 and analyzed how the correlations between them have changed over time. We tested the correlations over different interest rate environments as well as in changing rate environments. So, what did we find? With the federal funds rate serving as a proxy, the highest correlation between fixed-income and equity returns has occurred in rising rate environments. This mirrors the current predicament. As the US Federal Reserve seeks to rein in inflation, bond returns are not ameliorating the equity market losses but are, in fact, falling more or less in tandem with stocks. Indeed, we find that the correlation between stocks and bonds is lowest in flat interest rate environments. Whether this is because such environments correspond to the most stable of economic times is an open question. Nevertheless, whatever the cause, bonds and fixed income seem to offer the most diversification benefits and the least correlation with equities when interest rates are static. Average Stock-Bond Correlation by Rate Environment Rising Rates 0.5257 Flat Rates 0.3452 Falling Rates 0.4523 We next examined stock-bond correlations during low, medium, and high interest rate environments, that is when the federal funds rate is below 3%, between 3% and 7%, and above 7%, respectively. Here, we found that stock and bond correlations are highest when the federal funds rate is above 7%. Conversely, bonds offer the most diversification benefits, or the least correlation with equities, during low rate environments. Stock-Bond Correlations in Different Federal Funds Rate Environments Above 7% 0.5698 Between 3% and 7% 0.4236 Under 3% 0.2954 Finally, we explored how the benefits of diversification shift during recessions. To do this, we isolated the correlation between stocks and bonds at the outset of each of the seven recessions that have occurred since 1970 and then compared that to the stock-bond correlation at the conclusion of that particular recession.  In five of the seven recessions, the correlations increased, with the largest spikes occurring during the 1981 recession and in the Great Recession.  What lesson can we draw from this? That it is precisely when fixed income’s diversification benefits are most needed — during a recession — that they are least effective. Stock-Bond Correlations during Recessions End of Recession Start of Recession Change November 1973 to March 1975 0.7930 0.7095 0.0835 January 1980 to July 1980 0.4102 0.7569 -0.3468 July 1981 to November 1982 0.6955 0.0282 0.6673 July 199 to March 1991 0.7807 0.5156 0.2651 March 2001 to November 2001 -0.1957 0.3754 -0.5710 December 2007 to June 2009 0.8284 -0.2149 1.0433 February 2020 to April 2020 0.7364 0.3369 0.3995 This presents a sizeable dilemma for investors and portfolio managers alike. Amid recession or rising rate environments, we cannot count on fixed income’s hedging effect. Which means we need to look to other assets classes — perhaps commodities or derivatives — for protection in bear markets. Of course, they may not be capable of filling the gap either. If you liked this post, don’t forget to subscribe to the Enterprising Investor All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images/ Alphotographic Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

The legendary musician Prince exhorted us to “Party like it’s 1999,” but today, as a small-cap stock investor, I’d flip the calendar one year ahead, to 2000. That’s because by March 2000, the NASDAQ had peaked at 5048 and by April had plunged by almost 35%. The following 18 months were no party either. Many former high-flying tech stocks, including Pets.com and Priceline, lost all or nearly all their value. Even stalwarts like Intel, Cisco, and Oracle experienced major drawdowns. In fact, trillions of dollars vaporized during this infamous period that became known as the dot-com bubble. But for some investors, the aftermath of the dot-com bubble was one of the best times to deploy capital ever. It was the all-too-rare opportunity to acquire meaningful positions in quality companies for which the market simply had no appetite. I believe that quality small caps are in a similar position today. These days, small caps are unloved, unwanted, and uninvited to the party. And there has been a party — a big one hosted by a handful of mega-cap tech stocks, particularly those perceived as bellwethers of all things artificial intelligence (AI)-related. The parallels between AI mania and the dot-com era are hard to ignore. Back in 1999, any company that touted its internet bona fides was a market darling. Spoiler alert: It did not end well. Nevertheless, it was an excellent time for selective stock picking, and there are familiar echoes in today’s Canadian small-cap technology stocks. What’s Happening Now — Why the Big Discount? In life, as in investing, everything happens for a reason, or several reasons. And that holds true for the absolute and relative low valuations for small-cap stocks. 