In preparing for an energy panel, including the work of the energy transition and resource sustainability, capital markets once again come to the fore. After profiling some research about mutual fund underperformance, I started to think about the capital efficiency required of this energy transition. Many billions have been or will be wasted, which is why a combination of private firms and public firms in the vast energy space are important. The U.S. market is the pietri dish for this, a type of checks and balances, outside of politics and policy where these specific checks and balances are more of a swinging pendulum.
As a country deep into the activities of the energy transition (and it’s always in flux), I ask thought leaders about their boots-on-the-ground activities. One such private market player, with both renewables and fossil fuels experience, noted that wind energy can be cheaper [than fossil fuels] but there are reliability and capital inefficiencies that are derived from transmission issues and intermittency. Pitfalls exist and externalities are yet to be fully studied. He calculated a capital inefficiency of 40%: we’re using 100% of investment dollars but achieving 40% capital efficiency. In the book “Scale,” Dr. West writes that 1/3 of global energy is wasted, based on data from 1980 which shows a doubling of annual world energy consumption (p 235). That doesn’t even consider the cost of entropy, the losses resulting from externalities like pollution, low-grade heat, and other forms of environmental damage.
Circling back to capital flows, the mean reversion implied in the research cited above follows some of the dynamics inherent in ideas presented in the book as well, I think. A few findings:
Nevertheless, less than half, or 45.2%, of individual funds outperform the SPY in the long run —even in a comparison of mutual fund returns, before fees, to SPY returns that are net of fees. In the study, the authors use SPY as an alternative investment opportunity, or the benchmark, when computing wealth creation and loss.
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Zhang further clarifies a key point of the research. “You may think that investing in a mutual fund is a good deal, but the numbers are misleading,” he says. The 394% return before fees appears decent on the surface, but “the returns are skewed over the long term: the median fund’s buy-and-hold returns before fees are only 115%,” Zhang explains. He discussed how the skewness should be near zero if the distribution is normal, but it is not normal. That 394% average over the long term is driven by a small fraction of funds, which is what is meant by “the skewness.” Zhang surmises: It means that the 394% average of buy-and-hold returns is largely driven by outliers. And can you correctly pick those outliers?”
Basically, my leap of thinking is that, yes, there are outliers and we recognize them in action and often in hindsight. There are outlier mutual funds, those that outperform the benchmark of SPY, and outlier firms that endure “the benchmark life” or average, of firms as cited in the book “Scale.” The “law” of averages suggests that the SPY, “the market’s” growth is displaying a sort of relative superlinearity phenomenon (115%) as noted in the book, the extra 15%. Superlinearity occurs in the socio-economic realm and financial markets are just that, a mix of fundamental macroeconomics with the financial behavioral factors. (The four factor of approximately 400% is curious, possibly some universal identified in the book? That’s a mathematical leap for another day.) There’s a lot to unpack related to these numbers.
Returning to the energy challenge, as I make inferences, poorly or with potential, is that both wind and solar will need to become a better partner to existing energy mix incumbents or become a better outlier. That is, complementing existing approaches to be a longer-lived player in the energy mix of the present and/or benefiting from a leapfrog in technology that changes the future. Innovation will be required—human ingenuity, effort and capital resources.
We know the issues being raised about fossil fuel production and the effect of carbon emissions warming the planet. Many leading fossil fuel producers are trying to clean up and deliver lower-carbon energy. Renewables players are in the nascent stages of their challenges in being an energy mix stalwart. Truly conscious capital will find a way, and many entrepreneurs are seeking to advance these challenges. Our constraints are the need for innovation to propel us fast enough to match the effects of entropy inherent in energy sources and systems. Since the sustained speed of innovation is questionable, and the load heavy on the Earth’s natural capital, one glaringly obvious path seems to be that of becoming more efficient with what we have, both capital and natural resources— because time may not be on our side. The pandemic sort of bent time for many and revealed lessons of our fragile place in the Earth’s food chain.
(My Seattle post is a bit more upbeat.)