Fulfilling our fundamental role as an investor starts with active participation.
There is a growing public awareness that investors are in a potentially powerful position to promote certain socially desirable activities or to discourage undesirable activities. Investors can not only talk with their mouths but also with their feet — i.e., their capital flows. They can do so in their own interest and/or in the public interest. The tools at their disposal include engagement, activism and impact investing. It is open to debate whether all investors should use this power, whether this power is really always as large as some stakeholders or outsiders claim, and above all, how desirable or undesirable various activities really are. We most certainly welcome this debate. The following is an excerpt from our Responsible Investing policy which sets out Transtrend's position.
A theme that is increasingly in the spotlight in this respect is ESG, which concerns whether and how investors take Environmental, Social and Governance factors into account in their investment process. We suppose most investors do not strive to violate human rights by contributing to poverty, hunger, slavery, and the like; they will rather aim to promote human prosperity and welfare. Nor will many investors strive to contribute to the destruction of our planet, including its biodiversity and climate, if only because such destruction would undermine their own prosperity and that of their children. However, there seems to be a wide spectrum of approaches to dealing with these various thorny issues.
And that does not only hold for investors. One end of this spectrum can be described as ‘passive hiding’. People on this side of the spectrum prefer not to be associated with any of these issues. They do not want to be questioned or pointed at, and they do not want to get the feeling that they have to excuse themselves. In essence, they prefer not to be seen with dirty hands. With investing, this approach is most efficiently implemented by excluding all markets and instruments that are somehow linked to these thorny issues, preferably on the basis of ‘objective’ criteria formulated and quantified by an independent third party. We understand and respect this choice. The other end of the spectrum is made up by the larger number of people who do not mind to get their hands dirty: the housekeepers and the garbage collectors, the farmers who grow and harvest our food, the earth movers who dig up the minerals, metals and fossil fuels that our society cannot (yet) do without, the soldiers who risk their lives defending our freedom. In fulfilling the responsibilities they have assumed, these people are helped by well-organized, well-functioning markets. And so are their working conditions. We do not want to turn our back on these people, also not if doing so would somehow reflect favorably on us.
We believe that the most rewarding way to deal with issues is to be part of the solution, not by shying away from them and most certainly not by closing your eyes to them. Successful investing in our view is about being on the road forward, not about hiding behind the hedges.
From this, it may be clear that we at Transtrend are avid supporters of active participation. And within our investment program, we try to practice what we preach. We do not avoid thorny issues but rather discuss them, make our own decisions, and are willing to explain our choices. We sometimes do this proactively, for instance through a publication or by participating in a panel or other event. And yes, let there be no misunderstanding: we also prefer active participation because we believe this to be in our best interest. That is, in the best interest of our investments and therefore in the best interest of our clients. We are convinced that passivity in general does not deserve a reward and generally is not rewarded. When investors consider being seen with dirty hands a risk they want to avoid, they will pay a risk premium for that, which in turn can be harvested by investors that care less about their polished nails. We believe that the most rewarding way to deal with issues is to be part of the solution, not by shying away from them and most certainly not by closing your eyes to them. Successful investing in our view is about being on the road forward, not about hiding behind the hedges.
At the same time, no matter our convictions, we have to be extremely modest. Taking our role seriously starts by acknowledging the limitations of our power. The fact that we predominantly trade futures contracts seriously limits the number of ways we can have impact. Carrying price risk, contributing to price discovery and offering liquidity — as important as these roles are for the well-functioning of markets — that’s about it. And we can only fulfill these roles if we in fact actively trade these contracts, not if we exclude them. So our (potential) impact starts with inclusion.
