CFA Institute

Your Essential Guide to Sustainable Investing. 2022. Larry E. Swedroe and Samuel C. Adams. Harriman House. The establishment of the United Nations-backed Principles for Responsible Investment (PRI) in 2006 marked a turning point for investors. The PRI united signatories under a framework that was consistent with the neoclassical underpinnings of traditional finance — the pursuit of the best risk-adjusted returns — while making explicit how environmental, social, and governance (ESG) issues should be included in the analysis and valuation of securities and in subsequent engagement with management and the voting of proxies. While the practices of responsible investment (RI), socially responsible investment (SRI), and morals-based screening had been long intertwined without clear definition, by implicitly limiting the consideration of ESG issues to those that are financially material to shareholders the PRI set a boundary that in turn helped define the other sustainable finance practices. For most investors (universal owners such as pension funds may be slightly different) the overlap between RI and SRI ends when shareholder and stakeholder interests are no longer aligned. The primary benefits of the PRI’s framework have been as a catalyst for the incorporation of material ESG issues into investment practices, and as a signpost for the limits to which investors would naturally consider ESG issues. Beyond these limits stakeholders need to seek other avenues for change such as regulatory or legal reform, or changes to consumer behavior. Despite the PRI’s helpful framework, “sustainable investment” has less clarity today. Both media representation and asset manager marketing materials conflate the shareholder and stakeholder approaches with morals-based screening and impact investing, leaving us once again in need of guidance. Investment professionals and authors Larry Swedroe and Samuel Adams step into this quagmire of mixed messaging with a helpful and timely tome. Their first chapter tackles the central issue head on — “there are dozens of forms of sustainable investing” — and promptly (in the same sentence!) offers a framework that forms the outline for their guide — “we can categorize most of them into three general categories: ESG, SRI, and impact.” The book is well-organized, well-paced, well-articulated, and welcome; a good starting point for those seeking to understand the history and current practices of sustainable investing, and for those seeking practical guidance, including (for US investors) specific investment examples. The book recommendation comes with two important qualifications, however, which are discussed at the end of the review. First the strengths; Swedroe and Adams cover the “what,” “how,” and “who” of sustainable investing in the book’s first 30 pages. The “what” chapter includes summaries of SRI, impact investing, and ESG investing and includes examples of each strategy — a vegan climate ETF; a farmland REIT; and an ESG-aware ETF — which both professional and retail investors will find helpful. The “how” chapter explains the nuanced differences among: Negative/exclusionary screening Positive/best-in-class screening Norms-based screening ESG integration Sustainability-themed investing Impact/community investing Corporate engagement and shareholder action The “who” chapter covers: Sovereign wealth funds Pension plans College and university endowments Faith-based investors Family offices and foundations Financial advisors and wealth managers Individual investors Institutional asset managers Investor coalitions (including the PRI). This chapter provides insight into the methods and challenges of each investor type such as, “Endowments can find it challenging to invest sustainably because of their unique set of stakeholders.” Following their concise introduction Swedroe and Adams explore in depth “why” investors choose to invest sustainably and “what” they hope to accomplish. They note that sustainable investors “seek to promote a better world, through the societal return achieved by improving outcomes for both people and the planet.” The three returns to sustainable investing — financial, societal, and personal — are reviewed, leaving readers well equipped (after a short chapter that expands on the history of sustainable investing) to consider in depth the performance and impact of sustainable investing. Both chapters are comprehensive — combined, they account for about half of the book’s content — and have a strong academic tilt not present until this point. Investment professionals will find the two chapters particularly helpful, but retail investors may be challenged by the sheer volume of the literature review. It is also in these two chapters that the authors’ use of multiple frameworks (RI and SRI in particular) begins to creak under the strain of shifting perspectives. Noting that decades of data supported the factor research that refined the capital asset pricing model (CAPM), the authors caution that researchers’ current efforts to identify ESG factors are limited by the short time span of ESG data. They also note a divergence in both ratings and ratings methodologies by the major ESG ratings agencies, and it is here that the creaking is first heard. As with the issuer size and price-to-book ratios used in the original factor research, academics seeking to identify an ESG “factor” rely on standardized inputs for their research, including the ratings from ESG ratings providers. The same ESG ratings also help asset managers develop (and market) their negative or positive screens for investment funds, ratings, and screens that resonate with an investing public to align their moral or social goals with their investment holdings. However the divergence in ratings is much less relevant to active managers who integrate the ESG information into their valuation models. Researchers and investors use ESG ratings for their “headline scores,” while analysts use the 50-plus page reports as an input so that material ESG issues can be incorporated into a security’s valuation. That the utility of ESG ratings is dependent upon an end user’s perspective is emblematic of the current tangle in sustainable finance and highlights the benefit of a consistent framework — ideally the “financial materiality” framework promulgated by the PRI. As founding Sustainalytics CEO Michael Jantzi opined at a responsible investment conference I attended, the marketplace should ultimately determine which rating methodology is preferred by end users. The authors next review performance implications for ESG factors — sin stocks and screening, carbon intensity and risk, best-in-class — and cover impact, equity, and