1. Big pools of capital are increasingly going private. Pension funds and other large institutional investors are looking to generate alpha. In the past, they would allocate a portion of their investments to small-cap public companies to achieve that. Today, these investors are shifting their portfolios away from public markets and into private markets. When only a handful of stocks are driving most of the gains, asset managers have a hard time achieving outperformance. Hence, the diversification benefits of private equity and its alpha potential look appealing. For example, Yale University’s endowment fund has nearly 40% in private equity and venture capital funds today compared with only 5% in 1990. As demand for small-cap stocks declines, so do their valuations. 2. Investors are chasing performance. We have all heard of the Magnificent Seven, the mega-cap tech stocks that have driven recent equity returns: Nvidia, Microsoft, Amazon, Apple, Alphabet, Tesla, and Meta. To put things in perspective, Apple is worth more than all the smaller US companies contained in the entire Russell 2000. Investors have been chasing large-cap returns, and the five-year track record of the NASDAQ is excellent. That was true back in January 2000 as well. 3. There’s the macro and the micro. At the macro level, the small-cap market turned over in 2021 and has faced the headwinds for almost 2.5 years now. Rising interest rates were priced into small-cap valuations, and with different debt dynamics from their larger peers, smaller companies generally sell off first ahead of a potential recession. Smaller companies, especially those in earlier growth stages, tend to carry more debt, and that debt tends to have a shorter average maturity — 5.7 years vs. 8.2 years — which puts them at greater risk in tighter monetary environments. Smaller companies also have fewer sources of financing to rely on. What Are the Upside Catalysts? Against this backdrop, where are the opportunities in small-cap stocks? Smaller companies tend to lead the way ahead of a recovery. When monetary policy becomes more dovish, perhaps as early as the first quarter of 2024, small-cap equities should respond strongly. As performance leadership continues to narrow, institutional funds, among other investors, will begin to look elsewhere, and quality small caps are one place where they will likely deploy capital. Because small caps tend to be less liquid, a spike in demand can potentially generate significant surges in share prices and a re-rating. Mean regression dictates that, at some point, small-cap valuations will return to their long-term average. The M&A market is another source of potential upside for small caps. Today, willing sellers are hard to find. Many quality companies came to market at high valuations, and management teams have psychologically anchored to those higher multiples. But in time, their shareholders and board members will accept the new reality and realize that acquisition may be the best path to continued growth. The small-cap premium historically implies that small-cap stocks outperform their large-cap counterparts over the long term. For example, from 2000 to 2005, after the telecom boom and bust, the S&P 600 outperformed the S&P 500 by 12% per year on average. We’re in a period with a compressing multiple in small caps compared with large caps. As of September 2023, the forward P/E of the S&P 600 is 13.8. The last two times the S&P 600 had a forward P/E in this range was during the global financial crisis (GFC) and at the start of the global pandemic. On both those occasions, those investors who deployed capital to small caps were well rewarded. There could be a similar opportunity today. If you liked this post, don’t forget to subscribe to Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / jjwithers Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

The Behavioral Portfolio: Managing Portfolios and Investor Behavior in a Complex Economy. 2025. Phillip Toews. Harriman House. In The Behavioral Portfolio, author Phillip Toews — the lead portfolio manager of the Toews Funds and the Agility Shares exchange-traded funds, as well as the co-founder of the Behavioral Investing Institute — seeks to reconcile two largely unacknowledged problems in the investment advisory industry. First, the history and risks of both bond and stock portfolios far exceed what most investors and advisory practices can tolerate. For example, the United States experienced a 36-year bond bear market from 1945 to 1981 and a 14-year stock bear market around the time of the Great Depression. Second, the approach that most financial advisors take to communicate about portfolios is ineffective in helping clients avoid known biases and poor decision making. In addressing the first problem, the author instructs financial advisors to create robust “behavioral portfolios” designed to invest optimistically while addressing the real-world contingencies of investing in a high-debt world and the many downside risks that it presents. The US total public debt-to-GDP ratio currently stands at approximately 