I have always believed the message coming out of the ESG community was slightly confused. If I had to reduce it to its bare basics it goes something like this. Sustainable investing is one bit doing good, and one bit reducing downside risk, all without any obvious hit to performance. Obviously, the mix of these three factors depends on who you talk to, but doing good, reducing risk and not too much tracking error sounds like the holy trinity of investing. What’s not to like?
Back in the real world many of us have our suspicions. Let’s take the tracking error notion first. Many analysts such as Beyond Beta’s very own contributor Nicholas Rabener has crunched the numbers and remain unconvinced about the tracking point. Again, at the risk of over simplifying, one core observation is that the numerous ESG strategies have benefitted from a one-off boost because they avoided underperforming, value stocks such as energy businesses.
Many ESG strategies, by contrast, have tended to favour either businesses with a tech bias or quality factor style skew. Both of these tilts might change rapidly in the future and ESG screens could serially underperform.
The doing good in a sustainable way can also sound confusing because it conflates very different debates about those businesses with an admirably long-term bias towards sales and earnings growth against those businesses that are very self-consciously trying to achieve an impact-based ethical outcome. Put simply one can believe that the likes of Diageo or Unilever are highly sustainable businesses (and quality stocks) without doubting for one moment that they are above all profit maximisation machines.
For me the least confusing notion in my holy trinity is that of risk reduction, especially in the world of climate change mitigation and impact. Here the argument for ESG screening seems powerful and difficult to argue with especially for fixed income investors. And that’s the crucial twist.
Most ESG strategies have been built on equity-based strategies and to date, ESG fixed income investing is a pale shadow of its equity sibling. But it deserves to be much systemically important. Put simply at its core fixed income investing doesn’t care much about achieving some kind of alpha, rather the trick is making sure you get your principal original investment back in full plus those promised income streams. What should worry the fixed income investor is any scenario in which those, frequently long term, income streams might be impaired. And by any measure, climate change represents a real and tangible threat to some corporates future cash flows.
Impact on future cash flows
Crucially it is also increasingly easy to crunch the numbers that might give us some understanding of the impact on future cash flows. Take for instance the MSCI’s GMI database which now features due diligence data on over 90 governance factors across board, pay, ownership and control, and accounting activities.
Inside that database is the MSCI Intangible Value Assessment (IVA) rating buckets for the Bloomberg Barclays Euro Credit Aggregate universe. Dig around inside this treasure trove of information and one can already see that higher rated IVA issuers trade at tighter spreads than lower rated issuers. In effect, IVA ratings seem behaving like credit ratings. These data sets also easily allow bond investors to see credit risk deterioration across issuers – especially visible in sectors such as US unconventional oil and gas.
But lurking behind this increasing mountain of data we can also glimpse a more brutal, fundamental reality. Climate change presents real policy risks and opportunities which could impact those FI cashflows. Let me give one very real example.
In the summer of 2019, I attended the annual Amundi global investment forum which featured many speeches by the great and good, headlined by John Kerry, ex-secretary of state in the Obama administration. One fascinating panel featured the governor of the French central bank who said that institutions such as his might not look too favourably in the future on climate change impaired collateral in the event of a crisis.
So, if you are an investment bank with lots of energy sector loans impairing like crazy, you might start to think twice about offering those bonds up as collateral for any wholesale lending lines in the event of a future economic crisis. In the real world, that represents extra risk for the bank which must be reflected in the cost of debt, which must surely rise as the risk is articulated and measured.
In my humble view, ESG screening makes sense for any fixed income investor who cares about future cash flows. But what of the past? Has an ESG based strategy delivered any meaningful performance numbers for fixed income investors? Going back to our alpha point in the holy trinity, would a bond investor be ahead of their peers if they had have adopted ESG screens? The answer is yes according to a recent study looking at returns since 2014 by analysts at Amundi again.
They summarise their findings: “Since 2014, the integration of ESG has created alpha in euro-denominated fixed income portfolios. Indeed, for euro-denominated investment grade (“IG”) bonds portfolio, the annual excess credit return of long/ short strategy between best-in-class bonds (20% best-rated according to ESG scores) and worst-in class bonds (20% worst-rated according to ESG scores) bonds reaches 37 basis points.”
Curiously though this positive conclusion does not hold true for American markets where the results are more “disappointing in absolute value, but the correlation between ESG and performance is positive”, according to the Amundi report.
“Indeed, ESG investing was a source of underperformance from 2010 to 2019 if we consider both long/short, best-in-class versus worst-in-class strategies and benchmark-controlled optimised portfolios.
“Nevertheless, we noticed that the large underperformance during the 2010-2013 period has decreased significantly in the more recent period. The annual cost of ESG investing is 9 bps per year for benchmarked strategy since 2014 versus 24 bps from 2010 to 2013.”
Maybe the relatively restrained pace of policy initiatives, especially with the Trump administration, is imposing less of a policy drag on US investments.
The benefits of ESG analysis
These slightly disappointing stateside numbers shouldn’t blind investors though to an increasingly obvious reality – even huge US bond investing institutions are beginning to build ESG analysis into their credit risk analysis.
In a 2018 paper, PIMCO’s Gavin Power points to what he calls straws in the wind such as their “early analysis of corruption allegations against South Africa’s president in 2015 [which] resulted in an active call to reduce exposure to the country”.
According to Power, there is now a “growing body of evidence demonstrating, for example, that companies that effectively manage and integrate sustainability issues realise a range of competitive benefits – including resource and cost efficiencies, productivity gains, new revenue and product opportunities, and reputation benefits”.
So maybe that holy trinity of doing the right thing, avoiding risk and avoiding too much tracking error is not an impossible ask after all?
David Stevenson is a columnist at the Financial Times and editor-in-chief at ETF Stream
This article first appeared in the Q1 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy, click here.