As an investment professional, I know how easy it is to get caught between two extremes: chasing financial independence to retire early or staying in the industry far longer than we should — trading time for titles, bonuses, and perceived security. I’ve seen both paths lead to regret. That’s why I believe the real goal isn’t early retirement or late retirement — it’s meaningful retirement. There’s a magic window when we still have health, time, and financial freedom. The key is knowing when to step into it — and making sure you’ve built more than just wealth along the way. Work is often stressful, especially in banking and finance. So it’s no surprise that some professionals dream of leaving behind the daily grind as soon as they can. Lying on a beach and never having to reply to another work email seem enticing, especially when you have toxic colleagues and unreasonable bosses to deal with. However, after retiring, when the stress disappears, the golf course starts to feel repetitive, and spa days lose their magic. You begin to wonder: Is this it? Even though I have achieved my financial freedom, I’ve never quite subscribed to the FIRE movement because I know having money alone is not enough for a fulfilling retirement. If you spend much of your prime years solely focused on wealth accumulation, and neglect your relationships, interests, and your identity outside of work, you may find yourself having no purpose and no network post-retirement. Retiring at Retirement Age At the other end of the spectrum are those who wait too long to retire — setting ever-higher goals, afraid to leave the security or status of their careers. A LinkedIn poll I conducted showed that more than one-third of 2030 respondents believe they need at least $10 million to retire. Do we really need this much to retire? In banking and finance where the salary is good, it’s easy to stay in a job that you are no longer passionate about, just to keep clipping the coupon. In doing so, you may be missing out on the magical stage of your life. The Three Stages of Life Life can be divided in three stages: Stage 1: YouthYou have time and health, but not much money (unless you have a trust fund). Stage 2: Mid-LifeYou have money and health, but very little time — career and family consume most of it. Stage 3: Old AgeYou have time and money (hopefully), but health begins to deteriorate. But there’s a magical stage between Stage 2 and 3 where you have all three: time, health and money. Some people extend Stage 2 for too long, chasing promotions, accumulating wealth, and missing this precious window to live fully and intentionally. I left banking in 2017 to get into this magical stage where I have freedom to do what I like, and with whom I like. To make the most of this magical phase, and to ensure your retirement is meaningful, not just comfortable, you first need to build three forms of capital: financial capital, human capital, and social capital. Financial Capital This is the most obvious form of retirement readiness. You need enough money to support your lifestyle, healthcare, and travel plans. During my banking years, I lived below my means. I didn’t buy the Ferrari. I didn’t dine often at Michelin-starred restaurants. I wore a Timex instead of a Rolex. When I left UBS and returned from Hong Kong to Singapore, I bought the cheapest car I’ve ever owned. At first, I wondered: “Would people look down on me now that I no longer have the MD title or a luxury car?” I was overthinking. No one cared. What people did care about was how I transitioned — from banker to lecturer and writer with a large following on LinkedIn. Wealth doesn’t need to be displayed. Let your actions and impact speak for themselves. For my personal investment, I’ve shifted from properties and stocks into bonds and ETFs to reduce risk. Human Capital This refers to your skills, knowledge, and interests — the things that give you a sense of identity and purpose beyond your job title. Throughout my career, I invested in myself. I took courses that sparked my curiosity — not just finance, but graphic design and portrait photography. I incorporated those passions into my work, even offering to be the photographer at client events. I loved teaching, so I volunteered to conduct internal training for departments like credit, compliance, and legal, even though it wasn’t part of my KPIs. In the evenings, I taught finance as an adjunct associate professor at a top university in Asia. While still in banking, I started writing about career development on LinkedIn. Today, these skills and interests serve me well. I collaborate with major brands on sponsored content and events and continue to find fulfillment in the work I choose. Social Capital This is the trust and goodwill you’ve accumulated over the years by treating others with respect and helping them. You’ll need plenty of it after you quit your day job. When I published my book Small Actions, former banking colleagues supported me by buying multiple copies for their juniors. Some recommended me for speaking gigs; others regularly engaged with my LinkedIn posts. What many people don’t realize is a full-time job offers daily networking opportunities: you meet new colleagues and clients. After you retire, your social circle can shrink quickly. You tend to meet the same few friends, and you stop gaining new perspectives. When I was still a banker, I made a point to expand my network beyond the office. Today, I interact with many young professionals from diverse industries who keep me updated and relevant. While you are at your day job, invest in others: buy lunch and coffee, mentor junior colleagues, and support your friends’ projects. Don’t Just Accumulate Wealth, Accumulate Life Too Whether you retire early, late, or somewhere in between, to retire well, you need more than a number. You need financial, human, and social capital. Until you’ve built

There is an old adage on Wall Street: To succeed as an equity fund manager, follow interest rates and the bond markets. We decided to put that theory to the test: So, how do we determine whether active equity fund managers are following the bond markets? There is no perfect answer, but the proxy we apply here is the performance of in-family bond funds. Our theory is that the expertise required to produce outperforming bond funds would spill over and help generate above average returns for in-family active equity funds. For instance, if an asset management firm’s active bond managers did poorly over the past five years, we would anticipate their counterparts in active equity to underperform as well. With this premise in mind, we pulled the performance of all US dollar-denominated funds over the past five years and then matched each actively managed equity fund to their fund family and compared its performance to that of the average in-family fixed-income mutual fund. Our Bottom Bond Fund Performers category designates the lowest performance quartile over the five years under review, and the Top Bond Fund Performers those funds in the top 25%. We tested our theory across actively managed emerging market, value, growth, small-cap, large-cap, and international equity funds. In