A consistently sustainable approach to investment decisions is the best response to the challenges posed by the current global economic and political crises, according to a leading investment expert.

“We are living in challenging times, characterised by fundamental social, economic and political experiments,” said Burkhard P. Varnholt, chief investment officer of Bank Sarasin & Co, in the current edition of "Perspectives", a special report released by the bank.

Varnholt examines three specific challenges in the report: the dynamic growth of private and sovereign debt, unprecedented worldwide demographic changes and hidden deficits in Western social insurance programs.

The expert warned that index-tracking investments or buy-and-hold strategies could turn out to be the wrong approaches to asset management in the decade ahead.

"This is because on the one hand many stock indices do not yet incorporate crucial sustainability analysis, and because in such a dynamic world as ours it is simply irrational to entrust strategic asset allocation decisions to the "cruise control" technique of a buy-and-hold approach," he said.

According to him, the Western debt crisis illustrates one of the glaring weaknesses of democracies: democratically elected politicians tend to make (overly) expensive campaign promises.

"So it cannot come as a surprise that most of the OECD countries have not posted balanced public sector budgets since the early 1970s. There is a danger that the politics of expediency will steer clear of a sustainable financial policy while trying to buy time and social harmony through an expansionary monetary or fiscal policy," he stated.

That would be a bad and irresponsible policy for all citizens and creditors. There are several debt crises that have been successfully overcome, he pointed out.

Examples include the resolution of the Latin American debt crisis at the start of the 1980s, the resolution of the international banking crisis in the late 1980s, the resolution of the US savings & loan crisis, the resolution of the Scandinavian debt and banking crisis, and the resolution of the Asian debt crisis.

Explaining the remedy for the problem, Varnholt said the first step for investors should be to systematically evaluate all of their assets to determine whether they are directly or indirectly exposed to sustainability risks of an economic, social or environmental nature.

This rigorous analysis forms the centrepiece of modern sustainable asset management, he added.

"Second, the question of what is the ultimate "safe" asset needs to be radically re-examined. To date, government bonds have been considered an absolutely safe haven. But in the absence of an undisputed safe asset class, modern portfolio theory does not work," he noted.

"And third, index-tracking investments or buy-and-hold strategies could turn out to be the wrong approaches to asset management in the decade ahead. This is because on the one hand many stock indices do not yet incorporate crucial sustainability analysis, and also because in such a dynamic world as ours it is simply irrational to entrust strategic asset allocation decisions to the "cruise control" technique of a buy-and-hold approach," he explained.

"What remains is the compelling realisation that we need to safeguard the sustainability of the assets that we manage. That is the very least that future generations should be able to expect from today's asset managers, he added.

Biggest threat to prosperity

With the media preoccupied by the European debt crisis, the looming threat presented by demographic change is being pushed into the background. But there is in fact a close correlation between prosperity and demographic trends, remarked Varnholt.

"Our human capital creates wealth, and our wealth influences our willingness to reproduce. However, birth rates in a growing number of countries have dropped below the population replacement level of 2.1 children per female, while life expectancy has increased," he stated.

Social security systems, he said, were a cause of people having fewer children. Improved healthcare systems are the primary cause of longer life expectancy. Wherever the state has provided these, birth rates have fallen.

Coupled with longer life expectancy, this trend creates a generational conflict that is difficult to defuse. In a nutshell, our cherished life plan of early retirement at the age of 58 or 60, a life expectancy of 80 or 90 years, abstention from reproduction, and collecting government-funded social security payments cannot work out in the long run.

Stealth drivers of debt

In addition to worrying demographic trends, the high explicit public debt burdens in the OECD countries will be compounded in future by implicit government liabilities that will arise from underfunded social entitlements, systemic miscalculations and demographic changes.

This problem will bear down on these countries with increasing speed in the coming years for three reasons. First, rising old-age dependency ratios are overstraining the income redistribution systems currently in place.

Second, most social insurance institutions are overestimating their asset positions by making overly optimistic assumptions about expected future interest income and capital gains.

And third, the mathematical capacity to absorb risk has shrivelled beyond recognition for the overwhelming majority of social insurance institutions.

Varnholt listed out his four wishes that would alleviate these challenges. These, he said, are by no means revolutionary ideas, but they should actually gain political consensus.

"The debt-brake mechanisms can operate successfully if they take precedence in the legal hierarchy. Switzerland benefits from an effective debt-brake mechanism because it already works at the municipal level and from there exerts a balancing effect on the Swiss Confederation's federal budget," Varnholt added.-TradeArabia News Service