An example of this is our stance towards trading futures on crops such as wheat and rice. Whenever the price of such futures contracts rises to high levels again, ‘speculators’ are pointed at and publicly criticized for ‘making money on hunger’. Some investors do not want to trade such commodity futures because of this criticism. However, we consider this to be cheap populism. While the following may sound harsh, everybody who is active somewhere in the food chain — from plant breeders to farmers, from food processors and carriers to greengrocers and cooks — in essence makes money off people that would otherwise be hungry. We believe there is absolutely nothing wrong with fulfilling real needs. We would not know why it would be more responsible to for instance create and simultaneously fulfill a demand for something rather useless like a fidget spinner! There are important roles in feeding the world that need to be fulfilled by investors. We try to play a meaningful role in this process.
Our modesty with respect to our potential impact also explicitly lies at the basis of our investment philosophy. Our world is constantly evolving. And the inexhaustible source of energy behind this evolvement comes from all the people pursuing new ideas. The idea to make wagons ride on a rail track; the idea to connect computers into an internet; the idea to use wind as a clean source of energy; and so on. We are happy to see that these ideas include many ideas about social and environmental issues — ideas that we embrace ourselves as well. But from time to time people also pursue ideas that we like less. However, we cannot really afford to take that into account in our investment decisions. We simply have to respect the force of people pursuing ideas. Trading against that force, as a matter of principle, does not stop and reverse that force; we would just be overrun. For instance, we can make fun of the fidget spinner, but there was absolutely nothing we could do in our investments to stop the demand for it, nor to stop the supply. As a matter of fact, most of us did not even succeed in preventing our own children from acquiring one. Who better than our own children to teach us to be humble? While this example may just concern a toy, the principle is not really different for other trends.
Our world is constantly evolving. And the inexhaustible source of energy behind this evolvement comes from all the people pursuing new ideas.
Respecting the force of people pursuing new ideas also lies at the basis of our view on price discovery. The stock price of a company like Apple should rise if the goods or services that it produces are in demand. And if they are not, it should not rise. In other words, demand is leading. It does not work in the opposite direction. The demand for goods and services of a company will not rise just because its stock price is rising. It could well be that we truly believe that it would be good if the demand for a specific good would rise, for instance because of environmental reasons, but we consider that an extremely poor argument for buying stocks of the company that produces that particular good. Only the expectation that the demand will in fact rise, for instance because of the same environmental reasons, would be a valid argument for buying the stock.
But then we still would not buy the stock. Because we do not invest in stocks in our trading program. We only trade futures on stock indices — of which that particular stock could be one of the components — and total return swaps on individual stocks. Just like with commodity futures, buying one of these instruments does not result in ownership of the underlying, in this case a stock. We solely take on the price risk of stocks.
And this brings us to what exactly an on-exchange futures transaction constitutes:
This is precisely what futures contracts are designed for. Market participants that are vulnerable to a potential fall in price of for instance a commodity, can get rid of (the largest part of) that price risk by selling futures on that commodity. If subsequently the price of the commodity indeed falls, they will find the resulting loss compensated in their futures account. Should the price rise, however, they will have to transfer the resulting gain to their futures account to cover the deficit which has arisen there. At the other side of the transaction can be participants that want to get rid of their vulnerability to a potential price rise, but also participants that are willing to take over the price risk. These participants will have to transfer money to (will receive money in) their futures account when the other side collects (pays). This way, buyers and sellers of futures contracts exchange their price risk.
And, more importantly, this is what a futures transaction is not:
The buyer of a futures contract does not transfer any capital to the seller. Buyers only transfer capital to their futures account, starting with an initial margin. And also sellers have to transfer capital to their futures account. In this respect, buying a futures contract is not an investment in (the business of) the seller. Nor is it an investment in the underlying. In the case of a transaction in a stock index future, for instance, the firms that are part of the index do not receive any investment. And regarding a transaction in corn or crude oil futures, no corn or oil producer receives any investment. Such producers can be among the participants that trade these futures, but also then, just like any other futures trader, they will have to transfer capital to their futures account. Transtrend does not invest in companies. Nor do we invest in commodities.