general, our results were inconclusive. For instance, the average five-year return of emerging market equity funds in families with top-quartile bond managers was –1.22% per year, while the average return of those in a family with bottom-quartile bond managers was –1.12%. The –0.10 percentage point difference is hardly significant and demonstrates that bond fund performance does not predict equity fund performance in this category. Top Bond FundPerformers(Same Fund Family) Bottom BondFund Performers(Same Fund Family) Difference Emerging Market Equity –1.22% –1.12% –0.10% Value Equity 8.44% 8.56% –0.12% Growth Equity 9.28% 9.25% 0.03% Small-Cap Equity 6.38% 6.89% –0.51% Large-Cap Equity 7.33% 7.19% 0.14% International Equity 1.02% 0.87% 0.15% The only two sub-asset classes with results that might support our theory are large-cap and international equities. In the former, strong in-family bond fund performance is associated with 0.14 percentage points of equity fund outperformance per year compared to those in the bottom quartile. All in all, our results do not indicate that a fund family’s success with bond funds translates to the equity side of the ledger. Of course, our in-family proxy may not be the best gauge of which equity fund managers pay the most attention to interest rates and the bond markets. To be sure, only a truly novel set of data could accurately identify that cohort. 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 / dszc 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

Investors betting on a near-term plunge in interest rates may be mistaking political theater for monetary policy reality. President Donald Trump’s renewed pressure on Federal Reserve Chair Jerome Powell has stirred speculation in the bond and futures markets. But history — and Powell’s own posture — suggest that such expectations are misplaced. Past confrontations between presidents and Fed chairs rarely produce immediate policy shifts. The lesson: wagers on dramatic rate cuts rest more on wishful thinking than sound economic reasoning. Trump’s variety of moral suasion might strike investors as unconventional. “I call him every name in the book trying to get him to do something,” he said of Powell. But history offers several instructive examples of how presidents have tried — and mostly failed — to sway Fed chairs. In 1965, for example, President Lyndon Johnson had harsh words for William McChesney Martin, who had just pushed through a rate hike: “You’ve got me in a position where you can run a rapier into me and you’ve done it. You took advantage of me and I just want you to know that’s a despicable thing to do.” Johnson feared the higher rates would undermine his domestic spending programs and his escalation of the Vietnam War. Yet despite the pressure, Martin stood firm — and did not reverse the rate hike — illustrating how even intense presidential demands often fail to move the Fed. Why Powell Won’t Play Politics So far, Powell has stood his ground in the face of the president’s verbal assaults. “Everyone that I know,” he has said, “is forecasting a meaningful increase in inflation in coming months from tariffs because someone has to pay for the tariffs.”  There are two important reasons to doubt that the Powell will soon change tracks on interest rate management. For one thing, he has little to gain and much to lose by deviating from the stance he believes is best supported by current economic data. Nothing suggests that Powell regards the Federal Reserve chairmanship as a steppingstone to higher office and might therefore be motivated to play politics. Two of Powell’s predecessors — G. William Miller and Janet Yellen — did go on to serve as Secretary of the Treasury after leading the Federal Reserve. But their paths offer little reason to believe Powell would view that role as a likely reward. Miller was appointed to both posts by the same president, Jimmy Carter, so his move wasn’t the result of cross-party political calculation. Yellen, meanwhile, was initially appointed Fed Chair by Barack Obama, then passed over for reappointment by Trump, and later tapped for the Treasury role by President Joe Biden — Obama’s former vice president. In contrast, Powell was appointed to lead the Fed by Trump himself, but has since faced public criticism and even threats of dismissal from the former president. While Trump has shown a willingness to include former rivals in his cabinet, it’s hard to imagine Powell earning such favor. At best, he might hope Trump refrains from trying to fire him before his term expires in 2026 — a step of questionable legality. In that light, we can suppose that Powell is concerned with safeguarding his legacy.  He probably does not want to be remembered, as Arthur Burns sadly is, for submitting to political pressure and consequently failing to keep a lid on inflation. Misguided monetary policy also tarnished the reputation of Eugene Meyer. His much later successor Ben Bernanke concurred with economists Milton Friedman and Anna Schwartz in concluding that the Fed’s contractionary policy during Meyer’s tenure helped transform the economic downturn that began in 1929 into the Great Depression. The Limits of One Vote The second argument against betting bigtime on an imminent interest rate plummet is that even if Trump’s tactics improbably succeed in changing Powell’s mind, they would change only one vote out of 12 on the Federal Open Market Committee. The FOMC’s decision at its June 17 to 18 meeting to leave the target Fed funds rate at 4.25% to 4.50%, was unanimous. Furthermore, seven of the 19 officials who are eligible for the 12 voting positions predicted there will be no rate cuts for the remainder of 2025, up from four in March. History Suggests the Fed Won’t Fold Surely, you might say, the FOMC would never go against its chair if he altered his position on rates? If that were to happen it would not be unprecedented. In June 1978, Miller was in the minority as the full FOMC voted to raise rates. Investors who cling to hopes of a substantial drop in interest rates in the near future may have been heartened by recent statements by Federal Reserve officials Christopher Waller and Michelle Bowman. They said the Fed could begin lowering interest rates as soon as July. Note, however, that Waller specifically ruled out an immediate, sharp rate reduction, instead saying the FOMC should “start slow.”  Powell also rejected Trump’s stated rationale for demanding a reduction in interest rates, correctly pointing out that ensuring “cheap financing for the US government” is not part of the Fed’s legislative mandate. After Waller and Bowman’s remarks, Powell reaffirmed his previous stance, telling the House Financial Services Committee, “For the time being, we are well positioned to learn more about the likely course of the economy before considering any adjustments to our policy stance.” The futures market’s estimate of the probability of a quarter-point rate cut at the July 30 FOMC meeting rose from 8% just before Waller’s comment to 19% as of June 27. Still, the kind of steep, immediate rate cut Trump has called for remains a longshot. Hope Is Not a Strategy In summary, given Jerome Powell’s characteristically deliberate approach to monetary policy, his current stance on interest rates, and his likely focus on legacy during his final year as Fed Chair, there is little reason to expect presidential pressure — however forceful — to prompt a dramatic pivot. Tempting as a big market payday might seem,