122%, a dramatic increase from approximately 39% in 1966. The criteria to consider when building behavioral portfolios include comprehensively addressing tail risks, providing long-term above-inflation growth, capturing gains during rising markets, and preserving gains. In the author’s behavioral portfolio execution example, the conventional Norway model construct of a 60/40 stock/bond allocation, is modified in two ways. First, half of the stocks are placed in a hedged equities fund. Second, the conventional bond allocation is replaced by adaptive fixed income, allowing the strategy to adapt to negative bond market environments. Therefore, this example of the behavioral portfolio, which is based on Morningstar data, consists of three components: conventional equities (MSCI World NR USD), hedged equities, and adaptive fixed income. In my favorite section of the book, the author compares his behavioral portfolio with a conventional portfolio and presents several charts for a 16-year timeframe from 2008 to 2023. For example, in the three calendar years in the sample in which the benchmark experienced meaningful losses, the behavioral portfolio showed lower drawdowns, which in some cases (e.g., 2008) were significant. In the sample, the behavioral portfolio had slightly higher average mean returns, an 80% up capture ratio, and a 0.97 correlation to the benchmark during rising markets. Finally, the left tail of the behavioral portfolio is much shorter than that of a traditional portfolio, and the right tail is also compressed. In addressing the second problem, that of financial advisor–client communication to prevent poor decisions, the author correctly emphasizes the importance of “behavioral coaching,” which can be an important part of the advisor–client relationship. He shares specific, proactive strategies that can train investors to not only understand portfolio components but also embrace contrarian decision making that helps avoid known biases. Communicating the unique value of the behavioral portfolio to investors is an important part of these strategies. The author argues that financial advisors should shift the emphasis from reactive explanations to proactive preparation in communication with clients. That mindset shift can make a significant impact in helping clients stay disciplined through different market cycles. At the end of the book, Toews adeptly uses the hero’s narrative to describe the advisor’s role. Toews adroitly critiques the antiquated 60% equity/40% bond portfolio with precision, exposing its flaws in today’s market. Real-world examples drive his points home, making complex financial ideas accessible. For financial advisors and casual investors alike, this is an important book for moving away from traditional investing strategies. Although The Behavioral Portfolio: Managing Portfolios and Investor Behavior in a Complex Economy was written for advisors, it is also a recommended read for retail investors trying to decide on their own portfolio mix. The book challenges traditional portfolio construction, arguing that many common approaches leave investors exposed not only to economic shocks but also to the emotional responses that often accompany market dislocations. source

Economic data reflect global supply chain restructuring. Nearly two years into the regionalization, nearshoring, re-shoring, and “friend-shoring” of the global supply chain restructuring process, US and overseas economic data are revealing the consequences. As the supply chain shifts, accelerated by pandemic disruptions and policy uncertainty, previously dependable — and popular — data correlations are shifting as well. Consider US manufacturing. While technology, financial, and consulting firms have announced major layoffs amid 15 months of monetary tightening by the US Federal Reserve, the manufacturing sector remains resilient. Indeed, expansionary fiscal policies continue to spur positive growth and inflation, which, combined with federal efforts to move semiconductor production onshore, has triggered a manufacturing boom — and with it a severe labor shortage. Given an aging workforce and an economy and culture that emphasized college education over vocational training for generations, there are simply not enough skilled workers — electricians, welders, and semiconductor technicians — to meet demand. On the other side of the Pacific, “de-risking” among large North American and eurozone importers has created its own economic ripples. Export trade flows are shifting, according to a survey of 15,000 vendors at the 2023 Canton Fair in Guangzhou, China. While producers previously leveraged vertical integration to export vast volumes of finished goods to advanced economies, many manufacturers from Guangzhou to Shanghai are now fulfilling smaller orders of intermediate goods to “nearshoring” emerging market (EM) destinations for final assembly. In this new paradigm, exports from the port of Qingdao, a shipping hub for EM destinations, rose 16.6% year over year in the first