Above, we mentioned the “participants at the other side of the transaction”. That is technically not correct. Inherent to futures markets is that participants do not trade directly with each other. Of course, with all transactions there are buyers and sellers — these are the ones that transmit the bids and offers — but the moment a transaction is completed, the clearing house will act as the buyer for every seller and the seller for every buyer. In fact, the two participants in a transaction do not even know each other’s identity; they do not shake hands.
This immediately limits the scope of possibilities to achieve positive impact. When trading futures, we cannot choose with whom we want to trade. In essence, it could be anyone that has been allowed access to the exchange. Therefore, brave statements like “We do not trade with companies that use child labor, produce cluster bombs, or cut down rainforests.” cannot be made when trading futures. In our trading we strive to contribute to well-functioning markets, among others by participating in the price discovery process and by offering liquidity. We realize that these are ‘common goods’. The entire market — consisting of ‘good actors’ and ‘bad actors’ — benefits from this, just as society as a whole — consisting of ‘good citizens’ and ‘bad citizens’ — benefits from clean air, safety and freedom.
When we for instance buy live cattle futures, we have no control over the cattle. We have no way of interfering with how the animals are stabled, how they are fed, etc. This total lack of control partly follows from the previous point. A bank granting a loan to a farmer or an insurance company insuring the farmer’s stable against fire can impose certain requirements on the farmer as part of the deal. But when we buy futures, we do not know which farmers are taking care of the cattle, so we are unable to negotiate with them any potentially relevant terms. We can only interact with the participant that technically sold us the contract, i.e., the futures exchange.
This holds for all positions in futures contracts. Even though in the case of stock and bond futures we do know the issuer of the underlying, holding these futures does not establish any connection to these issuers either. For instance, being long futures or swaps on stocks does not give us access to any shareholder meetings. Bearing the price risk of a stock does not make us a stakeholder in the firm. Which essentially is a good thing. Firms already have enough other stakeholders to talk with. Futures traders fulfill other roles.
Let us return to the cattle example. If the cattle gets sick, for instance because they were maltreated, this is the responsibility of the farmer, not of the investor holding a long position in cattle futures. Comparably, if the herd breaks loose and causes a lot of damage, or when an overload of cattle manure pollutes the environment, it is again the responsibility of the farmer. We consider this basic principle an immediate consequence of the previous point. We believe issues can run completely out of control when responsibility for these issues rests not in the hands of those who are (supposed to be) in control of the matter.
This important principle deserves to be highlighted in discussions about the calculation of the carbon footprint of investment portfolios. Should derivatives such as futures contracts be included in the calculation? Or, to be more precise, should the carbon footprint of an underlying be duplicated into — or perhaps even transferred to — the carbon footprint of a position in a derivative on this underlying? We strongly advise against that. We understand the potential advantages. Including derivatives in the calculation is a very efficient way to make the ESG market much larger, which makes it easier for more investors and investment managers to tap into it. And above all, it provides a large variety of service providers ample opportunity to expand their services. But if the purpose of the exercise is not to create an as large as possible ESG market but the goal instead is to help reduce carbon emissions to put a brake on further global warming, positions in derivatives should not be included in the calculation of the carbon footprint of investment portfolios. The preservation of the link between responsibility and control is our main argument. The only ones that can reduce the carbon footprint of a firm are the ones in control of that firm, which includes the shareholders invited to the shareholder meetings. The more this responsibility is shared with other people, or even worse, transferred to other people, the less likely it is that appropriate measures will be taken.
We realize that this ‘futures positions carry no responsibility’ argument can be perceived as an easy way out. It is not our responsibility! But that is absolutely not what we are advocating. We just want to state that the only responsibility that results from having a position in a futures contract — as long as we do not hold it until delivery — is the responsibility to deposit sufficient margin when the position goes against us. In essence, this is what bearing price risk ultimately boils down to. Besides that, we have many other responsibilities. But for the most part, these do not directly result from the positions we have, but rather from the actions we take, including our trading activity. Contributing to price discovery and offering liquidity are two examples of such responsibilities. But we also have other means to contribute to well-functioning markets. This includes engagement, albeit not as a shareholder aimed at the management of listed companies, but as an experienced and passionate investment manager primarily aimed at decision makers and other relevant practitioners in the financial industry.