Russia’s invasion of Ukraine has had ramifications throughout the global investment community. There are the obvious repercussions: the rising volatility in the equity and commodities markets as well as spiking inflation. But there are also more subtle effects: The war has forced investment professionals to navigate complex gray areas where their choices might be legal from a regulatory standpoint but questionable from an ethical perspective.  The Russia–Ukraine War is not the first conflict to affect the financial industry in these ways, but it has changed the reality on the ground for practitioners. The investment community needs to recognize this and act accordingly. The threat of such conflicts and their consequences raise important questions that we as a community must address. Codes of professional standards like the CFA Institute Code of Ethics and Standards of Professional Conduct guide people facing real-world ethical dilemmas. Such dilemmas are like highway junctions with the particular code of conduct serving as a roadmap that tells us which lane to take. But a map is useful only as long as it accurately reflects reality. When reality changes, the map must be adjusted. Otherwise, those who take the wrong lane might encounter a more complex intersection further down the road. Should portfolio managers hold stock in companies that play some role in military aggression even when it’s perfectly legal to do so? Should an adviser cut ties with a client who is directly or indirectly involved in such conflicts? Where should the lines be drawn? War-related issues are hardly unique to the investment profession, so the answers to these questions should be guided by general moral norms and principles. But there are few phenomena that do as much damage to capital markets or society as a whole. War not only poses risks to the investment industry’s profitability but also to its reputation and credibility. Financial professionals or institutions that assist a government waging war to upend the rules-based world order can hardly bolster the public’s confidence in the financial markets or the investment profession. We need to be mindful of such risks. The Russian invasion of Ukraine has demonstrated that war has dramatic ripple effects that extend far beyond the front line and are hard if not impossible to model. What seemed rock solid can fall apart in a matter of days. Prior to the war, Russian equities traded on foreign exchanges. Many had “buy” ratings from major investment houses. Soon after the Russian attack, they were all worthless. Wealthy clients with established relationships found their accounts blocked. Lucrative deals had to be scrapped and businesses liquidated. At one point, the market was left to wonder whether agent banks would wire through coupon payments from the Russian government to its creditors. A year ago, such concerns would have raised more than a few eyebrows. The conflict has changed the investment landscape at such a sheer scale and with such speed that the rules must be adjusted to stay relevant. The question is: What should these new rules look like? Now is the time to begin that discussion. Should there be explicit rules requiring investors and institutions to dissociate themselves from war-related activities in certain circumstances? What about an exclusionary screening approach? It is never easy to find a common denominator on complicated and divisive ethical questions. Indeed, there are no perfect solutions to these dilemmas, but that doesn’t mean solutions aren’t possible. The investment industry could promote an environmental, social, and governance (ESG)-like approach when it comes to military conflict. This could take the form of guidance on best practices or disclosures around war-related information to current and potential clients. These might include a list of portfolio companies that do business in the aggressor country or a divestment strategy detailing how securities from such firms will be excluded in the future. There are no doubt other potential solutions that will emerge in the course of these conversations. The Russia–Ukraine conflict has demonstrated that the consequences of major wars are impossible to anticipate and too big to ignore. Which is why the investment community needs to come together to develop common standards to apply when such conflicts break out but with the ultimate goal of preventing them from breaking out in the first place. Let’s start the discussion. 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 courtesy of GoToVan, licensed under the Creative Commons Attribution 2.0 Generic license. Cropped. 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

“Ultimately, there’s one investment that supersedes all others: Invest in yourself. Nobody can take away what you’ve got in yourself, and everybody has potential they haven’t used yet.” — Warren Buffett Last year, I interviewed 52 remarkable people for my research paper “Smart Women and Men: How They Invest in Themselves,” which was released on 8 March 2023. Below are 10 stories told by people from various locations and cultures in response to the question: How do you invest in yourself? I’ve found that regarding the know your client (KYC) concept, few queries are more revealing. Donovan Bailey, CEO, Bailey Inc., Five-Time Olympic and World Champion Sprinter, Toronto “How do I invest in myself? Well, for context, my athletic career . . . is well documented. I am the first man in history to simultaneously be the world champion, Olympic champion, and world record holder for the 100 meters. I am a two-time Olympic gold champion, three-time world champion, and two-time world record holder. I am also the only person to be twice inducted into Canada’s Sports Hall of Fame. How did I accomplish all of that? My No. 1 priority is to invest in my body. “When I started out as a professional athlete, I spent over 60% of my earnings investing in my body: I had to buy the best food (I had to eat six meals a day!), the best physio, whatever it took to achieve my goal of becoming the greatest athlete on the planet. At age 54, I’m no longer competing, but I make sure to get regular exercise, eat high quality food, and sleep well. As you get older, it is important to find a structure that works for you.” Anna Jonsson, Head of Institutional Clients and Distribution, Storebrand, Stockholm “There are so