quarter of 2023, while container volume through the ports of Shanghai and Zhoushan, which serve European and North American routes, declined 6.4%. In aggregate, East Asian manufacturing centers are addressing overcapacity while select US sectors face capacity shortages. Such transformations are rarely costless. The once consolidated “factory gate price” is also undergoing a geographical shift. The optimization of global supply chains and vertical integration across key Asia manufacturing hubs over previous decades fueled co-movements between major export nations’ Producer Price Index (PPI) / factory gate price and Consumer Price Index (CPI) data in advanced economies. But these relationships hinged on the now disrupted pre-pandemic supply chain. With finished goods assembly more widely distributed across EM locales and amid ongoing supply chain retooling, US inflation and prices at manufacturing hubs may have weaker data correlation. Why? Because a more diffuse and less integrated supply chain will cement factory gate prices in different nations because of idiosyncratic local labor and materials considerations. With these factors in mind, a more geographically redundant but less efficient trade regime will likely be inflationary, as the new weighted average PPI will reflect various non-optimized pricing data. Alternatively, costs for energy, raw materials, and other commodities could serve as leading indicators in a more complex but resilient global supply network. US CPI and Bloomberg Commodity Index Sources: US Bureau of Labor Statistics, Bloomberg, Kekselias, Inc. Supply Chain Transformation = Uncertainty Given the current policy and business focus on supply chain redundancy, further diversification rather than consolidation and cost optimization is likely in the weeks and months ahead. Thus, the structure of global trade will continue to transform before it achieves a new equilibrium. This implies more data volatility, weaker relationships between once correlated peers, and perhaps most importantly, emerging opportunities for investors who understand and anticipate the new supply chain paradigms and data co-movements. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Natee Meepian Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source

Central banks are playing a critical role in addressing climate change by steering the financial sector toward sustainability. However, there is a significant disparity, particularly in developed countries such as the United States, between the creation of climate change strategies and their execution. This gap is apparent in the struggle to reach 2030 CO2 emission reduction targets, and points to the need for more practical measures[i]. The immediacy of the situation calls for a reinterpretation of financial principles. Central banks across the globe, historically focused on controlling inflation and fostering economic growth, have evolved to serve an essential role in guiding the market toward environmental sustainability. They are increasingly integrating climate risk factors into their economic evaluations. Over the past four decades, various economic philosophies have shaped the financial landscape in developed nations, with ideologies ranging from the laissez-faire principles of Neoliberalism to the proactive governmental roles suggested by Keynesianism, as well as the contemporary Modern Monetary Theory (MMT). Despite its fresh perspective on government spending and debt, MMT doesn’t accentuate the contribution of central banks, such as the Federal Reserve, toward environmentally friendly investments. Economists have voiced concerns about MMT, particularly relating to public debt and climate finance[ii]. The United States, recognized as a significant contributor to global CO2 emissions, is being pressured to amplify its efforts to curb climate change. Traditional economic theories, such as neoclassicism, forecast substantial financial obstacles, including a potential rise in inflation stemming from the enormous investments required for climate change mitigation. On the other hand, MMT believes the move is more political, proposing government backing to facilitate the ecological shift and advocating for government subsidies to aid the green transition[iii]. The practicality of MMT is under debate, however, with concerns about continuing inflation risks and declining international demand for US Treasury bonds. A more appropriate approach for US policymakers is to follow the European Central Bank (ECB) model and green regulatory framework. The ECB Model The ECB is stepping up its game, aligning its financial strategy with the EU’s climate objectives. It is revamping its Corporate Sector Purchase Programme and collateral framework and merging practical climate action with market neutrality. The ECB’s strategy is fondly dubbed ‘Green Quantitative Easing,’ focusing on purchasing green assets to support environment-friendly projects and lower finance costs. It’s a strategic move, nudging the European economy toward