Banker’s Paradise: Two Easy Ways To Fool Investors

it keeps playing out over and over

A couple of years back, Consultants and Financial Advisors across the EU and UK hit the road hard, pushing Sustainable Equity Index investing on clients.

Their pitch? Transforming the planet while beating market benchmarks.

Did all financial advisors mislead their clients? I don’t think so. Some probably fooled themselves and didn’t understand asset valuation theory in the first place.

Last week Kenneth French – one of the most influential figures in the world of finance – explained what even some financial professionals get wrong.


  • Investors struggle to understand returns. First, many don’t grasp how today’s higher prices may reduce tomorrow’s returns. Investors love chasing trends. Then, they have a blind spot for risk. Investors want cold, hard cash, not abstract concepts like risk-adjusted returns.
  • A combination of both of these issues creates a perfect cocktail to sell products to investors. Are advisors misleading clients? While advisors may not always do so consciously, because academic theory is subtle, their advice is often wrong nevertheless.
  • Why should you care? Because some parts of this story keeps playing out, over and over, in different ways—like in Tech, Value, or Thematic Investing today.
  • How exactly is this playing out? ESG is a perfect example. Because investors confuse realised with expected returns, the underperformance of ESG Equity Index Investing was predictable. We did so a couple of years ago, based on academic research. Which research? Papers like those by Kenneth French, which rarely receive attention.

Here is the full analysis

So what are the two abstract concepts that play with investors’ minds? Expected returns are not realised returns. And what matters are risk-adjusted returns, not absolute returns.

If you talked to any European consultant two or three years ago, they would tell you, you can do well by doing good. That was the mantra.

Fool me once.


Confusing expected with realised returns

Unlike cycling where you can exercise and explore the world at the same time, there is no magic in finance. 

You can either have higher prices today, or higher returns tomorrow. Not both. It works for Bonds, most investors get it. 

But for Stocks? That’s usually more surprising to investors. They chase trends. After all, isn’t history the best predictor of future returns? This logic can be a receipt for disaster. Expected returns are not the same as realised returns.

As you look back at all these papers, you obviously have the most famous ones. Everyone loves to talk about the factor papers. Are there any that either you have written or you could even say that in your mind currently that you feel like didn’t get enough interest? You’re like, oh man, this is just a killer paper, or this is something that I was working on that the rest of the world is just like, ah, not as interesting.

nobody reads this

In an excellent recent podcast, Meb Faber asked Kenneth French, renowned for his research, including the Fama-French Three-Factor Model — a cornerstone that contributed to Fama’s Nobel Prize — about his most underrated work:

One paper I really like is a paper I did with Gene Fama published in 2005. It’s called Disagreements, Tastes and Asset Pricing. And there’s nothing in there that any of my colleagues would find controversial these days, particularly insightful. But so much of the world is so confused about ESG investing, environmental, sustainable, governance investing. It thinks somehow or other that if they tilt their portfolio towards sustainability, for example, by tilting their portfolio, they’re going to increase their expected return because other people are also tilting their portfolio. They have the sign exactly wrong.

The result? Guaranteed underperformance!

French pointed to his 2005 paper, that hardly anyone pays attention to. Its conclusions can be applied to what happened 15 years later related to Sustainable Investing.

When we wrote a couple of years ago a guide claiming that investors will lock-in a future underperformance by investing in ESG Stocks, most of the financial industry was busy pitching planet impact combined with higher expected returns. 

In our guide, we pointed to the exact same 2005 paper, which French also explains in his own words in the recent podcast: 

“The whole point is, imagine 60% of investors decide they want more than their pro rata share of sustainable companies. Where did they get them from? The only way they can get more than their fair share is to buy them from the other 40%. What do they do when that 60% tries to buy shares from the 40% that have to sell them in order for the 60% to be happy? They must bid up the prices”

He then sums up the confusion between realised and expected returns:

“Now people get confused because while they’re pushing the price up, the realized return is going to be higher. It’s just we’re pushing prices so we get a higher realized return, but that doesn’t tell me then I should expect higher future returns. It tells me the exact opposite.”