many ways that you can invest in yourself — the key is that you need to find the time to pursue whatever that looks like for you. Make sure it happens. I don’t feel bad about finding the right balance for me. I choose to spend less time hanging out with friends because I have lots of socializing via my work events, and I make daily exercise my priority. I tell my five-year-old daughter that I’m a better mom when I run. You can’t have everything, but you can have a lot.” Christophe Bristiel, Sales Director, Château La Nerthe, Châteauneuf-du-Pape, France “After graduate school in business, I worked for many years, mostly for Citibank in New York, Frankfurt, and London. Although this was an exciting career, I believe the single most important ‘investment’ I have [made] was to leave the banking/trading world in late 2004 and get my Certified Sommelier degree at the Université du Vin in Suze-la-Rousse, which is only about 30 kilometers north of Châteauneuf du Pape. Châteauneuf du Pape is the oldest appellation in France, as it was established as a separate AOC [appellation d’origine contrôlée] in 1936, and I am proud to say that Château La Nerthe has been certified in organic farming since 1998, and I am happy to follow in my father’s footsteps as sales director.” Anita Kunz, Artist and Illustrator, Toronto “My career has been my most important investment in myself. I live in Canada now, but for over 20 years I lived in London and New York, contributing to magazines and working for design firms, book publishers, and advertising agencies all around the world. I’ve produced cover art for many magazines including Rolling Stone, The New Yorker, Sports Illustrated, Time, Newsweek, The Atlantic Monthly, and The New York Times Magazine. I have also illustrated more than 50 book jacket covers. “I like to invest in others: I want to give back. Ontario College of Art was remiss in telling students it is one thing to be an artist, but it is quite a different thing to be running a small business. Once a month, I teach in various cities around the world: I have a lot of useful information, and I don’t want the students to make the same mistakes that I did. It took me years to learn how to say no and how to ask for more money.” Harjot Singh, Global Chief Strategy Officer, McCann, London “How do I invest in myself? In three broad categories. First, I like and honor my physical comforts: a home that is soothing, sensorially comforting, and visually pleasing. I wait patiently till I can invest in what I know and believe is the most comfortable and beautiful, such as my handcrafted Hästens bed with horsehair. I waited several years till I could buy it. Second, I respect what fuels my body — both in the physical form in terms of what goes in my body but also what is the best emotional diet that I can consume. I seek out enrichment via art, music, spiritual learning, literature, and theater. Third, I am very selective about the people around me, and I invest in my relationships. I enjoy giving and sharing — to witness and enable good things [for] good people.” Laura Maia de Castro, Journalist, São Paulo “The number one way that I invest in myself is through meeting people and making connections. As a journalist, I spend a lot of time listening to stories and hearing different perspectives: It’s a great way to open my mind. I always have to pitch story ideas, so whether I am waiting on the street for an Uber or sitting in the waiting room at my doctor’s office, I listen to people, and this adds another layer to my existence. I have a lot of stories saved in my repertoire. I am a compulsive interviewer, and just the other day, I asked my statistician colleague at the bank to try to explain to me exactly what she does. I also asked the interns, ‘Why is there such hype around a certain meme?’ I am curious about everyone’s jobs and stories, and this is good for me both professionally and

Pim van Vliet, PhD, is the author of High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning. The low-volatility premium may be the most compelling anomaly in financial markets: Less risky securities outperform their riskier counterparts over the long term. Empirical tests of the capital asset pricing model (CAPM) first documented this counterintuitive phenomenon more than a half century ago. It emerged not in a search for alpha but rather as an unwelcome reality, an unintended consequence of theory testing, and remains poorly understood to this day. This makes the defensive low-volatility factor unique and sets it apart from other factors. Since the low volatility factor defies a risk-based explanation, academics who believe in efficient markets have trouble accepting it. Indeed, Eugene Fama and Kenneth French left low volatility out of their three-factor and five-factor models.  Practitioners, by contrast, often struggle to capitalize on the factor because of the high risk associated with it relative to its benchmarks and because of leverage constraints and potential career risks. Such complexities and hurdles make low volatility a special animal within the expanding “factor zoo.” Yet the low-volatility factor is both resilient and robust. Here, by applying the principle that the simplest explanation is usually the most accurate — Occam’s razor — we make the case for low volatility. The graphic below shows how low volatility interacts with other factors. Even after seven cuts or slices, the factor still performs. If it keeps its alpha after so many slices, its simplicity must be key to its significance. The Starting Point: CAPM Using US market data from July 1940 to December 2023, we measure the volatility factor much like a Fama and French style factor, by taking a long position on low-volatility stocks and a short one on their high-volatility counterparts. Over this period, the low volatility premium (VOL) equals 6.4% with a beta that by construction is very close to zero. The CAPM alpha is 6.3% per annum with a t-stat of 5.3, far above the critical levels Campbell Harvey recommended to minimize the risk of finding “fake factors.” Low-Volatility Premium (VOL) Controlled for Other Factors, July 1940 to December 2023 Sources: The Kenneth R. French Data Library and Paradox Investing The First Slice, 2FM (Rates): Two Factors, Equities and Bonds When the CAPM was unveiled, Richard Roll’s critique was that bonds and other assets should be included in the market portfolio. Since low-volatility stocks resemble bond-like stocks, this higher rate-sensitivity could be an explanation. Still, a two-factor regression that includes both equities and bonds lowers VOL’s alpha by only 0.3%. Second Slice, FF 3FM: Fama-French Three-Factor Model One explanation of the low-volatility factor is that value is often defensive. While the relationship is time varying, on average volatility loads positively on value and negatively on size. The classic three-factor Fama–French regression, which includes both the value and size factors, reduces VOL’s alpha by 1.1%. Third Slice, 4FM (Inv): Three-Factor Model Plus Investment Fama and French augmented their three-factor model with two more factors — investment and profitability — in 2015. We find the investment factor accounts for about 0.5% of VOL’s alpha. This makes intuitive sense since conservative, low-investment firms tend to exhibit less volatility.  