sustainable growth and development[iv]. In addition, the ECB is tackling climate-related financial risks head-on by introducing new tools and processes. The Fed’s Role in Tackling Climate Change Recognizing climate change is a considerable financial hazard, the US Federal Reserve initially took a research-focused approach before moving toward policy initiatives. This shift is a departure from the norm for the Fed, traditionally seen as neutral but now emerging as an essential pillar in tackling climate change’s financial and economic consequences. The divided nature of American politics and the substantial clout of the fossil fuel industry[v] substantially restrict the potential for more audacious climate action initiatives. As the US finance sector considers this paradigm shift, top-tier banks are shaping policies to boost green-oriented initiatives. These efforts are gaining momentum through innovative hybrid asset classes and new investment tools that marry traditional asset characteristics with a sharp focus on environmental sustainability. Their objective is twofold: achieving financial gains while advancing environmental goals, such as reducing carbon footprint and promoting renewable energy.  New asset classes — like those discussed in CFA Institute Research and Policy Center’s “Navigating Transition Finance” report — strive to consolidate funding avenues, giving birth to new financial instruments crucial to green economic tactics. Yet, this quest for innovation isn’t a lone journey. Central banks are teaming up with giant asset managers, including pension funds and sovereign wealth funds, making for a powerful alliance. Still, this cooperation underlines a significant challenge: there is a pressing need to direct a large share of these resources toward investments that align with climate preservation[vi]. The Role of GSIBs In the face of escalating regulations, societal changes, and technological advancements, Global Systemically Important Banks (G-SIBs) are amplifying their emphasis on strategies related to climate change. These strategies include promoting green financing, minimizing investment in high-emission sectors, and improving climate risk management. As a reflection of public demand and emerging opportunities offered by green finance, G-SIBs have pledged almost $9 trillion for sustainable financing by 2030. This commitment marks a notable advance toward the projected $130 trillion required for a worldwide transition to a net-zero economy by the midpoint of this century[vii].  The Fed has a significant role in fostering a greener economy. It can encourage environmentally conscious investments. Its partnerships with the Environmental Protection Agency and Securities and Exchange Commission further empower its capabilities. Furthermore, its participation in global discussions on sustainability reinforces its mission to reshape our financial backdrop without compromising its cherished independence[viii].  Now more than ever, green economics is vital in macroprudential policy. Financial organizations reluctant to adapt to an economy aware of its carbon footprint risk severe instability[ix]. In contrast, those who respond to these changes promptly stand to profit from the emerging green opportunities. The challenge for the industry lies in reducing direct and transitional climate risks and catering to the growing group of investors and borrowers who deem environmental sustainability a priority. The Fed’s Supervision Climate Committee (SCC) plays a significant role in fortifying financial organizations against the disruptions caused by climate change. The SCC is at the forefront of understanding and addressing the financial consequences of climate change. Their work includes evaluating risks, devising mitigating strategies, and ensuring that regulatory standards are adhered to for effective climate risk management.  In addition, the SCC extends its efforts to comprehend the economic implications of climate change through extensive research. It works tirelessly to increase stakeholders’ awareness and provides the crucial guidance and resources that financial institutions need. The SCC also holds sway over Congressional climate expenditure, thus shaping legislative and fiscal strategies concerning environmental policies[x]. In 2023, Fed Chairman Jerome Powell acknowledged the multifaceted financial implications of climate change. He emphasized, however, that the Fed would not nudge

