This article first appeared in Personal Wealth, The Edge Malaysia Weekly on September 30, 2019 - October 6, 2019
Artificial intelligence (AI) and climate change are major trends shaping the future of investing, but their risks have not been priced into the global financial markets yet.
According to the findings of a study by BNY Mellon Investment Management and Create-Research, 93% of institutional investors — who manage total assets of about US$12.75 trillion — say climate change is an investment risk that has yet to be priced in by the key financial markets. Meanwhile, 85% of the 45 investment professionals across 16 countries surveyed saw AI as an investment risk that could potentially provoke societal backlash as well as geopolitical tensions.
Labelled as “supertanker” trends, AI and climate change are expected to be the defining challenge for the asset management industry, according to the Future 2024: Future Proofing Your Asset Allocation in the Age of Mega Trends report.
When it came to AI, 52% of the respondents opined that the all-embracing technology presented risks and opportunities while 33% viewed it only as risk. While both sides agreed that AI is here to stay and it is only a matter of time before widespread deployment, they differed on what AI will mean for investors in the febrile climate of public opinion, as populism continues to dictate the national agenda in the West.
“Those citing it as a ‘risk’ were concerned about its societal impact on jobs: white collar as well as blue collar. In contrast, those citing ‘risk and opportunity’ took the view that AI has sparked an evolutionary revolution: its effect will be incremental, not wholesale,” says the report.
“These differing views point to broader challenges associated with AI as investors factor it into their future asset allocation. Over the past two decades, the twin rise of globalisation and technology have delivered benefits. But on the flip side, such benefits have accrued to many people in their role as consumers, not as workers or citizens.
“If anything, many Western nations have experienced a hollowing out of middle-class jobs, rising income inequalities and growing market concentration, contributing to the rise of populism. Its latest manifestation is the Gilets Jaunes (yellow vest) movement in France.
“Over-reliance on monetary policies in this decade has delayed long-overdue reforms in education, training and industrial policies. The turbo-charged globalisation of the past 25 years is giving way to a new age of beggar-thy-neighbour policies, raising all manner of political risks.”
The study, led by UK-based Create-Research founder and CEO Amin Rajan, found that financial markets struggle to price in issues around AI until they actually materialise. “Those taking a more sanguine view, on the other hand, argued that the current rate of AI adoption was far too gradual to cause mass upheaval, if history is any guide. Governments, on their part, are also piloting a new form of social contract — via universal basic income, tax credits and skills training — to reduce inequalities while promoting workforce resilience,” says the report.
The upsurge of AI has created four investment-specific challenges. First, corporate lifecycles are getting shorter as AI creates winners and losers. For example, Nokia went downhill in record time when one of the earliest versions of the iPhone appeared in 2007.
Second, sectoral boundaries are expected to blur as AI reconfigures an entire product, as in the case of Tesla, whose straddling of multiple sectors causes valuation issues.
Third, onshoring of manufacturing activities will diminish the future prospects of emerging economies, says the report, as shown by 3D printing, which is shifting the geographical centre of gravity in global supply chains.
“Finally, AI will be enhancing the intangible value of companies in ways that are hard to measure, as shown by Apple, whose intangible value has fluctuated far beyond its financial strength lately,” it adds.
In response to those challenges, investors are “increasingly mixing active and passive investment strategies, focusing on idiosyncratic risk in portfolios, targeting emerging innovation leaders and blending hard and soft metrics in their analysis”, says the report.
Risks and opportunities of climate change
On climate change, 57% of the survey respondents saw it as a “risk and opportunity” while 36% perceived it as “risk only”. The remaining 7% viewed climate change as an opportunity and not a risk. The statistics reflect the differences in their beliefs about whether global markets have priced in climate risks or are likely to do so in the near future.
Respondents citing “risk and opportunity” believe that markets are “on the cusp of a once-in-a-generation transformation” as their ecosystem is being reshaped by forces with potentially disastrous consequences from global warming.
“The prospect of fat-tailed risks does not seem too far off after all. In 2018, Nasa reported that 17 of the 18 hottest years globally since modern records were kept occurred this century. Besides, the whole ethos behind environmental, social and governance (ESG) investing is anchored in the belief that healthy markets require stronger economies and stable societies. Thus, investing has to be about ‘doing well’ and ‘doing good’,” says the report.
Those who saw climate change as “risk only” only did so because they were unsure whether markets were already pricing in ESG risks to the point where the risk-return trade-off is real.
The respondents’ view is that while ESG funds scored good returns in the last decade, the returns may have been propped up by central banks’ ultra-loose monetary policies, which have dampened volatility and effectively put a floor under all asset values. “The ESG effect is hard to untangle from the policy effect. In any case, they argue, the reality of both AI and ESG investing will be best judged not by the inflows while markets are artificially inflated but by their resilience when the inevitable correction comes,” says the report.
The areas at risk when it comes to climate change are slow progress in carbon pricing, stranded assets dilemma and engagement issues around fixed-income ESG as a risk factor because there are fewer opportunities to engage with companies through voting rights or general meeting attendance.
Allocations favour private markets
The report says future funds may support private markets more than public ones as the search for uncorrelated absolute returns intensifies. “To exploit AI’s risk premia, they will be investing in ‘smart buildings’ that blend AI and renewable energy. They will also be investing in private debt to support young start-ups. Finally, they will continue to rely on private equity to capitalise on corporate restructuring driven by AI. This is in the belief that the value of equity investing is now best realised via either early-stage seed finance or private markets, but not public markets.”
The participants’ allocation stood at between 19% and 31%, depending on the maturity profile of their liabilities. “Those with shorter horizons have made smaller allocations. The allocations will likely rise over the next few years to achieve a more robust portfolio,” says the report.
Create-Research also found that there has been growth in passive funds over the past decade, with exchange-traded funds and smart beta representing 20% to 40% of respondents’ portfolios. This is another area that is expected to grow over the next decade.
The report was based on a study of about 400 research reports and reinforced with interviews of 45 chief investment officers, investment strategists and portfolio managers with pension plans, asset managers and pension consultants from Australia, Canada, China, Denmark, Finland, France, Germany, India, Japan, Singapore, South Korea, Sweden, Switzerland, the Netherlands, the UK and the US.
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