Fourth Slice, 4FM (Prof): Three-Factor Model Plus Profitability Of these two new factors, profitability has a much stronger relationship to volatility and accounts for 1.2% of VOL’s alpha. We find that unprofitable firms tend to be very volatile even as their profitable peers do not always demonstrate the opposite. Thus, the short leg drives most of this result.  Fifth Slice, FF 5FM: Fama-French Five-Factor Model Combined, these five factors bring VOL’s alpha down by 0.9%. This indicates that investment and profitability are different dimensions of the quality factor that interact with value and size.  Sixth Slice, 6FM (Mom): Five-Factor Model Plus Momentum The most dynamic factor, momentum, generates high gross returns but requires considerable turnover, which erodes net returns. This is why Fama and French did not include it in their five-factor model. When we add momentum, the VOL premium does not rise or fall. Seventh Slice, 7FM: The Kitchen Sink In our final, all-inclusive “kitchen sink” regression, VOL’s alpha declines by 0.2% and is still standing at a statistically significant 2.1%.  All this demonstrates low volatility’s overall robustness. The factor’s outperformance survives critiques from all different angles. By applying Occam’s razor to the factor zoo and slicing low volatility every which way, the strategy still stands out as the premier factor. If it takes five or six factors to explain it, low volatility may not be that bad after all. To take it one step further, by integrating value, quality, and momentum into a “Conservative Formula,” we create an enhanced low-volatility strategy that beats VOL along with all the other factors. The following figure shows how the Conservative Minus Speculative (CMS) portfolio fares after each of our previous cuts. The alpha starts at 13.3% and only falls to 8.2% after all seven slices. Enhanced Volatility Premium (CMS) Controlled for Other Factors, July 1940 to December 2023 Sources: The Kenneth R. French Data Library and Paradox Investing Amid low demand for defensive investing during the recent tech-driven market rally, the case for low-volatility investing may be stronger than ever. In a market that often overlooks it and a world where the obvious is often overcrowded and overvalued, the low-volatility anomaly stands as a testament to the power of contrarian thinking. Sometimes, the less-trodden path offers the better journey. As we look ahead, the question remains: Will the market eventually catch up to this hidden gem, or will low volatility continue to be the market’s best-kept secret? For more from Pim van Vliet, PhD, don’t miss High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning. If you liked this post, don’t forget to subscribe to Enterprising Investor and the CFA Institute Research and Policy Center. All posts are the opinion of the author. As such, they should not be construed as investment

For more than a century, the equity risk premium (ERP) — the excess return from stocks over bonds or cash — has been the backbone of investing, delivering 5% to 6% annually above safer assets. But this era may be fading. With US valuations at historic highs, earnings growth slowing, and structural challenges mounting, the ERP could shrink to zero. In this new landscape, alpha — returns driven by skill and strategy — will become the primary source of performance. This blog examines why the ERP is declining, how alpha thrives in low-return environments, and most importantly how investors can adapt to a beta-constrained future. The Shrinking Equity Risk Premium Historically, US equities have returned 10% annually, fueled by expanding valuation multiples, robust earnings, favorable demographics, and US market dominance. From 1926 to 2024, the ERP averaged 6.2%, peaking at 10.6% from 2015 to 2024. Yet, history reveals a pattern of mean reversion: strong decades often precede weaker ones. After high-return periods, the subsequent decade’s ERP typically underperforms the long-term average by ~1%, while weak decades lead to returns ~1% above average (Figure 1). Figure 1 | Realized and subsequent US 10-year equity premiums Source: Robeco and Kenneth French Data library. US stock market returns 1926-2024. This graph is for illustrative purposes only. Today’s market conditions raise red flags. The cyclically adjusted price-to-earnings (CAPE) ratio hovers near historic highs, dividend yields are subdued, and real earnings growth faces headwinds from aging populations and rising costs. Leading asset managers, including AQR, Research Affiliates, Robeco, and Vanguard, project a near-zero US ERP for 2025 to 2029, with valuation-based models even warning of negative returns. In contrast, global markets –particularly Europe and emerging markets — offer a more attractive and still positive ERP, driven by higher valuations and growth potential. Alpha’s Rising Importance As beta weakens, alpha takes the spotlight. Factor premiums — returns from strategies like value, momentum, quality, and low volatility — perform robustly in low-return environments. Historical data (1926 to 2024) shows that when equity returns are high, factor alpha contributes 25% of total returns (3.9% of 15.4%). In weak markets, alpha’s share soars to 89% (4.9% of 5.5%), as factor premiums remain stable or rise (Figure 2). Figure 2 | Realized US Equity and Factor Premiums Source: Robeco and Kenneth French Data library. Sample US 1926-2024.This graph is for illustrative purposes only. Figure 2 demonstrates that factor premiums grow in importance as equity returns decline, boosting alpha’s role. Academic research reinforces this dynamic. Kosowski (2011) found that mutual funds generate +4.1% alpha during recessions, when markets are toughest, compared to -1.3% in expansions. Blitz (2023) shows that factor alphas increase when equity returns fall, making strategies like value and momentum critical in low-ERP environments. A broader historical perspective (1870 to 2024) by Baltussen, Swinkels, and van Vliet (2023) confirms that factor premiums thrive across market cycles, particularly during high-inflation or low-growth periods. Low-volatility stocks, for instance, outperform during market downturns, offering a defensive edge. This shift has profound implications. In a zero-ERP world, alpha isn’t just an enhancement; it is the dominant source of return. Active quantitative strategies, which systematically exploit factors like quality or low volatility, can deliver consistent outperformance when market beta falters. For investors accustomed to passive