Brian Minns, CFA, will speak at the Climate Risk and Returns Conference from CFA Institute, held 20–21 April 2023 in New York City. Partnerships among institutional investors are crucial to achieving a low-carbon economy. As institutional investors, we have a fiduciary duty to act in our beneficiaries’ best interests and earn sufficient investment returns to meet their expectations. To achieve this, we also need to ensure there are stable financial, social, and environmental systems on which to build those returns. At University Pension Plan (UPP), we believe promoting healthy systems goes hand in hand with our fiduciary duty to our members. That’s why, when we developed our response to climate change and our net-zero approach, we set our sights beyond our own portfolio, because we know that emissions must also decline in the real world and that a well-managed, low-carbon transition requires systemic change from all corners of the global economy. The net-zero transition also presents opportunities for investors — institutional and otherwise — to build confidence, resilience, and competitiveness in the wider economy through profitably financing activities that support sustainable solutions and lower emissions. By contributing to collaborative initiatives with the global investing community, investors create reciprocal relationships through which we can share expertise and best practices, leverage resources, and amplify our influence to create the change we need. In this way, we can reduce uncertainty and risk and maximize our return-generating potential. Such collaborative effort among asset owners is one of the most effective means for organizations like ours to catalyze systemic change and carry out our shared fiduciary duty. Systemic Risk Requires Collective Action When investors directly engage and set expectations for both the companies they own and the external managers they partner with, we help keep these firms focused on the transition pathway, on improving their resiliency and lowering emissions. Investors also need companies to improve their climate-related disclosures to better track their progress toward net-zero goals and make more informed investment decisions. Such finance-led groups as Climate Action 100+ and the Institutional Investors Group on Climate Change (IIGCC) work to ensure sound science, alignment, and consistency across all member activities. By engaging with various high-emissions companies through a common set of objectives, we are working not only to change their behavior but also to improve climate-related expectations and the structure of information flows for all companies and investors. Collective Advocacy to Protect and Enhance Value Through collective advocacy with policymakers and regulators, investors can encourage rules and frameworks that support the interests of our beneficiaries and create the conditions for a well-managed climate transition. Investors can collaborate and amplify their voices through such well-established industry initiatives as the UN-convened Net-Zero Asset Owner Alliance (NZAOA), a member organization composed of 85 institutional investors with more than US$11 trillion in assets under management (AUM), and the Ceres Investor Network on Climate Risk and Sustainability, which collectively represents more than 220 investors and in excess of US$60 trillion AUM. Through our participation in policy working groups, such as those convened by the Canadian Coalition for Good Governance and the Responsible Investment Association, we can define and promote good corporate governance practices in Canada and around the world. We can also influence public policy to improve governance standards. More transparency, accountability, and disclosure, in turn, help manage risk and protect the value of investments. Partnership in Times of Change Makes the Collective Stronger As domestic and international climate transition regulations and incentive frameworks evolve, investors face new legal and reputational risks as well as potential impacts on returns. Rather than navigating this evolving landscape alone, they can join investor alliances and help coordinate policy advocacy, facilitate improved knowledge sharing, and mitigate old and new risks. For example, to counteract greenwashing and provide investors with more and better information to help guide their decisions, the International Sustainability Standards Board (ISSB) will implement new global accounting standards for measuring and reporting climate-related impacts in January 2024. Collaborative investor groups contributed to the development of these new standards and stand ready to support their launch around the world. Once again, individual investors would be hard pressed to keep up with the rapid pace of change in this area or to develop the collective influence that a group of investors can muster. There are many options to join with like-minded investors in local markets or on the international stage. The global low-carbon transition will continue to pose a challenge for all types of investors and present both risk and opportunity along the way. Net zero won’t be achieved in isolation but will take collective action throughout the financial community. Together, through partnerships among institutional investors and investors of all sizes, we can help shape the future of finance and bring about the systemic, global change required to make net zero a reality. If you liked this post, don’t forget to subscribe to Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / JamesBrey Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker. source