My latest Money Week column is all about the remorseless rise of ESG investing. The section below I think nicely sums up the convincing narrative about why ESG funds have had a good crisis.
“According to SG’s own ETF analysts “ ESG was the only equity strategy showing positive flows in the market downturn in March and sustained positive flows in April”. Not surprisingly one of BlackRock’s key bosses(P. Hildebrand, BlackRock’s Vice-Chairman) revealed at a JP Morgan conference that since the beginning of the Covid crisis, this one firm had raised a staggering £2.5bn in extra funds for their sustainable ETFs. Arguably though the best summary of what big fund managers really think comes from Anne Richards, the CEO of mega fund manager Fidelity. She found that the price of a share in companies with a “high (A or B) Fidelity International sustainability rating dropped on average less than the S&P 500 from its 19 February peak to 26 March while those rated C to E fell more, on an unadjusted basis. On average, among the 2,689 companies rated, each ESG rating level was worth an additional 2.8 percentage points of stock performance versus the index during that period of volatility. “
These startling numbers find and echo in news out today from DWS that amongst pension based investors “65% intend to increase their climate-linked passive allocations over the next three years.” These are the results of a DWS-sponsored survey by consultants CREATE-Research. The study covered over 131 pension plans in 20 jurisdictions with a combined AUM of around EUR 2.25 trillion.
The study shows climate-linked investment has become embedded in passive asset allocation: 26% of plans said they commit over 15% of their passive funds to the segment. However, just over half (56%) still have no allocation at all as part of their passive investments, and 60% say they are constrained by data and definitional problems. “A full 70% of plans examine capacity and track record to fulfil a ‘green’ agenda when choosing an asset manager for climate-related investments.”
The devil of course is in the detail with ESG funds. What’s inside the ESG index? Where does the data come from? How are weightings built within the fund or the index? Will recent outperformance prove persistent or just a temporary fluke helped by abysmal returns form energy stocks?
Erosion vs Event risk : a useful distinction
Slowly but surely, we are seeing more detail emerge in the public domain about these important debates, and credit must go to MSCI analysts who are spending an inordinate amount of time explaining what goes on inside their ESG black box. Their latest research note is worth spending a bit time on – you can download it HERE at https://www.msci.com/esg/deconstructing-esg-performance
This analysis contains what I think is an important distinction between “event” risks and “erosion” risks to companies’ long-term competitiveness. This seems to be a useful distinction as it’s clear that many companies, especially in the industrials and energy space, are now much more vulnerable to this latter erosion risk spaced out over a long-time frame. The key insight is this – Erosion-driven ESG issues grab fewer headlines than the more abrupt and sometimes dramatic event-driven issues but they are no less risky for being slow moving.
The MSCI analysts attempt to separate out these two different types of risk by looking at different ‘transmission’ channels around 11 key ‘issues’ common to most ESG ratings systems. These transmission channels are:
- The cash-flow channel, whereby companies better at managing intangible capital (such as employees) may have been more competitive and hence more profitable over time
- Idiosyncratic risk, whereby companies with stronger risk management practices may have experienced fewer incidents that triggered unanticipated costs, such as accidents
- Systematic risk, whereby companies that used resources more efficiently may have been less susceptible to market shocks such as fluctuations in energy price
According to the MSCI report “the idiosyncratic-risk channel showed the most significant results across the 11 Key Issues tested. Furthermore, the Key Issues categorized under the Governance pillar showed, on average, the most significant results of all three channels. Companies with strong corporate governance had significantly better profitability, lower stock-specific risk and lower systemic risk than low-scoring companies across the Governance Key Issues, during the seven-year study period between December 2012 and December 2019. “ [ my emphasis added ]
There’s a lot of variables circling around this finding but for me there’s one crucial observation – investors need to look at the E, the S and the G. Separating these factors out can be counterproductive. Let me simply explain. My sense is that a business with poor corporate governance stands a much higher chance of developing poor social policies – especially to its workforce – and sets itself up for E based risks as well.
In particular a strong governance culture is likely to take much more notice of erosion based risks. Thus the MSCI analysts find that looking at environmental issues (carbon emissions, water stress and toxic emissions) the risk to most corporates comes from erosion. Their analysis “showed positive long-term differences between the top- and bottom-scoring companies. However, both top- and bottom-scoring companies showed negligible differences in propensity to event risks.”
Looking at the social pillar the focus is, rightly in my view, on differences in labor management (e.g., mitigating labor conflicts) showing strong event- and erosion-risk characteristics. “In fact, top-scoring companies on labor management not only outperformed bottom-scoring companies by an average of 3% per year, but also showed significant reductions in event risks — i.e., the top-scoring companies experienced severe stock-price losses only one-fifth as frequently as the low scorers.” This is I think a crucial finding and one with profound long term implications – treat your staff, and their unions fairly, and you stand a better chance of boosting stock performance. Looking at governance based issues, the MSCI analysts found “bottom-scoring companies on business ethics were approximately four times more likely than top-scoring companies to experience a severe stock-price loss during this period, while the bottom-scoring companies on corruption were only about 1-1/2 times more likely than the top-scoring companies to do so. In contrast, corporate governance — and especially the corruption Key Issue — showed positive long-term differences, with stronger erosion-risk characteristics and less event-driven risk differentiation. “
It’s worth dwelling one this one key observation for those running money – “ while Environmental Key Issues such as carbon emissions were purely erosion-driven (i.e., they unfolded continuously over time), Key Issues in the Social pillar were more balanced; some, such as labor management, showed both strong event-driven and erosion-driven performance characteristics. Governance-related Key Issues ran the gamut: All four Key Issues categorized under Governance showed event- and erosion-driven performance characteristics, with the highest share of event risks among the three pillars. The Governance Key Issues’ event-risk characteristics help explain why Governance as a whole has consistently shown the strongest significance for stock-price risks over shorter periods of time.” [my emphasis added]
One last key observation – long term investors might be well placed to focus their attention on “long-term erosion risks in their choice of ESG criteria and ESG integration and may aim to mitigate event risks through diversification. “
The War on people
One final note on ESG. Quite the smartest paper in recent weeks on ESG investing comes from Vincent Deluard’s, Global Macro Strategist at INTL FCStone (NASDAQ: INTL). His June research note entitled “A Smart Factor To Win The War On People”, suggests that ETF providers have missed the single best “smart beta” idea of 2020: long intangible assets / short workers.
What’s the best factor of 2020 according to Delard: “a high market value of intangible assets per worker? This metric elegantly captures the momentum effect, the premium for tech platforms, and the demise of humans.” The chart below nicely sums up this finding:
“Furthermore, this performance has been extremely consistent across all deciles, which is a great sign: robust factors should work across the entire spectrum, rather than get lucky to pick up a handful of stocks with exceptional performance.
Bloomberg’s data on firms’ employee count is unfortunately too patchy to generate reliable backtests, but I am convinced that this factor would have easily trumped the main anomalies which academics have “discovered” this past decade. If I could create one smart beta ETF, it would be this one”.