Our responsibilities for the most part do not directly result from the positions we have, but rather from the actions we take, including our trading activity.
Above, we clarified our stance on trading various agricultural futures. Another current thorny issue is investing in fossil fuels and associated companies. There is a growing number of above all private investors — including those whose pensions are managed by pension fund managers — that prefer to invest fossil-free. While we understand this desire, we do not believe that making large scale fossil-free investments is currently possible. Our society is still highly dependent on fossils. Petroleum, for instance, is an important raw material for producing popular products like plastic and other synthetics, as well as petrol and kerosene. The use of fossil energy may have partly been replaced by the use of energy from sustainable sources such as wind and solar energy, but a lot of fossil fuels had to be burned for the manufacturing and installation of all the required wind turbines and solar panels. Not even Greta Thunberg can perform all her activities without the use of fossil fuels! Firms and investment managers might compensate for their use of fossil fuels, but that does not fundamentally change their dependency.
However, underlying this demand for fossil-free investments lies a strong force of people that endeavor to reduce our society’s dependence on fossil fuels and — driving this goal — want to reduce the emission of carbon and other greenhouse gasses. We embrace this trend, and we most definitely want to participate in it. The question here is: What would be effective ways to do so? We do not believe that reducing the ‘carbon footprint’ of an investment portfolio by selling (existing) stocks of high-pollution firms and buying those of low-pollution firms really contributes. In essence, this only changes the (potential) composition of the shareholder meetings of these firms. The voting rights of the stocks of the more polluting firms will move towards owners that care less about pollution. We do not expect that this will drive these firms to reduce their pollution. And, if instead of the actual stocks, only futures and other derivatives on these stocks change hands, no one in the board room will notice any change. We do not shake up companies by trading derivatives.
But that does not prevent us from participating in such an important and far-reaching project as the energy transition — a transition that has a huge impact on many markets, not only those in the energy sector. For instance, large shifts in the sources of energy used, induce large changes in the demand for various metals. Such changes constitute a major source of risk for many parties involved. For the parties that have to adapt their consumption patterns as well as for the parties that have to adapt their production process. For the producers of goods that will likely meet strongly growing demand as well as for the producers of the goods that likely will meet diminishing demand but that our society cannot yet do without. To keep the momentum of this transition going, someone has to carry these risks. This is foremost the role of investors. Futures contracts are extremely efficient instruments for transferring these risks. Therefore, if we want to participate in this transition in a meaningful way, if we want to fulfill our fundamental role as an investor, we have to trade the futures contracts that are directly or indirectly linked to this transition. That all starts with inclusion, not with exclusion.
If we want to participate in the energy transition in a meaningful way, if we want to fulfill our fundamental role as an investor, we have to trade the futures contracts that are directly or indirectly linked to this transition. That all starts with inclusion, not with exclusion.
By trading futures contracts we do not only carry price risk, but we also offer liquidity and contribute to price discovery. More generally, we contribute to the well-functioning of these markets. Which actually seems to be a reason for some investors to exclude some of these futures contracts. They do not want to contribute to the well-functioning of for instance the “dirty” coal market. The implicit assumption here is that a well-functioning market favors the polluting entities. But is this really the case? Just ask yourself which participants typically benefit the most from impaired markets. These are the participants that are best positioned to control the market. In the case of coal, these are the producers. If the coal market does not function well while our society cannot yet do without coal, the position of coal producers becomes somewhat comparable to that of drug dealers — their profit margins would be huge. We rather prefer that all legal, legitimate markets function well. Which among others is a necessary condition for environmental costs to be priced in properly. We certainly think there is room for improvement here. But we will not make an effective contribution if we exclude these markets.