investing, this marks a paradigm shift toward skill-based approaches. Investing in a Low-ERP World A shrinking ERP requires investors to rethink their approach. Traditional market exposure, once the primary return driver, may no longer deliver. Instead, investors should prioritize alpha through systematic, evidence-based strategies: Factor Investing: Diversified exposure to factors like value, momentum, and low volatility can generate reliable alpha. Defensive equities, which tend to outperform in downturns, provide a cushion in volatile or sideways markets. Low-volatility strategies, for example, have historically delivered higher risk-adjusted returns during low-growth periods. Global Diversification: With Europe and emerging markets offering higher ERPs (still positive vs. the US’s near-zero), reallocating capital abroad can enhance returns. Small caps and equal-weighted strategies, often overlooked in favor of large-cap growth, also show promise due to their attractive valuations. Active Management: High-active-share or long-short strategies can capitalize on market inefficiencies, particularly in undervalued segments like small caps or low-volatility stocks. Active quant approaches, blending factor exposures with disciplined risk management, are well-suited to a low-ERP environment. A low-ERP world could reshape market dynamics. As investors chase alpha, capital may flow into factor-based strategies, potentially elevating valuations for these assets. The US’s market dominance, fueled by a high ERP over the past decade, may weaken as capital shifts to Europe, Asia, or small-cap markets. This could reverse the multi-decade trend toward passive investing, rewarding managers with proven alpha-generating skills. Moreover, a prolonged low-ERP environment may amplify the appeal of defensive strategies. Low-volatility and low-beta factors, which thrive in uncertainty, could attract significant inflows, offering stability in a market where positive returns are scarce. Investors who adapt early by embracing active quant strategies or diversifying globally stand to gain a competitive edge. Key Takeaway A declining ERP does not signal the end of investing; it demands a pivot to alpha-driven strategies. With US equity returns under pressure, systematic approaches like factor investing, defensive equities, and global diversification offer a path to resilient performance. In a zero-ERP world, alpha is not just a bonus; it’s the key to capital growth. As beta fades, alpha shines. For a deeper dive, read my full report. Pim van Vliet, PhD, is the author of High Returns from Low Risk: A Remarkable Stock Market Paradox, with Jan de Koning. Link to research papers by Pim van Vliet. References AQR. (2025). “2025 Capital market assumptions for major asset classes.” Available at www.aqr.com. Baltussen, G., Swinkels, L., & van Vliet, P. (2023). “Investing in deflation, inflation, and stagflation regimes,” Financial Analysts Journal, 79(3), 5–32. Blitz, D. (2023). “The cross-section of factor returns,” The Journal of Portfolio Management, 50(3), 74–89. Fandetti, M. (2024). “CAPE is high: Should you care?” Enterprising Investor. Available at www.cfainstitute.org. GMO. (2024). “Record highs…but we’re still excited.” Available at www.gmo.com. Kosowski, R. (2011).

My Value Creation Journey: An Autobiography of My Work. Bartley J. Madden. ‎2023. Bartley J. Madden Foundation. My Value Creation Journey, by Bartley J. Madden, is a unique book that consists of a memoir, a primer on systems thinking and knowledge creation, and a call to reform the medical care system. Madden, a retired managing director of Credit Suisse HOLT and author of the 2020 book Value Creation Principles, spent more than three decades in finance. His early research produced the cash flow return on investment metric (CFROI), which is widely used in money management. Madden has now moved into the philanthropic world at the Bartley J. Madden Foundation. The book begins with Madden’s circuitous path to business and finance, which includes a degree in mechanical engineering, a brief foray into boxing, and a fortunate military deployment to Salt Lake City rather than Vietnam. After completing his military service, Madden earned an MBA from the University of California, Berkeley and began his finance career in 1969 in the investment research department at Continental Bank in Chicago. While there, he was introduced to a security analyst, Chuck Callard, with whom he would founded Callard, Madden & Associates six months later. The two of them went on to create the CFROI metric. My Value Creation Journey’s core focus is Madden’s quest to better understand knowledge-building proficiency. According to Madden, the key to value creation is knowledge building. Throughout the book, Madden emphasizes the role of systems thinking and the knowledge-building loop, which he finds useful in formulating economic/business problems and developing solutions. Madden depicts the knowledge-building loop as a circular diagram that includes systems thinking, asking better questions, and language. This approach allows the user to think creatively about a problem and formulate better solutions than those achieved through the more widely accepted linear thinking. Although language may seem like an odd part of knowledge building, Madden notes that language limits our perceptions. For example, he points out how the founders of Airbnb created a new industry by asking, “What is a hotel room?” Much of the book is devoted to how CEOs can use systems thinking to improve the performance of their businesses. These concepts, however, apply to all areas of life and business. For those in the investment business, recognizing companies led by leaders who foster a knowledge-building culture, such as Ken Iverson of Nucor, may be rewarded with market-beating returns. To illustrate the importance of CFROI, Madden reformulates the traditional life-cycle graph by linking the cost of capital to CFROI. The cycle begins with high innovation as the firm successfully commercializes its product and its economic returns exceed the cost of capital. Competitive fade occurs when competitors attempt to replicate or improve on the originator’s innovation. How quickly the competitive fade begins depends on the innovator’s competitive advantage. Firms then move to the mature stage, where they merely earn the cost of capital. Finally, business failure occurs when the firm can no longer earn the cost of capital. This pattern is inevitable unless management recognizes this pattern and seeks to reinvent itself. To illustrate these concepts, Madden presents several case studies of firms that extricated themselves from years of mature growth to enjoy value-enhancing returns. First, he presents a brief history of John Deere, the farm equipment maker, from 1960 to 2018. The company, which was founded in 1837 by blacksmith John Deere, spent some four decades, from 1960 to 2000, in the mature