The world is so confused about this type of investing.

But A golden retriever wouldn't be fooled

Imagine two identical bones: one in plain packaging and the other in attractive packaging. The Golden Retriever doesn’t care about the difference, but the owner feels better purchasing the fancier package, believing it’s the best for their dog.

What’s better than dog food packaging? The Asset Management industry’s marketing.

Some stocks come with appealing benefits, like promoting environmental or social good, which makes them more desirable. Investors are drawn to these ‘feel-good’ stocks and often pay more for them. Just like with the bones’ taste, these perks don’t affect the companies’ cash flows. Such stocks trade at a premium to earnings, resulting in a higher P/E ratio and lower expected returns. 

The opposite is true for Tobacco. There is less taste for it, so it trades at a lower P/E and ensures higher expected returns. Don’t believe me? Check which stocks were the best performers over the past 100 years!

Full Episode: Professor Kenneth French On Meb Faber Show

Listen in your player:

Listen to the entire episode with French, including other excellent insights. One of them relates to active performance.

But before you listen, write down how many years of data you need to say that a Hedge Fund manager actually has skill, rather than luck to attribute his outperformance to his talent and justify the costs/expenses and fees?

fool me twice.

Unleashing the nuclear weapon.

How to fool sophisticated investors: risk-adjusted returns

Most investors will get fooled by seeing higher realised returns. That will do the trick. After all, Investors want cold, hard cash, not abstract concepts like risk-adjusted returns.

But the podcast doesn’t go into the second way investors get fooled. More sophisticated investors will sniff out that this whole thing jacks up P/Es, so they stay alert.

In those cases, the advisors unleash the nuclear weapon: better Risk-adjusted Returns. How does it play out for ESG?

The advisor pitch goes like this: Yes, you buy at higher P/Es but that’s because risk is lower. In layman terms, you get more bang for your buck. Easy enough to sell, because it makes perfect intuitive sense. ESG companies should be better protected, right?

Why is it a nuclear weapon? It’s hard to verify, and you need a solid financial background to understand it. It’s much easier to brag about beating the non-ESG version of the ETF or the S&P 500. 

It sounds impressive. But does it actually prove anything? 

Something neither the investor (nor the advisor) can verify.

No. Because you removed some stocks from the non-ESG Index. These filters changed the ESG Fund factor exposure.

Ideally you’d want to regress the ESG fund performance on common factors to make sure it actually outperforms on a risk-adjusted basis. This is why professional portfolio managers pay attention to risk factors. Their risk departments would you run this performance on software like RiskMetrics/Barra, BlackRock’s Aladdin or Charles River.

But most advisors aren’t able to or/and won’t do it. Worse, they might have even been fooled by ESG product sellers themselves. It’s a bit of a banker’s – the product seller’s – paradise. 

But, as you can imagine some researchers did the work. What is the result? ESG funds repackaged the same old risk factors we knew for decades. As we summarised, it resulted in no additional risk factor, no alpha, and higher fees. The cherry on the cake? The ESG ratings didn’t protect the planet either.

But guess what? These papers – similar to Fama and French’s 2005 paper – are hardly ever read.

The Geeky Section 🤓

Technical Note: The underperformance mentioned previously can be attributed to a combination of things. Firstly, the valuations of ESG stocks are inflated due to a heightened investor preference (or taste) for sustainability. Secondly, this inflationary effect is not observed in non-ESG stocks, even though they share similar risk factors. Consequently, on a risk-adjusted basis, ESG stocks are predisposed to underperform.

Fool Me Once, Shame on the banker, Foll me twice...

Why should you care?

It applies to value & tech investing

So, now you know. Fool Me Once, Shame on the Banker; Fool Me Twice, Shame on the Investor. 

The tricky part is understanding the nuclear weapon: Risk-adjusted returns. Our next article will explain the concept even better, through a story.

You will understand what a lot of Value and Growth investors are getting wrong. And who can be your best friend 🐶.

In the meantime, we republished 3 potential strategies for investors that can actually may make the world a better place.

Thank you for reading.
Good Luck and Keep’em* Rolling!

(* Wheels & Dividends)



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