phase, with CFROI indicating that it was simply earning the cost of capital. Under the leadership of Robert Lane from 2000 to 2009 and Samuel Allen from 2010 to 2019, Deere embraced the digital world and transformed itself from a product-centric business focused on the firm’s products to a platform-centric business that helps farmers increase yield and reduce costs. These changes have allowed shareholders to enjoy a 20-fold increase in their stock price since 2000. Another case study examines Cummins, which designs, distributes, manufactures, and services diesel, electric, and hybrid powertrains and related components. From 1997 to 2003, Cummins was losing market share in the diesel engine market. In 2000, however, when Tim Solso became CEO, he successfully improved productivity and increased R&D expenditure. These changes allowed the firm to produce innovative diesel engines that met Environmental Protection Agency standards while maintaining fuel efficiency, giving the firm a competitive advantage over its peers. During Solso’s time as CEO, Cummins outperformed the S&P 500 Index approximately 10-fold. Madden points out that the naysayers believe Cummins will be overtaken by electric truck manufacturers, such as Tesla. He points out, however, that this conclusion springs from a flaw in linear thinking. Electric vehicles may be more environmentally friendly than diesel vehicles, but this ignores the environmental costs of electric generation, battery manufacturing, and the production of solar panels. One area where Madden hopes to use his knowledge-building approach to benefit society is reforming the Food and Drug Administration (FDA). Researchers at the Madden Center for Value Creation at Florida Atlantic University pursue many topics, including revising the FDA’s procedures. Madden has used his book Free to Choose Medicine: Better Drugs at Lower Cost and several articles to promote some of these ideas. He provides a detailed approach by which the FDA could change its procedures to allow potentially life-saving drugs to be administered to terminally ill patients. This would not be just a means of providing compassionate care. It would also facilitate collection of valuable information that might allow new drugs to receive full FDA approval sooner and provide a greater understanding of who would benefit most from the treatments. In summary, Madden has produced a book that challenges business leaders to think outside the box systematically. It is not a “how-to” book that provides detailed recipes for success. Instead, it provides a framework for thinking through difficult problems. Business leaders and investment professionals who can apply some of the concepts to their decision making will likely be rewarded. As the world continues to change, Madden’s insights

Surprise, surprise. Contrary to conventional wisdom, the bond market may be taking its risk cues from equities. At least, that appears to be the case when fluctuations in the two major volatility indices are compared. Equity investors often look to the CBOE Volatility Index (VIX) as a gauge of fear or future uncertainty in the stock market. Meanwhile, fixed-income investors rely on the Merrill Lynch Option Volatility Estimate (MOVE Index) to track expectations of future volatility in the bond market. But which market sets the tone for the other? Does one of these volatility measures lead the other, or are they simply reacting to distinct sources of risk within their own domains? Challenging Assumptions: Evidence That Equities Lead Bond To answer that question, we examined how the VIX and MOVE indices have interacted over time, using daily data going back to 2003. Our analysis revealed a surprising result: while fluctuations in the MOVE index do not predict movements in the VIX, changes in the VIX do help forecast future moves in the MOVE index. This flips conventional wisdom. Investors often assume that the bond market, with its sensitivity to interest rate expectations and macroeconomic signals, sets the tone for equities. But at least when it comes to market-implied future uncertainty, the relationship appears reversed: the bond market is taking its cues from stocks. To explore this, we looked at how the two indices behave together. Over the last 20 years, they’ve generally moved in tandem, particularly during periods of macroeconomic stress, with a 30-day rolling correlation that averaged around 0.59. But correlation isn’t causation. To test for a predictive relationship, we used Granger causality analysis, which helps determine whether one time series improves forecasts of another. In our case, the answer was clear: the VIX leads. Market Stress and Temporary Bond Leadership Interestingly, the pattern shifts during periods of elevated stress. When both the VIX and MOVE indices spike above their 75th percentile levels, indicating a high-volatility period, we observe a reversal: the MOVE index shows some predictive power over the VIX. In these moments, equities appear to take cues from bonds. While rare, this exception suggests that in times of acute uncertainty, the usual flow of information between markets can briefly reverse. One way to interpret these results is that because the MOVE index seems to take the lead during periods of extreme uncertainty, bond managers are more attune to huge macro shifts in the economy and capture big sentiment shifts better than equity managers (i.e., when we go from positive to negative momentum). Implications for Multi-Asset and Hedging Strategies These findings may have the most impact not for investors that invest solely in one asset, but more so for investors that are spread across various asset classes. The results highlight that for multi-asset managers, when it comes to assessing fear in the market, it may be best to pay attention to the bond market when big moves in fear or uncertainty become apparent. But when dealing with small movements in the perception of future uncertainty, the stock market may surprisingly be the better measure of risk to track. These results also have strong implications for investors who are not in the equity market or the debt market, yet use them to hedge risk. If a commodities trader is looking for early signs of big moves in the equity market or bond market to get out of commodities, they may want to shift their attention between the VIX and the MOVE indices as regimes move. These findings challenge a long-standing assumption: that the bond market always leads. At least when it comes to measuring future uncertainty, equities seem to set the tone, except, notably, in the most volatile moments, when bonds regain their influence. It appears that, in general, the bond market is looking more to the equity market for future assessments of risk rather than the other way around. These results merit further study, not just into which market is leading the other, but how this spillover of uncertainty travels between them. source